Well this is embarrassing. Turns out that Banca D’Italia released its latest financial stability report on November 2.
It’s a shame we missed it because it is literally jam-packed with market info. Worth a read on all fronts.
We’re still picking our way through it. But here’s one chart that immediately jumps out:
Note a) the sudden drop in the percentage of Italian bonds failing to settle around the middle of 2011 alongside b) a massive jump in the “specialness” of Italian bonds at the same time.
As we’ve said before, Italy — just like Greece — was one of the few European bond markets to suffer a dramatic pickup in settlement fails post the 2008 crisis.
Nobody really knows why, but one thing that has been pointed out is that unlike many other European markets, the Italian and Greek bond markets don’t feature the same central bank mechanisms for easing tightness in particular issues, which are common in others. For example, in many cases, central banks hold back supply from auctions just so that they can have inventory to return to the market when repo rates get out of whack. Other central banks offer so-called phantom services, which simply manufacture copies of hard-to-locate bonds for a fee. In all cases the point is to ease government bond “specialness”, which may otherwise lead to negative repo-rates and/or high amounts of settlement fails. (The fails come about because there’s no incentive to cover shorts, since the cost of obtaining the bonds is so high).
So what caused the specialness spike in Italy up until mid 2011?
According to Banca d’Italia, there was a sudden pickup in the economic incentive for foreign participants to fail (a.k.a never cover their short positions). Or as they put it:
In the second quarter the percentage of the trades entered in the securities settlement system not settled on the intended settlement date (fails) began to increase, especially in the government securities component (Figure 4.17). The rise was almost entirely accounted for by foreign participants and in any event has not been large enough to compromise the efficient functioning of the settlement system. In part, the fails appear to be ascribable to an economic incentive, as is confirmed by the high positive correlation, until July, between the percentage of unsettled transactions and specialness (the difference between the rates on general collateral and on special repos, which is a proxy for the opportunity cost of procuring specific types of securities).
What’s really interesting, however, is what the authorities decided to do next.
As the Banca d’Italia explains:
At the request of the Bank of Italy and Consob, during the summer Monte Titoli began to revise the system of penalties for fails (see the box below). The announcement of the initial measures on 5 August coincided with a significant reduction in fails, but they began to increase again in September in concomitance with renewed strains on the special repo market; even so, they remained at lower levels than at the start of the summer. It is too early to judge the effectiveness of the first countermeasures, which only went into effect in September. Monte Titoli may review or supplement them as part of a broader revision of the system of penalties.
And as we’ve already noted, the introduction of the penalty system on September 1 actually coincided with a dramatic spike in Italian bond yields.
Did foreign participants simply decide to bail rather than pay up the penalties? Seems like it.
In any case, here are some more details from Banca D’Italia on the nature of the penalty system and how it coincided with new short-selling rules:
THE MEASURES AGAINST FAILS AND SHORT SELLING A new system of penalties has been introduced in the effort to reduce the share of fails not due to technical problems. It replaces the old mechanism that levied a fixed penalty of €200 on Express II participants when unsettled trades in the security settlement system as a whole reached a set threshold. The new system applies penalties to participants in proportion to the volume of daily fails security by security, valued at market prices.
The penalty rates are 0.001 per cent for corporate bonds and government securities and 0.02 per cent for all other securities (shares, warrants and ETF s). To avoid excessive administrative costs there are thresholds below which penalties are not levied (€5 million for bonds and €250,000 for other securities). The proceeds of the penalties are redistributed, pro rated by individual security, to the participants to whom the delivery of the relevant securities was not made during the reference month.
In August, in order to counter the slump in share prices in July and August, Consob prohibited traders from taking new net short positions on the shares of financial companies or increasing existing ones. The measure, which followed similar ones taken by the authorities in other euro-area countries, was initially to be in force for 15 days. Subsequently, under the coordination of the European Securities and Markets Authority, it was extended until 11 November. The ban exempts market makers, for whom the possibility of short sales is considered to be normal.
When you can’t naked short, be net short or fail — is there really any point in trading the market as a foreign participant at all?
No wonder liquidity has died.
And the really dumb thing – noone depends on a functioning Italian repo market more than Italy’s biggest domestic bands.
In the words of Banca d’Italia:
Estimates based on data from the TARGET 2 gross settlement system indicate that Italian
banks had ample recourse instead to the OTC market, which for the largest operators is practically the sole means used to procure uncollateralized funds from abroad. As a rule the banks have bilateral OTC relations with a smaller number of counterparties than they deal with on e-MID. This necessitates careful screening and assessment of the counterparties with which to conduct this kind of activity on an ongoing basis.
Oh, the sound of someone shooting themselves in the foot.
Related links:
Italian settlement fail penalty, bond sell-off — causation or correlation? - FT Alphaville
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