Regulators are looking at ways to protect investors from losing funds backing their derivatives trades in the event of a Lehman-style bank failure.

Regulators have asked dealers to look into their clients' ability to reclaim collateral for contracts cleared through the five central counterparty clearinghouses in the United States and Europe in the event of a failure of a clearing member, according to people familiar with the matter.

Depending on the outcome of the legal analysis, regulators could seek changes to ensure that clients' collateral payments on the trades are segregated from the banks' other operations, one of those people said.

If necessary, regulators may also seek to tweak bankruptcy laws if there are any legal barriers to counterparties' ability to reclaim collateral.

The regulators efforts come amid a plan by the Obama administration to exert more control over derivatives trading, estimated at around $450 trillion globally, and which are seen as having exacerbated the global credit crisis.

Some investors took losses when they were unable to reclaim collateral posted against derivatives with Lehman Brothers because the assets became mired in bankruptcy proceedings after the firm collapsed in September 2008.

Collateral is normally immediately available to trade counterparties but some investors were unable to retrieve the funds because it was mixed in with the investment bank's other assets.

Six months earlier, fears that cash put up against derivative contracts may not be repaid was a large factor in a run on Bear Stearns as funds withdrew their money on the first sign the storied investment bank may fail.

In a domino effect, if just one hedge fund starts shopping around for a new dealer to move their trade and collateral to it can quickly become public. This can lead to other funds following suit out of fear of being the last one with their money still in -- exacerbating the problem.

Some funds have already required dealers to segregate their initial margins on a few over-the-counter derivative trades, though its very rare.

But dealers are resisting moves to segregate collateral as the loss of flexibility from being able to use the funds in their daily operations will reduce their available liquidity.

It's a cost factor, if you force the prime broker to segregate your collateral they're going to charge you more, said Joel Telpner, partner at law firm Mayer Brown.

Anecdotally I think there are a number of buyside players that lost collateral in the Lehman bankruptcy that are starting to put pressure on prime brokers to segregate their collateral at a reasonable cost, he said.

Since his time as head of the New York Federal Reserve, current U.S. Treasury Secretary Timothy Geithner has been pushing the industry to tighten up over-the-counter derivatives trading. Some standardized contracts have begun to be cleared through a central clearinghouses.

One of the standard features of exchange traded and cleared derivatives, such as financial and commodity futures and options contracts regulated by the U.S. Commodity Futures Trading Commission (CFTC) for example, is the segregation of client margin funds or collateral from dealer proprietary funds.

Regulators also hope the process of analyzing the five available clearing houses will force dealers to engage with all of them, promoting competition, a person familiar with the situation said.

So far, Intercontinental Exchange -- which dealers have a 50-50 equity-sharing partnership with -- has had the upper hand on clearing credit default swaps.

Other clearing houses include the CME Group , NYSE Euronext , London-based LCH.Clearnet and Frankfurt-based Deutsche Boerse .

(Reporting by Kristina Cooke and Karen Brettell)

Investment