Oct. 8 (Bloomberg) -- Legislation by Representative Barney Frank to tighten derivatives regulation contains an exemption that may let most financial firms escape new collateral and disclosure rules, the head of the Commodity Futures Trading Commission said.

The provision is among several loopholes in the draft legislation, officials of the CFTC and Securities and Exchange Commission said in testimony yesterday before the House Financial Services Committee headed by Frank.

The Massachusetts Democrat said he would “sharpen” his plan, intended to rein in the $592 trillion over-the-counter derivatives market. The committee has scheduled votes on it beginning Oct. 14. Frank predicted the legislation would pass the House by November and be signed into law by December.

A plan offered by the Obama administration would subject all swaps dealers and “major market participants” to new regulations for capital, business conduct, record-keeping and reporting. Frank’s version would exempt corporations from that definition if they use derivatives for “risk management” purposes.

While Frank’s proposal is a “step in the right direction,” its “ambiguous” definition of risk management may leave a large number of corporations unregulated, Henry T.C. Hu, director of the SEC’s new division of risk, strategy and financial innovation, told the committee.

‘A Null Set’

“As just about all swaps could be defined as being used for risk management purposes, we’re concerned that unintentionally the category of ‘major swap participant’ could have been narrowed so significantly, or even to a null set,” CFTC Chairman Gary Gensler told reporters after the hearing.

“Major hedge funds” may be excluded from oversight, as may the mortgage-finance companies Fannie Mae and Freddie Mac “because of course the government-supported enterprises use swaps for risk management purposes,” Gensler said.

Frank should eliminate the “risk management” exclusion altogether, Gensler said.

“I agree it needs to be sharpened,” Frank said in a telephone interview yesterday. “I don’t think what he says is accurate, but my view is why take the chance? So we agree with him as to the concepts and we’ll make the language very clear.”

Gensler, who has previously asked Congress to strengthen, not weaken, the derivatives proposal the administration offered in August, also said Frank’s legislation shouldn’t let hedge funds or financial firms evade requirements that their derivatives contracts go through central clearinghouses.

Securities Industry

The Frank proposal has drawn praise from business groups including the National Association of Manufacturers and the Securities Industry and Financial Markets Association. James Hill, a Morgan Stanley managing director who testified on behalf of the association, said in his testimony that the draft bill “includes many significant improvements” over the administration’s proposal.

Derivatives are contracts corporations use to hedge against risks such as swings in stocks, currencies, commodities and interest rates. Critics say Frank’s plan would do too little to curb abuses of the instruments that helped speed the downfall of American International Group Inc. and exacerbate the credit crisis over the last 18 months.

“It is clearly the weakest of all the proposals I’ve seen to date,” said Christopher Whalen, managing director of Institutional Risk Analytics in Torrance, California, in an interview before the hearing. Whalen, who has testified before Congress on derivatives regulation, is an independent bank analyst. “Frank’s committee seems to be intent on gutting any meaningful reform.”

Easing Requirements

The draft would ease trading and clearing requirements for derivatives dealers such as Morgan Stanley and Goldman Sachs Group Inc., compared with the administration’s proposal.

The administration’s plan would force all standardized derivatives transactions to be executed on an exchange or processed through a regulated clearinghouse, which impose collateral and margin requirements on trades. Frank’s bill wouldn’t move as many trades to exchanges.

Representatives Judy Biggert, an Illinois Republican, and Mel Watt, a North Carolina Democrat, criticized the bill at the hearing for being too lax.

Watt said the measure “created a loophole that’s way, way, way too big for major swaps dealers and major swaps participants.” Biggert said the draft “has some troubling things in its current form.”

Trade Repository

Frank’s bill would permit so-called non-standard contracts to be reported to a trade repository, which wouldn’t require companies to post collateral, instead of being processed through a clearinghouse.

It also differs from Obama’s plan in allowing regulators to decide which transactions need to be cleared, instead of giving clearinghouses that power.

Frank’s measure would give Cargill Inc., John Deere Capital Corp., Apple Inc. and other so-called end-users -- companies that hedge operational risks with derivatives -- an exemption from many new collateral and disclosure requirements for over- the-counter derivatives contracts. Those are privately negotiated deals that aren’t traded on exchanges.

The draft was crafted in part to win support from the New Democrat Coalition, which describes itself as moderate and “pro-growth.” Representative Mike McMahon, a New York Democrat and a member of the group, led in negotiating changes to the bill to ease requirements he said could have hampered the industry.

“With derivatives, a lot of people think it’s about speculation, but it’s about good American companies hedging their risks so they can be vibrant and competitive in the world market,” McMahon said in a telephone interview.

Financial District

The lawmaker, who represents Staten Island and southwest Brooklyn in New York, said the changes will also help preserve jobs on Wall Street.

“There are 80,000 people in my district who get up every day and go to work by ferry or subway or bus to the Financial District,” he said. “I want to make sure their jobs aren’t lost or eliminated or sent overseas.”

To contact the reporters on this story: Tina Seeley in Washington at tseeley@bloomberg.net; Dawn Kopecki in Washington at dkopecki@bloomberg.com.

Last Updated: October 8, 2009 00:00 EDT