LONDON (Reuters) - The European Union’s default market access for foreign financial firms will not be eased for Britain after Brexit and improvements to the equivalence regime will apply to all third countries, an EU official told Reuters.

FILE PHOTO: The Union Flag and European Union flags fly near the Elizabeth Tower, housing the Big Ben bell in Parliament Square in central London, Britain September 9, 2017. REUTERS/Tolga Akmen

The official’s comments raise the prospect that banks and insurers in the City of London financial district will at best face restricted cross-border trade with the bloc after Britain leaves the EU.

City institutions have already scaled back expectations of continued full access to the EU from Britain once any transition period ends, or that a novel, bespoke trade deal can be agreed.

This leaves Britain with the bloc’s “off the shelf” system of direct market access -- known as equivalence -- as the probable if imperfect bet, EU officials have said.

It refers to Brussels granting access if it decides that the home rules of a foreign firm offer protection for EU investors to the same extent as the bloc’s own rules. It means a foreign firm can avoid the cost of setting up a subsidiary in the EU.

EU leaders said in March that Britain could be offered an improved version of equivalence, raising hopes of a more accommodative system for financial firms in London.

But a senior European Commission official said the improvements Brussels has in mind are already being made.

“Our legislation is already fit for the purposes of equivalence,” the official said, on condition of anonymity.

“We have globally the most open rules for recognizing third country regimes, but we are looking, case by case as we review legislation, if changes are necessary.”

The reforms so far tighten rather than ease requirements as Brussels races to adapt equivalence to cope with a huge foreign financial center that will soon be on its doorstep.

It has proposed tougher oversight of major foreign clearing houses that handle big trades for EU customers, which will affect LCH, a unit of the London Stock Exchange LSE.L.

There will also be more stringent requirements for foreign investment banks, many of which are in London.

“From our perspective at the current stage, those are the essential changes that need to be made,” the official said.

UK-based financial firms are opening hubs in the EU to cope with the uncertainty about what any Brexit deal will look like.

“RULE TAKER”

Equivalence has been granted in over 100 cases to financial firms in Japan, Singapore, the United States and elsewhere.

But Britain’s government and its main financial trade bodies reject the scheme, saying it does not cover all financial activities, the process is politicized, and access can be revoked at short notice.

It would turn Britain into a “rule taker” that must copy EU rules, like Norway or Switzerland, they say.

Britain’s finance minister Philip Hammond said last week that changes to equivalence proposed so far were more about forcing business to move to the EU, rather than making a one-sided system acceptable.

While UK regulators say all is still to play for in trade negotiations, Brussels is sticking to its guns.

“It’s true that equivalence, like with substituted compliance in the U.S., is a discretionary decision that ... can also be revoked,” the Commission official said.

“That is something that goes with the nature of equivalence and that is something that we don’t intend to change, and would be legally difficult to change,” the official added.

U.S. WORRIES

U.S. regulators say the planned changes to equivalence could be a taste of what’s to come for everyone.

“The EU’s approach to foreign clearing houses is likely to be a framework that other areas of EU financial regulation will follow,” Eric Pan, director of international affairs at the U.S. Commodity Futures Trading Commission, told Reuters.

“It represents an evolution in thinking in the EU to expand EU control over firms providing financial services outside of the EU, creating potential conflict with foreign regulators.”

This contrasts with the U.S. approach of so-called deference, or relying on a firm’s home regulator, he said.

“The clearing house proposal is testing the ground for an extra-territorial approach in supervision,” Pan said.

Brussels replies that the CFTC has oversight of LCH’s dollar-denominated clearing operations in London and the EU just wants the same.