UPDATE 2-Clearing key to making derivatives safer - EU

* EU executive says clearing key to cutting derivatives risk

* Standardisation of derivatives contracts urged

* Plans less radical than U.S. push to exchange trading

* Industry groups say accept need for central clearing

* Final proposals by end 2009, possible draft law

(Adds more industry reaction, news conference)

BRUSSELS, July 3 (Reuters) - Derivatives pose risks on financial markets that central clearing of contracts would mitigate, the European Commission said on Friday, outlining plans that fall short of more radical U.S. steps.

EU Internal Market Commissioner, Charlie McCreevy, opened an investigation into the sector last October, a month after the collapse of Lehman Brothers, a bank heavily involved in the global $600 trillion off-exchange derivatives market.

Off-exchange traded derivatives are a vitally important part of the economy but the worst crisis in decades highlights concerns over the "web of mutual dependence" the sector has created, the Commission said.

McCreevy's findings and policy proposals, published on Friday, said contracts should be standardised -- a process already underway -- and a central data depository created to store records of trades.

The plans stop short of more radical steps envisaged by the United States which seek to go beyond centrally clearing over-the-counter trades to shift trading onto exchanges or trading platforms where possible.

"The Commission will further assess the pros and cons of channelling of further trade flow through transparent and efficient trading venues and the appropriate level of transparency -- price, transaction, position -- for the variety of derivative markets trading venues," the Commission's policy document said.

A closer study was needed because forcing OTC trades onto an exchange could deprive consumers of benefits such as the ability to trade large orders, it said.

Dealers breathed a sigh of relief that Brussels was holding back from insisting on exchange trading for now.

The International Swaps and Derivatives Association (ISDA) said those exposed to credit risk should be allowed to choose the type of transaction that best suits them.

"Removing that flexibility, such as by forcing bilateral participants to trade on an exchange or otherwise limiting the availability of customized risk management solutions, would be a step backwards," ISDA said in a statement.

The Futures and Options Association, a European industry body, said the EU has abolished mandatory share trading on an exchange to allow customers a choice of where to trade.

"Consumers have always had this freedom across the whole range of their economic activities and there is no reason why, against the background of much closer market oversight, they should not continue to be able to exercise that right as regards OTC transactions," FOA chief executive Anthony Belchambers said.

TRANSATLANTIC

The bulk of the world's OTC trading is done in London and New York and a less strict regime in the EU could attract business from across the Atlantic, industry experts say.

OTC contracts range from credit default swaps (CDS) to interest rate, equity-linked and commodity contracts. The G20 group of industrialised and emerging countries agreed in April that CDS transactions should be centrally cleared.

Clearing is already commonplace in Europe in OTC products like interest rate swaps and McCreevy obtained a pledge from dealers to start clearing some types of CDS contracts in Europe from the end of this month at the latest.

The problems at insurer AIG (AIG.N) and Lehman and Bear Stearns banks showed regulators how little they knew about the sector.

"The opaqueness of the market prevented, on the one hand, other market participants from knowing exactly what the exposures of their counterparties were to these three entities, which resulted in mistrust and in the sudden drying up of liquidity," the Commission's document said.

Positions at Lehman were unwound quickly and successfully by LCH.Clearnet but still raised alarm bells among regulators.

Commission officials said standardisation should cover a wide range of OTC contracts so that common legal terms make the automation of trade processing easier.

A European central data repository -- widely referred to in the industry as a warehouse for "golden copies" of trades -- should be looked at, the document added.

American clearing house DTCC already operates a warehouse in the United States which stores records of nearly all CDS trades in the world but EU officials want a European equivalent that would store details of a wider range of OTC contracts.

The Commission will hold a public hearing on Sept. 25 to discuss final policy proposals that will be presented by year end and could include legislation. (Writing by Huw Jones, editing by Mark John/Ruth Pitchford)