By Huw Jones
LONDON (Reuters) - The European Union could be left with no exchange big enough to compete with U.S. rivals and no trading link into Britain if it allows the London Stock Exchange <LSE.L> and Deutsche Boerse <DB1Gn.DE> merger to die.
Although the Anglo-German tie-up is awaiting formal EU regulatory approval, the LSE said on Sunday it would not meet an extra condition from Brussels, effectively pulling the plug on the 29 billion euro ($30.7 billion) deal.
For exchanges in the EU, that means a vision of creating a major trading house capable of competing with U.S. giants like InterContinentalExchange <ICE.N>, Nasdaq <NDAQ.O> and CME <CME.N> or Asia's growing exchanges is over for now.
"Politics is ultimately going to get in the way of further movement on European financial markets," Rebecca Healey, head of market structure and strategy in Europe for Liquidnet, a trading platform, said on Tuesday.
"Ultimately, national exchanges are a protected species."
Deutsche Boerse Chief Executive Carsten Kengeter had warned that a failure to complete the LSE deal would weaken Frankfurt, Germany's main financial center, robbing it of a "bridge" to London, Europe's only global money hub.
And while Deutsche Boerse could be left with no access to the British capital once Britain leaves the EU, LSE will not be isolated from the continent even if Britain fails to negotiate EU financial market access after Brexit.
The London bourse has a clearing house in Paris, and owns the Italian exchange and its clearing and settlement units, giving it a strong continental base to build on.
ICE COMETH AGAIN?
The 200-year old British exchange could also become a target for ICE, CME or Nasdaq, even in the face of Brexit, which Britons voted for in June last year.
While any such approach would face similar nationalistic concerns to the ones that beset talks with Deutsche Boerse, Britain may be open to a deal given Prime Minister Theresa May's enthusiasm for a closer trading relationship with the U.S.
A deal with a U.S. exchange would create a formidable transatlantic bridge, linking London more closely with the world's biggest financial market, where Deutsche Boerse's efforts have had mixed results. Frankfurt ended up selling its U.S. options business ISE to Nasdaq.
Steve Grob, director of strategy at Fidessa, a trading technology company, said the fall in the value of sterling since Brexit could entice ICE to reconsider a bid for London, but others are less sure.
"It would be very difficult for ICE to come in. It would run into the same complications," Larry Tabb, who heads the TABB consultancy on trading in New York, said.
ICE bought NYSE Euronext, a transatlantic exchange, but spun off the Euronext stock trading arm, and kept its London derivatives platform. It also owns the New York Stock Exchange, meaning EU competition regulators would likely demand divestments before waving any new deal through.
ICE, which declined to comment, noted that its CEO Jeff Sprecher told an analyst call on Feb. 7 that, "I expect that any such M&A focus will be towards smaller, complementary transactions rather than the larger deals of past years, given our confidence in the growth platform that we have today."
A tie-up between Nasdaq <NDAQ.O> and the LSE might get backing from European antitrust officials more easily, Tabb said.
Brexit also poses challenges for LSE as it will force banks in London, who are among CEO Xavier Rolet's top customers, to begin moving some trading operations to the EU so they can still serve continental customers, raising questions about the LSE's future valuation.
The LSE also needs to digest properly some of its major acquisitions, such as the Russell suite of stock benchmarks, industry analysts said.
For Frankfurt, the future is equally uncertain.
Possible combinations involving other exchanges in Europe, such as Euronext or the Madrid bourse would fail to create a global player that could compete with ICE, CME or Asian bourses.
EU attempts to create a capital markets union have already taken a beating by Brexit, which removes the region's biggest financial hub.
"Nobody in Germany has a plan for what happens if the merger fails. It is not simply the case that nothing will happen," said Dirk Schiereck of the technical university of Darmstadt, who carried out a study on the merger.
"One of the very few potential alternative partners for Frankfurt is China".
Patrick Young, an exchanges consultant, said the whole concept of a European market champion was flawed.
"The European markets are multi-faceted and at many different stages of development. Bulking up inside Europe is going to be very difficult as you either hit antitrust issues or are too small to be exciting," he said.
For a graphic on "How LSE, Deutsche Boerse and Euronext compare", click: http://fingfx.thomsonreuters.com/gfx/rngs/DEUTSCHE%20BOERSE-M-A-LSE/0100321K4NH/DEUTSCHE-BOERSE.jpg
(Additional reporting by Andreas Kroener and John O'Donnell in Frankfurt; Editing by Alexander Smith)