* EU action falls short of formal transition period
* Industry welcomes room for regulatory discretion
* Steps aimed at helping smaller firms in market (Adds more detail)
By Huw Jones
LONDON, Feb 23 (Reuters) - European Union regulators can use discretion in enforcing a new rule for derivatives from next week as long as firms show they are making an effort to comply with changes which some said they had not had enough time to be ready for.
The EU's European Securities and Markets Authority (ESMA), the European Banking Authority (EBA), and the European Insurance and Occupational Pensions Authority announced the softening on Thursday, saying they were aware of "operational challenges" in meeting the deadline, especially at smaller firms.
The rule, which was agreed in the aftermath of the 2007-09 financial crisis to make the $544 trillion market safer, is aimed at firms which use swaps or privately traded derivatives contracts to hedge against interest rate or currency risks.
From March 1 users must post a "variation margin" in the form of cash or bonds to cover day-to-day swings in market prices and ensure there is enough cash to cover losses.
The industry has warned of potential disruption given that many firms will not be ready in time due to lengthy paperwork and had called for a six-month phase in period.
Among the concessions, regulators could take into account the size of exposures in swaps contracts and default risk when going about their day-to-day enforcement work, the three watchdogs said in a statement on Thursday.
Market users would still have to document the steps taken towards full compliance and put in place alternative arrangements to ensure that risk of non-compliance is contained.
"This approach does not entail a general forbearance, but a case-by-case assessment from the competent authorities on the degree of compliance and progress," they added.
Scott O'Malia, chief executive of ISDA, the global body that represents the derivatives sector, welcomed the move.
"As the regulators point out, many firms already post margin, so taking a case-by-case approach wouldn't lead to an increase in systemic risk," O'Malia said.
While the U.S. Commodity Futures Trading Commission has issued a "no-action" letter giving six months to get up to speed and regulators in Hong Kong, Singapore and Australia have taken similar steps, EU watchdogs don't have powers to grant a formal transitional period without changing the law.
They said the start date for the new rule has been known since 2015, and "it is unfortunate that the financial industry has not managed to prepare for the implementation".
They expect the industry's difficulties to be solved "in the coming few months" and that all trades from March 1 remain subject to a variation margin. (Editing by Jason Neely and Alexander Smith)