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UPDATE 2-LSE says splitting euro clearing would create rump EU market

(Adds Eurex rejection of industry margin estimates)

LONDON, June 12 (Reuters) - Shifting clearing of euro-denominated derivatives from London to the European continent would create an "illiquid rump" market that costs customers more, the London Stock Exchange Group's Chief Executive Xavier Rolet said on Monday.

The European Union's executive European Commission is due to publish a draft law on Tuesday on how the clearing of euro-denominated financial instruments should be handled after Brexit. Clearing stands between two sides of a transaction to ensure its safe and smooth completion.

LSE subsidiary LCH currently clears the bulk of euro-denominated interest rate swaps, a derivative contract that helps companies to guard against unexpected moves in interest rates or currencies. Britain, however, is due to leave the bloc in 2019, putting it out of the EU's regulatory reach.

Rolet said the group could cope with whatever Brussels decides, given it has a fully authorized clearing house in Paris to ensure continuity of service to customers.

"This is fundamentally an issue for customers and not for the LSE. Whatever the outcome of the euro clearing debate, we are well positioned to react and to take advantage of opportunities in this market," Rolet told an investor day event.

Forced relocation would create two pools of liquidity - a liquid "offshore" market outside the EU, and an increasingly "rump, illiquid and systematically more dangerous" market inside the bloc, Rolet said.

He said that the LSE supported another option being looked at by Brussels, so-called enhanced supervision, whereby the EU has a direct say in regulating a clearing house in London.

Some industry officials and analysts expect Brussels to opt for this, but with such intrusive terms that clearing houses would simply relocate to the EU anyway.

The International Swaps and Derivatives Association (ISDA), one of the world's top derivatives industry bodies, also said on Monday that "relocation" would reduce the ability of banks to save on margin, or cash set aside in case of defaults, by offsetting positions in the same liquidity pool.

That would lead to an increase of 15 to 20 percent in initial margin or cash that is set aside against an interest rate swap in case of a default, it said.

"Many of the detrimental consequences ... will be felt most keenly by banks' clients," ISDA Chief Executive Scott O'Malia said in a letter to the European commissioner in charge of financial services, Valdis Dombrovskis.

Last week another industry body, the Futures Industry Association, said relocation would nearly double the amount of margin that would be needed, to $160 billion from $83 billion currently.

However, Frankfurt-based Eurex Clearing said in a blog on Monday that the margin requirement would only rise by between $3 billion and $9 billion from the $83 billion base figure for interest rate swaps.

(Editing by Mark Potter and David Goodman)