U.S. regulators unveiled plans on Friday that will determine which companies and funds will be forced to hold more cash to trade in the lucrative over-the-counter derivatives market.

The proposals, which will subject Wall Street firms to even more regulatory scrutiny, are designed to mitigate risk to markets and avoid a repeat of what happened when AIG's unsecured derivatives threatened the global financial system.

On Friday, the Securities and Exchange Commission followed the Commodity Futures Trading Commission and began efforts to define who would be classified as a swap dealer and major swaps market participant.

Under the regulators' proposal, an entity would be deemed a major swap participant if it held a substantial position in any of the major swap categories such as credit derivatives, foreign exchange swaps or interest rate swaps.

The regulators also targeted those whose outstanding swaps positions created substantial counterparty exposure that could have serious adverse effects on the U.S. financial system.

A financial entity holding a substantial swaps position that is highly leveraged and not already subject to a federal banking regulator's capital requirements would also fall under that category.

SEC Commissioner Troy Paredes said he was concerned that the thresholds to determine a major swap participant were too high.

SEC staff estimated that only about 10 entities would have to start going through tests to determine whether they were major security-based swap participants. Those entities would most likely include AIG and hedge funds holding large speculative swap positions.

Wall Street firms dominate the derivatives market. JPMorgan Chase, Bank of America, Goldman Sachs, Citigroup and Morgan Stanley together held about $171 trillion in over-the-counter swaps at midyear.

TURF BATTLES

Under the Dodd-Frank financial reform legislation, the CFTC and the SEC won power to police the roughly $600 trillion off-exchange derivatives market. But long-standing oversight turf battles between the agriculture and financial committees in Congress prevented the merger of the two market regulators.

As a result, the SEC only has authority over the security-based swaps market, which represents 5-10 percent, or $25 trillion-$60 trillion, of the overall swaps market.

The CFTC has authority over all other swaps including commodities, foreign exchange and interest rate swaps.

The SEC estimated that about 50 entities would be labeled security-based swap dealers and be required to register with the agency.

The proposals, other derivatives rules and sweeping requirements under the Dodd-Frank legislation are designed to plug regulatory gaps exposed by the 2007-09 financial crisis.

At the same time, the SEC and CFTC are trying ensure that companies, municipalities and others that use swaps to hedge fluctuating commodity prices and other risks will not be labeled as swap dealers or major swap participants.

The proposals would exclude those holding a swap position for hedging or mitigating commercial risk.

The SEC proposal is open for a 60-day comment period.

The SEC has already proposed rules for the centers that will store the swaps trading data, as well as plans to mitigate conflicts of interests at venues that will handle the swaps.

(Editing by Dave Zimmerman, Lisa Von Ahn and Ted Kerr)

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