The two leading Parisian clubs are planning to come together for the 2017-18 season.
"It's a huge shock, there's a big rivalry in the derby games," Phillips told BBC Wales Sport.
New Zealand legend Dan Carter leads Racing's list of stars while Italy's Sergio Parisse is on Stade's books.
Stade Francais won the French Top 14 title in 2014-15 while Racing took over as champions the following year, though both are currently in the lower half of the division.
Racing's new 30,000-capacity stadium is due to be completed later in 2017 while their rivals have updated and expanded their Stade Jean-Bouin home to take 20,000 fans in recent years.
Phillips, now with Sale Sharks, played for Racing for two and a half seasons and said he did not believe the initial reports from Paris.
"I'm massively surprised," he said.
"The guys (at Sale) talked about it in training and firstly I said 'That's not true, it's just the French media' but it was for real."
Phillips won 94 caps for Wales and made five Test appearances for the British and Irish Lions before partnering Carter in the blue and white Racing colours.
Wales colleagues Jamie Roberts, Luke Charteris and Dan Lydiate have also played for Racing.
"Stade won the league two years ago, they beat us two or three times, then the following year we managed to win the league and our president Jacky Lorenzetti was thrilled," added Phillips.
"Both clubs have got a huge history in French rugby and Stade Francais have won the title many times, they have a massive tradition just like Racing."
He says the rivalry even extended to where players were meant to live.
"You weren't allowed to live in a certain area because that's where the majority of Stade Francais players lived and that was pushed by Jacky Lorenzetti, he was in control of that," he said.
The proposed merger has yet to be approved by the French league authorities, the LNR.
Former Wales scrum-half Mike Phillips is shocked by a planned merger between his former club Racing 92 and their rivals Stade Francais.