Closer scrutiny of derivatives clearing at a combined London Stock Exchange Group Plc/Deutsche Börse AG could spell bad news for the firms as they look to merge.

Sources told the Financial Times that European competition regulators have significantly narrowed the scope of their antitrust investigation of the potential deal to focus on the impact on the derivatives clearing market.

The companies have viewed combining their clearinghouses as a key synergy of the mooted $14 billion merger. Deutsche Börse's Eurex has a dominant position in exchange-traded derivatives, while LSE's LCH.Clearnet represents 95% of the cleared swap market. Concerns over creating too large a player in derivatives markets were responsible for the failure of Deutsche Börse's 2012 attempted merger with NYSE Euronext.

"If the regulators force LSE or Deutsche Börse to drop one or the other, it kills one of the key rationales for the deal," Eric Compton, a financial services analyst at investment research firm Morningstar, told S&P Global Market Intelligence. Morningstar, which in March gave the merger a 50% chance of taking place, has adjusted its view of the likelihood to 25%.

Combining the margin pools of Eurex and LCH has been one of the key drivers for the deal all along, but also probably the most problematic from a regulatory approval point of view, Compton said. The merger would create the world's biggest margin pool, with total worth of €150 billion, according to the European Commission, which has until March 2017 to rule on the deal.

Without that, Compton said, the combined firm would be left with some operational efficiencies from centralizing some IT functions and getting rid of redundant offices, but would have lost a "key strategic reason" as well as the touted client efficiency benefits such a tie-up was supposed to bring.

"I think this would be a deal-breaker," said Amir Khwaja, CEO of swaps market-focused Clarus Financial Technology, in an interview with S&P Global Market Intelligence.

European mega-exchange

Clearing, the process whereby customers settle trades to buy and sell securities, has grown in importance since 2008, as regulators have sought to shift trading on to regulated exchanges, increasing the range of financial products that need to be cleared. In another sign of the shifting landscape, the EC published proposals in November that would allow authorities to intervene in the early stages if a clearinghouse runs into difficulty.

But European authorities may wish the merger to go ahead so the continent has a champion mega-exchange to compete with large overseas rivals such as the New York Stock Exchange. The combined market capitalization of the LSE and Deutsche Börse, $27 billion, still is only two-thirds that of CME Group Inc. and three-quarters that of Intercontinental Exchange Inc.

If the EU accepts that it may want one market and one central securities depository, then the deal should be allowed to go through, Brian Taylor, a London-based exchanges consultant, told S&P Global Market Intelligence.

Nevertheless, plans by the LSE and Deutsche Börse to sell off LCH SA, the French operating arm of LCH.Clearnet, even together with a sale of the Italian stock exchange, which has been suggested, may not be enough to assuage antitrust concerns.

"They can still dump the prices and provide immense access to their remaining markets at a low price," Taylor said. "Eurex has no impact on, say, the cash markets where they can provide cross listing services to foreign markets for free. How can any other market compete? They will hold a dominant position in too many product lines."

However, one London-based derivatives trader told S&P Global Market Intelligence that a merged clearing house, even if large, may nonetheless have little room to engage in anticompetitive behavior such as price-fixing.

"It really boils down to, (a) what market share would the combined entity have; (b) what percentage of trades will ultimately clear; and (c) how much scope and discretion is there for price-fixing with respect to fees and collateral rules." Although (a) and (b) are high, (c) is low, he said.

Regulators are set to announce their approach to evaluating the deal for competition in the week of Dec. 12.