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Brexit strengthens case for LSE-Deutsche Boerse merger: Bundesbank

London must prepare to lose euro trading and clearing activities once Britain leaves the European Union but the business case for merging the London and German stock exchanges has been strengthened, Bundesbank board member Andreas Dombret said on Wednesday.

Last month's Brexit referendum has cast a shadow over the $27 billion merger between London Stock Exchange and Deutsche Boerse, with the firms facing regulatory questions about the future of the business once Britain leaves the EU.

Indeed, Germany's financial regulator Bafin last month said London could not host the headquarters of the merged entity, nor could London remain a center for trading in euros since it was leaving the bloc.

"Regarding the merger between Deutsche Boerse and London Stock Exchange, the referendum outcome has even strengthened the economic rationale," Dombret told a conference in Frankfurt.

"Once the UK has left the European Union, bridges between both economies will be more important than ever before," he added. "The announced merger of LSE and Deutsche Boerse has the potential to become such a bridge."

Dombret does not have a direct say on the merger but is the most senior German official to publicly support the merger since the referendum on June 23.

London Clearing House LCH, majority owned by the LSE, accounts for the biggest chunk of euro clearing and analysts have suggested that the merged group could relocate the business to Frankfurt.

Supporting such an argument, Dombret said that euro-denominated trading, depository services and clearing are unlikely to have a future outside the EU and Frankfurt would be a more appropriate alternative.

Around 1 trillion euros ($1.1 trillion) are exchanged in Britain every day while the turnover for interest rate derivatives, such as forward rate agreements, swaps, and options is 927 billion euros per day, Brussels based think tank Bruegel said.

Dombret said that much still needs to be decided, including UK banks' passporting rights, but some of the more pessimistic forecasts, including a 0.6 percent negative impact on 2017 euro zone growth, were "exaggerated."

No excuse

Although financial markets may not yet have found a new equilibrium since the post-referendum turmoil, Dombret warned euro zone countries against using the volatility as an excuse to circumvent bank regulations, particularly bail-in rules.

"If we allow states to provide discretionary aid to their banks, this impedes a core element of the bail-in regime, namely its credibility," Dombret said. "If the bail-in mechanism were to be exposed or even dismantled, markets would no longer exert their disciplinary function."

The comments appear to be directed at Italy, which has been in talks with the EU to provide state aid to its troubled bank sector, weighted down by 360 billion euros ($400 billion) of non-performing loans.

Italy's chief concern is that recapitalization could require banks to bail in investors, who include ordinary households, making any restructuring politically painful.

ECB policymakers have argued that state aid, particularly in case of systemic risk may be acceptable but the bail-in rules must be respected.

The compromise may be government compensation for small investors but euro zone finance ministers threw cold water on the idea on Monday when they argued there was no acute crisis and a bank-by-bank solution was needed.