July 30 (Bloomberg) -- A new U.S. regulatory regime being pushed by Representatives Barney Frank and Collin Peterson for the $592 trillion over-the-counter derivatives market leaves open for debate whether to ban so-called naked trading.

The legislative proposal, which would push most derivatives onto an exchange or clearinghouse, fails to resolve the issue of outlawing credit-default swaps where the buyer doesn’t own the underlying asset. A three-page summary of the plan also shows lawmakers haven’t agreed on disclosure rules and trading limits, or how to divide oversight between the Securities and Exchange Commission and the Commodity Futures Trading Commission.

“None of the remaining areas are deal breakers,” Frank, a Massachusetts Democrat and chairman of the House Financial Services Committee, said at a news conference in Washington today touting the plan. He said “we are very close,” and a bill may pass Congress by the end of the year.

At a minimum, hedge funds and other companies using credit- default swaps would have to report to regulators any short positions related to those contracts, according to the proposal. The bill, which may change as it works its way through committees and the House floor, includes most of what the Obama administration has been pitching to rein in the derivatives market, including clearinghouses and margin requirements.

“We clearly want to err on the side of too much regulation rather than too little, given what we’ve been through,” Peterson, a Minnesota Democrat and chairman of the House Agriculture Committee, said at the news conference.

Margin Requirements

President Barack Obama’s plan to regulate derivatives is part of a wider overhaul of financial industry rules meant to prevent any repeat of last year, when the collapse of Lehman Brothers Holdings Inc. and American International Group Inc. froze credit markets and worsened the recession.

Peterson and Frank would require standardized derivatives to be moved through clearinghouses and are seeking to also push most of the contracts onto regulated exchanges by imposing “significantly higher” capital and margin requirements for over-the-counter products. While customized derivatives and companies that aren’t “major market” players may be exempt from clearing, they would be subject to higher capital requirements.

Lawmakers don’t want to ban any particular derivatives products or “even severely diminish them” as a financial risk tool, Frank said. “The goal is to get as many as is practical into a clearinghouse” and to give incentives to move derivatives trading onto regulated exchanges, he said.

Bias Toward CFTC

The legislation will give the SEC and CFTC “full authority” to impose position limits and time outs,” Frank said. While the proposal sets up a Financial Services Oversight Council to resolve disputes, Frank and Peterson haven’t agreed yet on how to divide regulation between the SEC and CFTC.

“We on the Ag committee have a bias toward the CFTC; they’re more nimble,” Peterson said. “The SEC is very lawyer driven, they have a lot of lawyers, a lot of bureaucracy. You can get something out of the CFTC in six months where it might take 5 years at the SEC.”

Frank in a July 23 interview said that he understood how credit-default swaps do “perform a useful function” in the economy. There may be “alternatives to banning naked credit- default swaps” if most derivatives are moved to a regulated exchange, he said then.

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, Frank said in the interview, “then that may do it.”

Short Positions

Some lawmakers and regulators have said they are looking more closely into whether credit-default swaps were manipulated by short sellers to spread false rumors about financial companies such as Lehman last year to drive down stock prices.

Credit-default swaps are derivatives that were created primarily to protect lenders and bondholders from company defaults. A short position is an investment in which the trader tries to profit by betting a stock price will fall. Naked contracts or positions are those in which the buyer doesn’t own the underlying asset or stock on which the trading is based.

Peterson said there’s “a lot of interest” in Congress to place aggregate position limits on certain types of derivatives contracts to reduce abusive speculation that he says many believe have distorted prices for energy and commodities.

As much as 80 percent of the $26.4 trillion credit-default swap market is traded by investors who don’t own the underlying debt, according to Eric Dinallo, who stepped down this month as superintendent of the New York State Insurance Department.

Derivatives are contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather.

To contact the reporters on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Robert Schmidt in Washington at rschmidt5@bloomberg.net.

Last Updated: July 30, 2009 13:14 EDT