The European Union next week unveils its third broadside against credit rating agencies since the financial crisis began, and this time the Big Three face a direct hit where it hurts.

Thursday's mistaken downgrade by Standard & Poor's of France's sovereign debt won't help a sector seen by policymakers as an oligopoly that fomented and exacerbated market turmoil globally and more recently in the euro zone.

This reinforces my conviction that Europe must have rigorous, strict and solid regulation for credit rating agencies, said Michel Barnier, the EU financial services chief who wrote the draft law that will be published next Tuesday.

A key element will be a civil liability framework in the case of serious misconduct or gross negligence, Barnier said in response to the S&P error which sparked major market moves.

The 27-country bloc has already approved two rules, the first forcing agencies to seek authorisation and a second requiring them to report directly to a new EU regulator.

But the latest measure goes much further by trying to end the global dominance of S&P, Moody's and Fitch Ratings seen by many Europeans as being too U.S.-centric, even though Fitch is listed in Paris.

The plan will curb how agencies rate sovereign debt -- a sensitive issue as the euro zone tries to restore investor confidence in its bonds after bailouts of three members.

ROTATION

A version of the draft law leaked last month rang alarm bells not only at agencies but also among users of ratings such banks and businesses.

The draft outlined a tough plan to introduce more competition by forcing users to rotate or switch agencies regularly with a cooling off gap of four years in between.

With most top firms and banks rated by two if not all of the Big Three, if would mean that after one to two years users must switch to using some of the 10 or so smaller agencies registered in Europe, such as Euler Hermes .

Investors in Asia or the United States may not be familiar with the smaller European agencies, making them think twice about investing, rating agency officials argue.

This would come at a time when European companies will have to rely more on bond markets for raising money as their traditional source of capital, the banks, conserve cash to build up safety buffers.

Smaller agencies would also be given business without having to compete on price or quality.

There is concern that mandatory rotation of agencies could be counter-productive, said Richard Hopkin, a managing director at the Association for Financial Markets in Europe, which represents the region's top banks.

Rotation would increase rating volatility and decrease the quality of credit ratings due to the limited number of global players and the significant and increasing barriers to entry for potential competitors, Hopkin said.

Michel Madelain, president of Moody's Investors Service, told Barnier and EU finance ministers last month that unless the tough rotation rule was watered down it would in the end be very disruptive to the flow of capital to European issuers.

A source familiar with the situation said that the central rotation element will be lightened up a bit, such as by having a longer period before mandatory switching kicks in.

The same rules may not also apply to both agencies when an issuer needs two ratings, the source added.

BLACKOUTS

Another core element is to give EU states powers to introduce temporary blackouts or a ban on ratings on their sovereign debt in particularly exceptional circumstances.

The EU was furious when last year an agency downgraded the debt of Greece just as it was putting together the country's first bailout package, seen as making the task harder.

EU states like Britain, which is expected to oppose the draft law, question how this would shore up credibility in the euro zone or stop agencies from outside the EU from issuing opinions.

The bloc will also next Tuesday finalise another step to try to take market pressure off its sovereign debt: the European Parliament will vote through a ban on naked or uncovered credit default swaps linked to government debt.

Finance and ratings agency officials say both measures are simply a case of shooting the messenger while the real problem lies at the door of heavily indebted countries.

(Reporting by Huw Jones; Editing by Helen Massy-Beresford)