* Deutsche exposed to Brexit because of London trading
* Supervisors want back-up plan if Brexit turns sour
* Frankfurt hopes for business boost
By John O'Donnell
FRANKFURT, May 18 (Reuters) - European supervisors want Deutsche Bank to prepare a fallback plan to lay out how it could shift the clearing of trades from London, one person with direct knowledge of the matter said, as the region seeks to guard itself against a possible hard Brexit.
The European Central Bank, which monitors euro zone lenders, is worried about the impact on the region's financial sector, should Britain drop out of the European Union without agreeing the terms of future trade, including cross-border banking.
That would hurt not only banks using London as a springboard to Europe but also those on the continent that rely on it to clear trillions of euros of derivatives deals - one of the pillars of Europe's biggest trading centre.
Some politicians, such as in France, want the clearing of such financial contracts in euros to move to continental Europe after Brexit, a move industry has warned would cost Britain thousands of jobs.
Deutsche, Germany's top commercial lender, is particularly vulnerable because it is one of the bigger European dealers of euro-denominated derivatives in London, which it has said would become difficult if a 'hard' Brexit abruptly severed links with the continent.
"Deutsche Bank has to make up its mind within months," said one top European regulator, referring to the possible need for a shift of trading. "They need a back-up plan for a cliff-edge Brexit."
While disentangling such financial ties between continental Europe and London would be costly and time consuming, preparations are under way in Frankfurt and Paris to take advantage of Brexit.
Deutsche Boerse, owner of Eurex Clearing, which processes or clears trades, has seen a sharp rise in activity, in part due to Brexit.
Anticipating a shift of business from London, it has conducted a series of test runs to see whether its Eurex Clearing arm could cope with processing substantially more trades and is satisfied it would.
"Particularly around clearing we see increased client demand for our services across the full suite of listed and OTC (over the counter) derivatives," Eurex Clearing Chief Executive Erik Mueller said.
"Our...systems are...fully scalable."
Other global banks, which dominate the trading of derivatives, would also be affected but Deutsche is one of the biggest European players.
Others large dealers include Morgan Stanley, JP Morgan and Goldman Sachs.
Deutsche Bank and the ECB declined to comment. However, last month, Sylvie Matherat, the bank's chief regulatory officer, indicated that she had concerns about the impact of Brexit on its UK trading operations.
She highlighted the risk that the capital charge on banks for processing euro-denominated derivative trades in London could climb dramatically when Britain leaves the bloc.
Regulators said this would happen if Britain's divorce talks, which must conclude in less than two years, ended without an EU agreement to recognise British clearing houses, an outcome bank executives fear.
"Nobody in the financial industry is able to stand that," said Matherat, a former regulatory official at the Bank of France, adding that this could ultimately encourage "everybody" to move elsewhere.
Other banks including Morgan Stanley and Goldman Sachs, both of which are considering bolstering operations in Frankfurt, are also closely examining this issue, people familiar with the matter said. Both declined to comment.
The question of where to put clearing after Brexit is far from clear cut.
The European Union could introduce rules requiring the clearing of derivatives trades in euros to take place within the 19-member euro zone.
But shifting any part of the multi-trillion euro derivative trading sector would be laborious and could create uncertainty as contracts shift countries.
It is being strongly resisted by industry.
"If the EU is proposing to repatriate EU clearing from London to Europe they're clearly going to impose upon London some sort of penalty," Michael Spencer, chief executive of Nex Group, told journalists.
Spencer said such proposals were economic nationalism, describing them as "ludicrous" because of the global nature of trading.
Nonetheless, the uncertainty over whether a new trading framework will be reached between the EU and Britain before the close of divorce talks in less than two years could leave banks with little choice but to prepare a move.
"You can wait ... up to a certain point," said Deutsche's Matherat. "There is a deadline, where we can't keep optionality."
Additional reporting by Andreas Kroener in Frankfurt, Huw Jones in London and Esha Vaish in Bangalore; Editing by Rachel Armstrong and Susan Thomas