Italian debt strife reveals pitfalls of Europe’s market structure

The gyrations in the Italian government bond market have revealed how Europe’s liquidity-starved sovereign debt markets are being heavily tested by even short bouts of political instability.

The rapid rise and fall in yields in the eurozone’s largest debt market in recent weeks has been exacerbated by thin sovereign debt liquidity.

During the most intense price swings some primary dealers — banks which deal directly with the national central bank to distribute its bonds into the wider market — reported that the electronic screens they used were showing fewer potential deals than normal.

This made it difficult for them to carry out their traditional role of market-makers — providing liquidity to reduce price volatility.

In contrast, other trading venues saw record volumes of Italian debt change hands. Tradeweb’s electronic trading platform, in which banks buy and sell to clients like asset managers, saw record average daily volumes of Italian debt sold in May.

Such patterns may become more frequent in Europe as traders try to cope with an unpredictable cocktail of political instability and tight market liquidity, caused in part by tougher capital rules and the European Central Bank’s loose monetary policy of recent years.

“There are a lot of markets in European government bonds, and the German market structure is very different to the French, which is different to the Italian,” said Enrico Bruni, head of Europe and Asia at Tradeweb.

One thing these markets have in common, though, is a single widely-used bond trading platform. MTS, a bond trading venue majority owned by the London Stock Exchange Group, normally trades around €340bn a month; about half of that is Italian debt.

Begun as a venture between the Italian Treasury and the Bank of Italy in the late 1980s, its prices are the starting point for dealers at investment banks to price and sell debt issued by governments across Europe.

But its liquidity has been fragile for several years. In its 2016 annual report, the Bank of Italy put this down to structural changes, like tougher capital rules and the ECB’s bond-buying programme, in which the central bank is buying €30bn of bonds a month.

“By relying on the constant daily purchases of central banks, market makers have become more willing to supply quotations for purchases but, at the same time, they have become less available to provide quotes for sales,” the Bank of Italy said.

The rest of the market is traded via privately-negotiated deals, either on electronic venues like Tradeweb or by using an human intermediary such as interdealer brokers like TP ICAP.

Deals between the banks and their customers often take place on closed “request-for-quote” systems, whereby investors can request electronic quotes from multiple dealers and choose one to trade with.

The Italian political uncertainty gave investors a good opportunity to see how this fragmented trading environment performs when liquidity dries up. Trading on platforms which the banks use to deal with clients was brisk, with Tradeweb hitting a record average weekly trading volume of €3.9bn in Italian debt.

“There was a lot of noise coming from the BTP desk,” said one interdealer broker at TP ICAP.

In contrast, volumes at MTS by nominal value dropped by about 30 per cent in late May and early June compared to earlier weeks, according to one executive.

“Interbank liquidity has fallen off a cliff,” according to one experienced London trader. “A set of banks have almost withdrawn from the market. Some banks shut down their trading desk at times of market volatility to protect their financial position.”

As a result of the slowdown in interbank BTP trading, traders say banks are having to hold bonds on their books for longer or quoting deals with wider bid-offer spreads, because banks needed additional recompense for the additional length of time they had to hold the assets. The rapid newsflow also kept bid-offer spreads wide, executives say.

Against this backdrop, two markets have reaped the benefits. The first has been the listed derivatives markets — futures and options contracts on 10-year Italian debt have become the main source of liquidity and pricing, rather than the cash market.

Banks have been hedging price moves with futures, executives say. Deutsche Börse’s Eurex market, the main Italian debt futures market, saw record volume in BTP futures last month, more than double April’s levels at more than 7m contracts.

At the same time, traders have been keeping debt close to hand, ready to trade, by using repurchase, or repo, deals. This market is used by investors to finance their short-term positions by borrowing and lending assets for a couple of days.

The average traded value on MTS’s term-adjusted repo market soared from its normal level of about €300bn-€350bn a month to €500bn. Similarly after Catalonia’s referendum on independence from Spain last year, rival Nex had a record volume day in the repo market.

The already-stressed conditions in the Italian market are a harbinger of what could happen in a wider eurozone political crisis, according to experienced participants.

As a result, one senior European government bond trader at a London bank said, volumes were likely to remain thin. “The situation remains fragile and now we have seen what the market is capable of, so it is hard to imagine we will go back to the market conditions we saw before [the crisis].’’

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