June 18, 2012 / 2:01 PM / 7 years ago

MONEY MARKETS-Spanish bond shortage distorts repo

* Spanish bond shortage distorts repo market

* Italian rates rise but market still functioning

* Interbank cash rates fall on rate cut expectations

By Kirsten Donovan

LONDON, June 18 (Reuters) - A lack of available Spanish government bonds, due to so many being used to obtain funding at the European Central Bank, is distorting pricing in repo markets and causing investors headaches as they seek to cover hefty short positions.

As international investors sold Spanish government bonds this year, domestic banks bought them and parked them at the ECB in return for funds - particularly during the two recent three-year funding operations.

As a result, investors who need the bonds because of their own short positions must pay a premium for the paper.

When this happens in repo markets - where banks commonly use government bonds as collateral to raise funding - bonds are said to be trading “special”.

Effectively, the investor who needs the bonds pays a premium to their counterparty in the trade - the opposite of a typical repo trade where the party borrowing cash pays the premium.

“There’s some good evidence of a collateral shortage out there,” said ICAP rate strategist Chris Clark. “Quite a lot may be being used at the ECB and the market short (positions) out there will be increasing the demand for specific bonds.”

It is the opposite of what might be expected when a country’s debt comes under pressure. Then counterparties are usually more reluctant to be left holding the bonds.

“The collateral just isn’t there. That’s one of the problems and the few bonds that are still available are highly sought after by people who want to cover their short positions,” said Commerzbank rate strategist Benjamin Schroeder.

Ten-year Spanish government bond yields have risen more than 130 basis points since the start of May, while two-year yields are up over 2 percentage points.

That prompted international clearing house LCH.Clearnet SA to increase the cost of using Spanish bonds to raise funds via its repo service last month. Analysts said their trading desks had since seen volumes over the platform drop.

“It’s a further segregation of European money markets, where banks are retreating from central clearing houses and going back to domestic clearing or bilateral agreements,” Schroeder said.

As the euro zone debt crisis intensified this month, mainly due to worries about Spain’s banking sector, Italian general collateral (GC) repo rates, paid to borrow funds against a basket of government bonds, have been pushed higher.

There is little trade in the Spanish general collateral market but banks are still able to borrow using Italian bonds as collateral, despite Italy being seen as vulnerable to contagion from worries about Spain.

Three-month Italian GC rates rose to 0.42 percent at the end of last week, compared to the Eonia overnight rate at around 30 basis points, according to ICAP. The Italian rate had traded below Eonia from the time of the ECB’s second three-year funding operation at the end of February until the end of May.

“There’s been a rise in Italian general collateral rates, both outright and relative to the Eonia OIS curve,” ICAP’s Clark said. “Despite a reduction in the amount of term activity that goes on, the Italian market is still very much functional.”


Three-month Euribor interbank lending rates eased again, hitting their lowest since the second quarter of 2010 as speculation grew the ECB may cut interest rates.

ECB president Mario Draghi heightened expectations the bank could cut interest rates or take further policy action soon after saying on Friday that the euro zone economy faced serious risks and no inflation threat.

September and December Euribor futures contracts rallied to contract highs, pushing implied rates lower.

Markets are pricing in a 50 percent chance of a 12.5 basis point cut in the ECB’s 0.25 percent deposit rate this year, and a 25 percent of the rate being cut to zero, according to RBS.

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