Lawmakers were locked in an impasse over derivatives on Thursday as they struggled to finish their historic rewrite of U.S. financial regulations.

As a negotiating session entered its 12th hour, Democratic lawmakers and officials from the Democratic administration of President Barack Obama struggled to find common ground on a controversial proposal to force banks to spin off their lucrative swaps-dealing operations.

I went to a meeting for three hours and all I got was a headache, said Democratic Representative Collin Peterson.

Dozens of Democrats in the House of Representatives threatened to vote against the final bill, the most sweeping overhaul of Wall Street rules since the 1930s, if it contained the swaps ban. But the measure's sponsor, Democratic Senator Blanche Lincoln, insisted that it stay in.

Democrats face enormous pressure to resolve the issue and complete work on the bill in the coming hours, before Obama discusses recovery and reform with leaders of other economic powers at the Group of 20 meeting in Canada.

Passage would also give Democrats an important legislative victory, alongside healthcare reform, ahead of congressional elections in November.

As the global economy emerges from the financial crisis of 2007-2009, Europe's efforts to present a united front on regulation hit a roadblock on Thursday when lawmakers and diplomats failed to agree on new hedge fund rules.

In Washington, lawmakers worked late into the night to resolve the standoff over derivatives. They had yet to tackle the so-called Volcker rule that would limit banks' trading and investment activities.

Both proposals aim to avoid future bailouts by separating taxpayer-backed bank deposits from riskier market activity.

Senate Democrats proposed a compromise that would give regulators less wiggle room to waive the trading ban but would also allow banks to maintain small investment stakes.

Banks would be able to invest up to 3 percent of their tangible common equity in hedge funds and private equity funds, and bank investment in any single fund could not exceed 3 percent of the fund's capital.

The House members of the panel merging the reform bills from the two chambers of Congress had yet to weigh in on the proposal.

BALANCING ACT

The rewrite of the regulations -- nearly 2,000 pages in all -- aims to avoid a repeat of the crisis that plunged the global economy into a deep recession and led to taxpayer bailouts of troubled banks. It would saddle the industry with tougher oversight and could cut revenues by billions of dollars.

As the House-Senate panel crafts a final bill, Democrats must balance their desire to crack down on Wall Street with the need to retain the votes of moderates from both parties.

Democrats hope Obama can sign the reforms into law by July 4 but the final package must first win approval in the House and Senate.

One Senate moderate, Republican Scott Brown, was at the center of efforts to weaken the Volcker rule, according to aides. Brown was poised to win exemptions sought by mutual funds, insurers and banks in his home state of Massachusetts.

On Wall Street, the prospect of tough new rules sent U.S. bank stocks lower, helping to pull down the overall market. The KBW banks index closed down 2.2 percent.

The crackdown aims to tame the $615 trillion derivatives market by forcing much trading activity onto exchanges and clearinghouses. Over-the-counter derivatives worsened the financial crisis and led to a $182 billion taxpayer bailout of insurance giant AIG.

Large financial firms might have to pay a tax of roughly $19 billion, spread out over several years, to cover the cost of the bill, said Democratic Representative Barney Frank, who is chairing the panel.

Lawmakers resolved some other sticking points.

The panel agreed to tighten bank capital rules to help them ride out future crises.

Banks would have five years to meet the rules, which force them to exclude some riskier securities from core capital. Banks with less than $15 billion in assets would be exempt.

Some $118 billion in bank assets would not count toward the new capital requirements, according to credit ratings agency Moody's Investors Service.

That could further worsen a credit crunch that is hampering economic recovery, said Jeff Davis, bank analyst at Guggenheim Partners, because banks may shrink their asset base to raise their capital levels.

On other issues, the panel agreed to let regulators set higher standards of duty for broker-dealers who give financial advice and agreed to give investors an easier way to nominate corporate board directors.

They also watered down a provision to give shareholders a nonbinding vote on executive pay. That vote would take place once every two or three years, not annually.

There are two very strong criticisms of this bill: one that it is too big and the other that it is too little, said Frank, who looked as rumpled as the staffers who had worked through Wednesday night and into Thursday evening.

Wall Street lobbyists have been unable to kill the overhaul as Democrats ride a wave of public disgust at bank bailouts and bonuses. Some 73 percent of Americans support strong financial reforms, according to a Lake Research Partners poll touted by Democrats on Thursday.

(Additional reporting by Kim Dixon, Roberta Rampton, Kevin Drawbaugh, Andy Sullivan and David Lawder in Washington and Leah Schnurr and Elinor Comlay in New York; writing by Andy Sullivan; Editing by Alistair Bell and John O'Callaghan)

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