A federal watchdog at the heart of Dodd-Frank is facing major budget cuts that could derail its new duties to oversee the derivatives market and lead to regulatory uncertainty in the financial industry.

House Republicans and Senate Democrats have agreed to stop new funds from going to the Commodities Futures Trading Commission in the 2012 budget—a move that outside experts say would hamper the agency’s ability to put the new derivatives regulation into effect.

CFTC chairman Gary Gensler. (SOURCE/BLOOMBERG)

If enacted, this could place big constraints on an agency that’s being asked to do more than ever before. The CFTC currently oversees the futures markets, but is now responsible for creating and overseeing an open exchange for Over-the-Counter derivatives as a major part of Dodd-Frank. Compared to the $40 trillion futures market, the OTC market is far bigger, with a $300 trillion notional value —approximately 20 times the size of the U.S. economy, according to CFTC chair Gary Gensler. Like many supporters of Dodd-Frank, Gensler believes that OTC derivatives played a key role in the 2008 financial meltdown, as traders “were often unable to adequately judge the risks they were assuming due to the complexity and lack of transparency of the instruments they were trading and the counterparty credit risk they were assuming,” as he testified last year. The CFTC’s new clearinghouse is intended to reduce such risks.

But Congress’ refusal to increase funding for the agency has increased concern that the CFTC won’t be able to carry out all its new responsibilities. Already, the agency is behind schedule in writing the new regulations—most of which remain in draft form—as the deadline has been pushed back from July 2011 to the end of 2012. Under the proposed Congressional budget, the agency may be able to finish writing the regulations, but “implementation and enforcement in my mind will be next to impossible,” says Michael Greenberger, a University of Maryland law professor and former CFTC official. “Without the necessary and required budget to meet the demands required by Dodd Frank, Congress is effectively tying one hand of the CFTC behind its back,” adds Christian Johnson, a law professor at the University of Utah.

That may, in fact, be the intention of Republicans who oppose Dodd-Frank itself. Though they don’t have the votes to repeal Wall Street reform right now, they can try to starve the budgets of the agencies responsible for carrying it out, much as they’ve attempted to do in the health-care sector to impede the Affordable Care Act.

Problem is, simply lowering levels of funding, without actual repealing the new rules, could contribute to uncertainty in the industry—one of the GOP’s chief complaints about Obama’s reforms in the first place. What happens, for instance, if the CFTC writes new rules but lacks the full capacity to implement and enforce them? “It will cause chaos to go halfway down road, with new regulatory uncertainty,” says Greenberger. “Certainty that framework will be in place, but people will want to know, which [derivatives] will be cleared, and who will do the clearing?” Johnson shared similar concerns. “If the CFTC is not able to meet its responsibilities due to budget cuts, the industry risks chaos caused by legal uncertainty and insufficient staffing.

Even before the latest round of negotiations, the CFTC had said its current budget is inadequate, with one Democratic commissioner describing the agency as under “serious strain at its current funding” back in February. In June, the New York Times reported that the agency was “still struggling to fill crucial jobs, enforce new rules and upgrade market surveillance technology.”

Democrats have been sympathetic to the CFTC’s plight, but budget constraints could force them to sacrifice funding for the agency for other priorities. Under the debt-ceiling deal, both parties agreed to cut $900 billion in spending in this 2012 budget. In exchange for giving up the additional funds for the CFTC, Democrats got more money for food assistance for women and children, among other programs that the party holds dear.