LONDON, Jan 15 (Reuters) - A stand-off between Britain and the European Union over the future of London's vast financial services industry is shaping up as one of the key Brexit battlegrounds of this year.
EU trade negotiator Michel Barnier has said there will be no special deal for one of Britain's most important industries, delivering a blow to hopes of a trade agreement that maintains current flows of staff and services.
But British government officials believe the EU will change its mind partly because European countries risk damaging their own economies if they are cut off from its markets.
Financial services, which account for about 12 percent of Britain's economic output and pay more tax than any other industry, potentially has a lot to lose from the end of unfettered access to the EU market of 440 million people after Brexit.
Below are some scenarios for financial services access to the EU after Brexit:
EUROPEAN ECONOMIC AREA
Dubbed the Norway option, if Britain joined the European Economic Area it would have access to the EU single market in return for accepting free movement of EU citizens, and contributing to the bloc's budget, but with no say over the EU rules it must implement.
Joining Norway, Iceland and Liechtenstein in the EEA is not seen as a viable option for Britain given the government has ruled out accepting free movement of EU citizens, continuing contributions to the EU budget and applying EU rules it might not agree with in future.
Canada took several years to negotiate its "CETA" free trade deal with the EU and it only has a minimal section on financial services. If a Canadian financial firm wants to do business in the EU it must set up a presence inside the bloc and comply with EU regulations.
The chapter on financial services says the EU and Canada must treat each other's sectors equally, but a "prudential carve-out" allows each side to protect consumers and financial services providers, and maintain financial stability.
"In light of CETAs overall ambition, it is unlikely that its impact on the financial services sector in Canada and the European Union will be significant, at least in the short and medium term," Patrick Leblond of the Centre for International Governance Innovation said.
The EU allows access to foreign financial firms if it deems their home rules to be "equivalent" or as robust as the bloc's own regulation. This designation is solely in the gift of the EU and can be withdrawn at a month's notice.
Not all aspects of financial services are covered, and the EU has proposed a law to make the equivalence test tougher for investment banks.
The City of London financial district says equivalence as applied by the EU is unworkable over the long term for a financial center of Britain's size as it would make it a "rule taker" of EU regulation.
"People are quite hardline about not having equivalence as the final state," the City's EU envoy, Jeremy Browne, has said.
Barnier has said the EU could treat some UK financial rules as being equivalent, but there won't be broad access, meaning it cannot be used to replicate the passporting to EU markets that banks in Britain now enjoy.
Like the British government, the City wants a free trade deal with the EU that grants access to each other's financial markets based on broad acceptance of each other's rules.
Brexit minister David Davis has said Britain could negotiate such a "bespoke" deal with the EU that would extend to services.
"We'll probably start with the best of Canada, and the best of Japan and the best of South Korea and then add to that the bit that's missing, which is the services. He added: "'Canada plus plus plus' would be one way of putting it."
The aim would be to replicate as much as possible current EU passporting.
The City says a bespoke deal would be more equal than the "one way street" of the equivalence regime, with a mechanism for managing divergences in rules that may emerge as time goes by.
"We've been pushing the idea of Canada plus," said one senior banker. "We've been told it's Canada dry for the financial services industry."
A trade deal in financial services on this scale has never been done before and could take years to agree - the City acknowledges it would be on "unoccupied ground" somewhere between EEA membership and Canada's trade deal.
The EU would be cautious about giving Britain preferential access without free movement of EU citizens in the UK. The bloc could also annoy the United States, Switzerland and Asian countries.
Barnier said Britain's "financial services cannot benefit from a passport in the single market nor from a system of generalized equivalence of standards."
Many banks are working on a worst case scenario of having to fall back on World Trade Organization (WTO) rules for trade with the EU which would rely on a system of tariffs policed by the body that does not adequately cover financial services.
Under a "hard" Brexit, Britain would have to set tariffs on its goods and services, a process that could take years to complete. The General Agreement on Trade in Services, or GATS, is the WTO agreement governing trade in services.
Trade in financial services on the basis of GATS would mean the loss of the current form of cross-border passporting. There is no presumed right of market access in GATS but Most Favoured Nation (MFN) treatment obligation prohibits discrimination between 'like' services and service suppliers from WTO members.
The National Treatment obligation prohibits WTO members from treating services and service suppliers of any other WTO member less favorably than it treats domestic ones. (Reporting by Andrew MacAskill, Anjuli Davies and Huw Jones; Editing by Edmund Blair)