FRANKFURT/LONDON If Britons vote to leave the EU, London's financial center faces losing one of its top money spinners - the trade in trillions of euros in derivatives - and the European Central Bank will be pushing hard for the business to move onto its patch.
According to euro zone central bank officials, the ECB is determined to tackle an anomaly dating from 1999 when Britain opted out of the euro's launch: a dominant share of trading in the currency it issues goes on outside its jurisdiction in London.
Euro zone officials are reluctant to discuss publicly such a sensitive issue - and the risk that London could lose out to rivals Frankfurt and Paris - before the June 23 referendum on a British exit from the European Union.
But Christian Noyer, a former ECB vice president and Bank of France governor, is free to make the case as he no longer holds a high office in the euro zone.
"If Britain left the EU, the euro area authorities could no longer tolerate such a high proportion of financial activities involving their currency taking place abroad," he said.
"It is already very difficult for euro members to accept that our currency is largely traded outside the currency area, beyond the control of the ECB," Noyer wrote in an article for economic think tank OMFIF.
Two euro zone central bank officials, requesting anonymity, made the same points to Reuters.
The trading of euro-based securities spans trillions of euros of derivatives deals as well as the 'repo' market providing short-term funding for banks - 2 trillion euros (1.60 trillion pounds) of which experts say is based in London. On top of this, there is foreign exchange trading in the currency itself.
The Frankfurt-based ECB wants oversight of this business for a practical reason: if any disaster were to hit these markets like the 2008 collapse of Lehman Brothers bank in the United States, it would be responsible for dealing with the crisis.
The ECB declined to comment on the derivatives oversight issue.
Supporters of a British exit from the EU say predictions of London's demise as a financial center when it failed to adopt the common currency proved wrong, and the same would be true in the event of a "Brexit".
So far, campaigning has focused on issues ranging from immigration to the Brussels bureaucracy, with Brexit supporters arguing that the EU has moved far from the bloc's original aim of merely boosting trade within Europe.
However, the City of London remains a major employer and accounts for 12 percent of the British economy, generating roughly 66 billion pounds in tax revenue a year for a cash-strapped exchequer.
So far, Britain's EU membership has helped London to maintain its position as Europe's financial capital, with the result that the ECB is set apart in one crucial respect from the Bank of England, the Bank of Japan and U.S. Federal Reserve.
"In big currency areas - including sterling, yen, dollar - the central bank has a significant hold on trading in the domestic currency," said Nicholas Veron, EU financial services expert at the Bruegel think tank in Brussels.
"The euro zone is an outlier and that is supported by the EU framework but if that is no longer there, this outlier status might not be sustainable," Veron added.
The ECB has already tried to assert its authority, insisting that clearing houses that process euro derivative trades should be based in the 19-nation currency bloc. Britain mounted a legal challenge to defend its financial sector and won at the EU's second-highest court last year.
But banks and other market players expect the tables would turn after a Brexit, eroding London's preeminence in a derivatives market that has thrived in spite of the financial crash.
A recent legal study by the Association of Financial Markets in Europe, whose members include HSBC, Deutsche Bank and broker ICAP, identified this risk.
If Britain finds itself outside the European single market, UK-based institutions could lose the right to use "passporting" rules which currently allow them to provide cross-border services to clients elsewhere in the EU.
"Under Brexit, market infrastructures could not permanently rely on the EU passporting arrangements," Simon Lewis, the association's chief executive, told Reuters.
The International Capital Market Association, whose members include treasury departments of companies such as GE and banks like Goldman Sachs, have come to the same conclusion, warning of a threat to "London's competitive position".
EU governments could press the issue, along with the ECB which since late 2014 has regulated the euro zone's biggest banks, although those headquartered elsewhere might be less willing to respond.
"The EU can exert a lot of pressure and make rules that are so complicated that it makes sense for the continental banks to take their trading back to Paris or Frankfurt," said Soeren Moerch, head of fixed income trading at Danske Bank.
"But I am much more skeptical as to whether the big American banks would move their main European trading hub from London."
Graham Bishop, a regulatory consultant, believes the ECB would use its full powers. "It would be extraordinary for the ECB to allow trading and use of its money to go on outside its control," he said.
According to the Bank for International Settlements, interest rate swaps accounted for $435 trillion of the world's $550 trillion derivatives market in 2015.
London-based LCH.Clearnet(LSE.L), in which the London Stock Exchange owns a majority stake, clears more than half of all interest rate swaps traded globally.
Daily it clears about $3.3 trillion in such swaps, with $1.76 trillion in dollar-denominated contracts. Euro-denominated contracts total 736.3 billion euros or $836.6 billion and are the second largest component.
LCH, using what it says are robust risk controls, essentially underwrites such deals, stepping in if a buyer or seller drops out.
However, the ECB wants better oversight of the clearing houses that one bank lobbyist called the 'nuclear power plants' of financial markets, to avert any Lehman-style collapse.
"In the end, the ECB is responsible," said Bishop. "The ECB is the only one which can create new euros in a liquidity crisis."
BRIGHT FUTURE OUTSIDE
Nigel Farage, who leads the United Kingdom Independence Party, believes London has a bright future outside the EU if Britain negotiates a new relationship with the bloc.
"I heard the same argument 15 years ago about joining the euro. 'If you don't join, trading will move to Frankfurt'," he told Reuters. "That was wrong then and it's wrong now. London is a global trading center. By leaving the EU and doing a deal after we left, we might get a better deal for financial services than we have today."
Few in the City share his optimism.
Brexit and a possible shake up of derivatives is already shaping thinking around a planned merger between Germany's Deutsche Boerse and the London Stock Exchange.
Both own clearing houses. Although LCH.Clearnet in London and Frankfurt's Eurex specialize in different types of derivatives, this could change, allowing more processing of euro-based trades, say, to happen in Frankfurt.
(Additional reporting by John Geddie in London; Writing by John O'Donnell)
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