Oct. 21 (Bloomberg) -- Hedge funds and financial firms shouldn’t be allowed to sidestep potential new laws governing the $592 trillion over-the-counter derivatives market, Gary Gensler, chairman of the Commodity Futures Trading Commission said today in Chicago.

Any exemptions for so-called end-users should be “very narrowly defined” to include only nonfinancial institutions, Gensler said. End-users such as utilities, energy producers and agricultural companies have pushed for exemptions to new laws that would require standardized over-the-counter trades to go through exchanges or clearing houses.

“Some may accuse us of overreacting and overreaching,” Gensler told traders, brokers and exchange officials gathered at the Futures Industry Association’s Futures & Options Expo. “But the worst financial crisis in 80 years demands the most comprehensive regulatory reform in generations.”

Companies use derivatives to hedge exposure to changes in the price of commodities, currencies or interest rates. Gensler said companies concerned about having to post cash or other assets to back the trades should be allowed to work out flexible arrangements with the banks that they trade with.

Gensler has asked the U.S. Congress for the authority to restrict commodity speculation in the over-the-counter derivatives market, where loopholes allow traders to amass positions far larger than limits designed to keep one trader from gaining too much control.

House Bill

The House Financial Services Committee has approved legislation, introduced by Chairman Barney Frank, that may allow the commission to tighten some of those loopholes, extending its reach to over-the-counter trades and foreign contracts that are linked to U.S. futures. Gensler has said that he believes speculators were a factor in record-high commodity prices last year, when oil hit a peak of $147.27 on July 11, 2008.

CME Group Inc., the world’s largest futures market, told U.S. lawmakers and regulators that business is moving abroad because of potential trading limits under consideration by the commission.

Companies that offer derivatives investments, including Deutsche Bank AG, have shifted activity to markets outside the U.S. because of the proposed limits, Chicago-based CME said in a letter to Gensler dated yesterday and obtained by Bloomberg News.

Capital Flight

“The CFTC has created the impression in the market that it intends to impose a stringent position-limit regime,” CME Executive Chairman Terrence A. Duffy and Chief Executive Officer Craig Donohue wrote. “This impression, coupled with participants’ concerns about how much further the CFTC may go, has already influenced multiple funds to change their investment decisions, reducing their use of U.S. futures products.”

The U.S. Natural Gas Fund, the largest exchange-traded fund in the fuel, has shifted to bilateral swaps negotiated outside of the regulated exchanges, reducing its position on the New York Mercantile Exchange and Intercontinental Exchange Inc. because of current and potential limits.

Bart Chilton, a CFTC commissioner, said today in a speech in Houston that he favored “erring on the high side” with position limits “to avoid migration” to unregulated and foreign exchanges.

“I think at first we need to ensure we do no harm, yet establish a system to guard against excessive speculation,” Chilton said.

European Assistance

Gensler said in Chicago that the U.S. “is not alone in its push for comprehensive regulatory reform,” citing efforts announced yesterday by the European Commission for changes in derivatives regulation.

“It is encouraging that Europe and the United States are moving in the same direction regarding regulatory reform,” Gensler said. “Through a cooperative effort, we can best protect the global financial system,” Gensler said.

The battle over derivatives legislation is a test for the Obama administration’s efforts to tighten financial rules to prevent a repeat of the financial crisis that shook the global economy, a situation exacerbated by unregulated derivatives trading.

Opaque financial products, including some derivatives, have contributed to almost $1.6 trillion in writedowns and losses at the world’s biggest banks, brokers and insurers since the start of 2007, according to data compiled by Bloomberg. Among fallen companies are Lehman Brothers Holdings Inc., the investment bank that filed for bankruptcy, and insurer American International Group Inc., which has been surviving on government loans.

Bank Support

Obama administration advisers have said that U.S. banks bailed out with taxpayer money have a responsibility to support the president’s effort to overhaul rules regulating Wall Street. Their anger has been aimed even at companies such as New York- based JPMorgan Chase & Co. and Goldman Sachs Group Inc., which have paid back their government assistance.

Banks receiving aid are “literally going and fighting the very type of regulations and reforms” need to prevent a recurrence of the crisis, Chief of Staff Rahm Emanuel said on CNN’s “State of the Union” on Oct. 18.

Gensler testified that an early version of Frank’s bill might have allowed hedge funds or financial firms to evade requirements that their derivative contracts go through central clearinghouses. He also said the proposal was unclear on whether the regulator would have to determine on a case-by-case basis whether swaps would be subject to clearing.

Amendments to the bill took a “significant step” toward addressing those concerns, Gensler said last week. There are still “substantive challenges,” he said. The legislation was approved by the committee on Oct. 15. The House Agriculture Committee is marking up its own version of the bill today and the two will have to be reconciled.

To contact the reporters on this story: Asjylyn Loder in New York aloder@bloomberg.net. To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net.

Last Updated: October 21, 2009 11:43 EDT