This is the performance in 10-year Italian bonds this year (chart courtesy of Bloomberg):
What’s intriguing, of course, is how the bond yields spiked so suddenly in early July. Almost out of the blue.
It even baffled analysts, who struggled to explain it at the time.
And just as quickly as it spiked, it settled back by early August ….only to resurface equally dramatically by September 1.
Causation or correlation, we do not know, but the July date does intrigue us — it was the very same month Italian market regulators decided to bring efficiency to the Italian repo market, which prior to that had been experiencing an unacceptable rate of settlement failure, by amending the settlement procedure.
Since the authorities were convinced that high fail rates were the result of operational glitches — people not picking up phones, or overlooking faxes — rather than any sinister settlement-avoidance strategies, they moved to give market participants more time to settle trades. A total of 10 extra days was in fact the recommendation.
All very well, except that a similar move to extend the settlement period in Greece — also to avoid a messy fail rate — was thought by some politicians to have been a key driver in encouraging the Greek bond death spiral. The amendments had, after all, come just before the bond sell-off began in earnest.
As the FT wrote in May 2010:
The change was reportedly made in response to a request from the Association of Greek Banks, which represents market-makers in Greek bonds. But it gave short sellers a longer window of opportunity to push down the price of a Greek bond before delivering it on the settlement date, Ms Papandreou said. The central bank also abolished penalties for investors which did not deliver a bond on the settlement date in a move that allowed failed transactions to be continuously recycled.
Critically, these rules made it easier for market-makers to sell the bonds short.
Fast forward to Italy and the country’s equivalent authority Monte Titoli — perhaps trying to make amends for its previous settlement extension folly — decided instead to try to control settlement efficiency by introducing penalties instead.
In August it thus announced the following:
Consob and the Bank of Italy’s settlement service regulation require Monte Titoli participants to guarantee the availability of cash and securities necessary to finalise settlement of transactions with their counter-parties. This in addition, will allow Monte Titoli to improve the efficiency of the settlement system. A penalties model has been developed to encourage participants to comply with this requirement. For this reason full details of the penalties model have been made available on this document.1. Should the settlement cycle not be finalized within the default timetable, Monte Titoli will evaluate the causes, and determine whether or not penalties should be applied. Please note, that participants will be provided with adequate information should they incur in any penalties.
The penalty was enforced on September 1.
But while it should, theoretically, have stamped out settlement fails (and naked shorting) — thus supporting Italian bonds — there was one major caveat.
As RBC Dexia noted, when it comes to OTC markets, market makers are still not forced to deliver securities:
Buy-ins exist in the Italian market only for those trades executed on-exchange. Not applicable for off-exchange transactions. Buy-ins may occur for on-exchange transactions that are against a CCP (CCG or Clearnet). Under Decree 5/5/2004, The Ministry of Economy and Finance has announced the introduction of penalties for auction trades, and repurchase and bond exchange operations that fail to settle on the settlement date (SD).
For Markets covered by the CCG, including MTA International, the current procedure provides that, should a trade not settle for three days following the original settlement date, due to a lack of securities, a buy-in notification will automatically be sent by CCG to the failing counterparty on SD+4. The failing party has three additional days to settle the trade. Otherwise, in the evening of SD+7 (currently defined as 7th “Market opening day” following the original settlement date), the trade will be deleted from the system and in the morning of SD+8 the buy-in will be executed.”
Forced buy-ins and penalties thus seem only to apply to the on-exchange market. A fact which may, or may not, be creating a bit of a two-tier system.
Frozen in the Greek repo markets – FT Alphaville
Take HDAT, Greek politicians – FT Alphaville
Are some traders gaming the system with settlement fails? – FT Alphaville