MILAN, Sept 12 (Reuters) - British clearing house LCH.Clearnet has dropped a guarantee on Italian government bonds' repo transactions, potentially hurting an important funding channel for Italian banks while many still grapple with capital shortfalls.
The move increases the potential risk for investors settling Italian government bond repos - short-term loans guaranteed by Italian debt securities - through LCH, analysts said.
The decision, buried in an Aug. 2 update of its complex clearing rule book, came after months of wrangling with Italian and European authorities, which were sceptical about the move, a source close to the matter told Reuters.
It introduces a 'cash settlement' in case of default of counterparty Cassa Compensazione e Garanzia (CCG), freeing LCH from a previous obligation to protect repo lenders.
"The Bank of Italy and the Treasury, as well as the European Central Bank, all expressed scepticism about the move," the source said, adding LCH had initially wanted to introduce the change in early 2013.
The source also said that LCH separately lowered earlier this year the maximum exposure it was prepared to take on Italian debt for a single client, potentially curbing investors' ability to trade on Italian bonds if market activity were to rise back to pre-crisis levels.
The Bank of Italy, the Treasury, the ECB and LCH had no comment.
Citi estimates Italian banks have around 130 billion euros ($172.9 bln) in funding raised through private repo transaction, making them the largest private repo borrowers in Europe. More than half of that figure goes through LCH, they say.
Italian lenders will now be pushed to seek bilateral repo lines, which are likely to be smaller and costlier than when LCH was involved as an intermediary, Citi analysts believe.
Much of the 160 billion euro increase in Italian bond holdings at domestic banks seen since mid-2010 is likely to have been funded on repo, Citi says.
"Against this backdrop, the risk-reward in both sovereign and bank bonds seems uncompelling. We recommend selling (Italian) BTPs versus (German) Bunds or (Spanish) Bonos, selling the sovereign basis, and selling Italian bank bonds against Italian corporates or against banks in the core," they wrote.
LCH's decision, though consistent with regulatory guidelines, surprised analysts and traders as it came while risks of a euro zone break-up have abated and Italy's economy is expected to emerge from a two-year recession this quarter.
While yields on Italian government bonds have receded from the risky peaks hit in late 2011 and again last summer, the threat of an imminent new government crisis has eroded their appeal compared to Spanish bonds this month.
The London Stock Exchange group controls both LCH Clearnet and Italy's CCG. The two have had worked in partnership for the last 10 years. ($1 = 0.7518 euros)