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Foreign Exchange

Euro slides as LCH margin hike sparks debt sell-off

LCH Clearnet, Europe’s largest clearing house, raised the margin required to trade Italian government securities on Wednesday, a move that could prompt a fresh escalation in the eurozone debt crisis and herald an attempt to fund a bail-out for cash-strapped Rome.

The move undermined the euro and put pressure on the European Central Bank to become more active in the Italian bond market. Thus far, reports suggest the ECB, under new president Mario Draghi, has only just been buying enough Italian debt to take the froth out of the market while insuring that heightened pressure remains on the government to reform its finances. 

LCH raised the initial margin call applied to Italian debt by between 3.5 and 5 percentage points across all maturities of BTP and inflation-linked BTP bonds.

The decision came after the spread of the yield on Italian government bonds over their German counterparts exceeded 450 basis points, a level which LCH considers a benchmark for raising its collateral requirements.

The move raised the cost of holding Italian debt and followed margin call increases for Greece, Portugal and Ireland over the past year and a half, which signalled a new and more dangerous chapter in the eurozone debt crisis.

Indeed, when LCH raised margin requirements on Greek, Portuguese and Irish debt, bail-outs followed shortly afterwards.

But the difference with Italy is that it is simply too big to be rescued through the current mechanisms that have been put in place by European authorities, and thus any bail-out deal would have to come after a complete overhaul of the current system. 

"There is no bail-out possible," said Neil Mellor at Bank of New York Mellon. "It's a frightening situation."

The euro had found support ahead of the decision, as a pledge from Italian prime minister Silvio Berlusconi to stand down raised hopes that Rome might find some breathing space to get its finances in order.

However, the single currency suffered, dropping two cents against the dollar to a session low of $1.3630 as the yield on benchmark 10-year Italian bonds rose to a euro-era record of 7.43% as investors liquidated their positions in Italian debt. The spread of the yield of Italian 10-year bonds over German 10-year notes rose to 520 basis points, the level at which Portugal was bailed out.  

“Berlusconi may be headed for the door but news that LCH Clearnet will raise Italian margin requirements across the board is another sign that the crisis surrounding Italy is intensifying,” says Jane Foley, senior currency strategist at Rabobank.

She explained that the move was designed to protect the clearing house from unnecessary losses, but it was also set to pressure further the Italian bond market and so cultivate a negative feedback loop.

“The crisis appears to be worsening and this could see investors increasing their EUR shorts,” adds Foley. “EURUSD will remain sensitive to headline news but we cannot rule out another run on the downside towards the $1.33 area.”

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