Oct. 7 (Bloomberg) -- U.S. Representative Barney Frank’s proposed overhaul of derivatives regulation may leave gaps in oversight and unnecessary exemptions, the Commodity Futures Trading Commission and Securities and Exchange Commission said.

“Certain aspects of the discussion draft could unintentionally preserve existing regulatory gaps,” Henry T.C. Hu, director of the SEC’s new division of risk, strategy and financial innovation, said of legislation proposed Oct. 2 by House Financial Services Committee Chairman Frank. Hu made the comments at a hearing of Frank’s committee today.

The measure to regulate the $592 trillion over-the-counter derivatives market 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 executive who will testify on behalf of the association, said in his prepared remarks that the draft bill “includes many significant improvements” over an Obama administration proposal.

Frank, a Massachusetts Democrat, agreed with some of the criticisms of his bill and said he was planning to “tighten up” the measure.

“There are some areas here where there are gaps that shouldn’t have been there,” Frank said. If the draft proposal he issued were perfect, there wouldn’t be a need for committee hearings, said Frank.

Evade Requirements

Commodity Futures Trading Commission Chairman Gary Gensler said the legislation shouldn’t allow hedge funds or financial firms to evade requirements that their derivative contracts go through central clearinghouses. He also said the proposal is unclear on whether the regulator would have to determine on a case-by-case basis whether swaps would be subject to clearing.

Business reaction to Frank’s proposal suggests it lacks restrictions sought by critics who blame derivatives for speeding the downfall of American International Group Inc. and for exacerbating 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. 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.”

‘Ambiguous’ on Risk Management

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, Hu said.

President Barack Obama’s administration has sought to rein in the little-regulated over-the-counter derivatives industry. The administration proposed tighter oversight of derivatives, which are contracts corporations use to hedge against risks such as swings in stocks, currencies, commodities and interest rates.

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, both criticized the bill for being too lax on the industry.

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

Non-Standard Contracts

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.

“For the end-users, it’s certainly better to have the regulators because they would better understand” what should be cleared, Representative Mike McMahon, a New York Democrat said yesterday. He said clearinghouses may have a vested interest in processing more transactions to generate more revenue.

Hill, Morgan Stanley’s managing director in credit-trading and structured credit products in New York, said the Securities Industry and Financial Markets Association supports much in Frank’s version.

Cargill, Apple

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.

Executives from Cargill, Prudential Financial Inc. and Chatham Financial Corp. are also scheduled to testify on the draft proposal today.

McMahon led the New Democrat Coalition, which describes itself as moderate and “pro-growth,” 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.

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

Financial District Jobs

“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.”

Industry executives are pushing for more changes to the bill, Hill said. The legislation would still subject transactions with end-users to burdensome margin requirements and would come at a high cost for some corporations even though they could post non-cash as collateral, he said.

He said members of the securities industry association also oppose additional capital requirements for swaps transactions that are cleared and subject to separate margin requirements by clearinghouses.

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

Last Updated: October 7, 2009 11:05 EDT