* Trade group sets up committee to draw up specs for new contract

* ICE considers adding delivery locations outside United States

* Industry continues try to woo CME

By Josephine Mason

NEW YORK, Dec 5 (Reuters) - A group of cotton traders have joined forces to develop the first global futures contract, seeking to supplant the century-old U.S. benchmark that they say is increasingly vulnerable to price-distorting squeezes.

In the first sign that the industry is getting more serious about the idea after several years of informal talks, the International Cotton Association has set up a committee to draw up the specifications of a futures contract that would accept cotton grown outside the United States, members of the trade group said.

The ICA first suggested creating the committee at its annual convention in Hong Kong in November, sources said. A firm proposal for an alternative to IntercontinentalExchange Inc's benchmark could be ready in months.

As those discussions gather pace, Atlanta-based ICE is considering measures to protect its stronghold in the niche fibers market, including the addition of international delivery locations to its U.S.-based contract, according to four sources at merchants.

Many traders have a "massive problem" with the ICE contract, said a broker involved in the discussions. He said the talks were focused on two options: starting a new contract on another exchange, or expanding the ICE contract to allow for delivery in locations outside the United States.

Many details are still being hammered out, including which exchange might be willing to host a new contract. Merchants have twice failed to convince chief ICE rival CME Group Inc to start a cotton contract, the sources said, although tentative talks have resumed.

It would be a challenge to convince growers, traders and textile mills across Africa, Asia and the Americas to agree on the details, and perhaps even harder to lure money away from a deeply entrenched benchmark that still enjoys the support of the U.S. industry's biggest players.

But the existence of a breakaway industry group is another sign that the turmoil caused by whipsawing prices, bankruptcies and contract defaults over the past four years is still reverberating across the industry. It also reflects the diminishing U.S. role in the global cotton market.

Plexus Cotton, a medium-sized merchant based in Liverpool, England, supports the push to go global.

A world contract would create "proper price discovery" and "something the industry can effectively use as a hedge," said Plexus owner and founder Nick Earlam.

"If you're able to do that, you're not going to face the same situations with defaults, and you're going to bring calm and security to the industry that you're very unlikely to get with the current contract as it exists."

Other big-name proponents include Asia-based merchants Noble Group Ltd and Olam International Ltd, the sources said. Neither company responded to requests for comment.

SMALL BUT IMPORTANT

Measured by open interest, the market for cotton is smaller than those for other commodities, but it has been under regulatory scrutiny as wild price gyrations in 2008 and 2011 hobbled some of the world's largest merchants, cost some high-profile traders their jobs and triggered a legal spat involving one of the world's largest agricultural merchants.

ICE has floated an informal proposal to consider Dubai and Malaysia as new delivery points, although discussions are at an early stage and few expect a decision any time soon, according to sources who have dealt with the exchange.

ICE and ICA declined to comment on the situation.

Representatives of the industry say they have tried to convince CME to launch a cotton contract after the price surge and collapse of 2008 and again earlier this year as ICE prepared to shut its New York outcry trading floor.

"We've all realized first we have to agree on the type of contract and it wouldn't be hard to get an exchange to take it on," Earlam said, adding that a proposal could be ready within the next few months.

Industry representatives have been sounding out CME again, according to sources.

"We regularly talk with customers and market participants about ways to enhance our markets, and remain focused on helping CME Group's customers manage their risk in our deep and liquid agricultural markets," said a spokesman for the Chicago-based exchange, which operates sugar, coffee and cocoa futures and options contracts.

Some market participants do not believe the industry should ditch ICE in favor of another exchange as the established contract has global recognition and traction along the supply chain, from growers in Brazil to textile mills in China.

"I think we should amend the current contract," said Jordan Lea, chairman and co-owner of Eastern Trading in South Carolina. "But the sentiment is that we should list a new contract, and if it flies, then we'll fold the current into the new."

There are few alternative pricing mechanisms. The only other futures exchanges are in China - the Zhengzhou Commodity Exchange and the state-owned China National Cotton Exchange - and are off-limits to users outside of that country.

OUT OF DATE

Merchants and brokers who support going global say ICE's cotton No. 2 contract, whose roots go back 140 years to when the United States dominated world production and exports, is out of date.

Asian nations now account for a growing proportion of production, spinning and trade. In 1990 the United States was growing about 15 percent of the world's cotton, while China and India grew about a third. The U.S. share has shrunk since then, while China and India now account for nearly half of the output.

Adding cotton grown outside the United States and international delivery points would boost liquidity and prevent future wild price swings, proponents of a bigger contract say.

The main drawback with the existing one is that only U.S. cotton is deliverable to the exchange. When the U.S. crop is almost sold out as the marketing year to July 31 winds down, there is always a potential for a squeeze on prices, merchants say.

"The problem with the current ICE contract is that in any given season, you have 6 to 10 percent of the world crop deliverable so whenever something goes wrong with that, you may not have a good correlation with the rest of the world," said a source at a merchant who is in favor of a world contract.

For example, part of the reason for the soaring prices in 2011 was a drought that wiped out much of the crop in Texas, the largest U.S. cotton-producing state.

According to the early plans for a new contract, Brazilian, Australian and U.S. cotton could be accepted for delivery, although some merchants want fibers from more countries to be included. One major stumbling block is whether to make delivery points in a location of net consumption or a region of export, sources say.

Most agree it could take time for the industry to reach a consensus.

"Everybody's got their own ideas," said a source at a large cooperative. "I can't see it happening for a while."