ANALYSIS-A big short growing in Italian debt

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LONDON, Nov 9 (Reuters) - A surge of interest in Italian bond futures may be a sign of a substantial short position building up in the derivatives market as tensions rise over budget negotiations between Rome and Brussels.

The big short in the futures market reflects a buildup in speculative and hedging activity after a tumultous summer in the Italian markets and also indicates rising concerns of capital outflows.

Investors say it also leaves the market potentially open to a sharp rebound if the debt story improves in some way over the coming months either through a breakthrough in negotiations over the debt dynamics or approval from credit rating agencies.

As Italy's anti-establishment government attempts to pass an expansionary budget in the face of opposition from the European Union, investors are ramping up their use of a product that is increasingly being used to take bets that more losses are in store for the country's bonds.

Italy has the biggest outstanding bond market in the euro zone and futures trading has rocketed in recent months as hedge funds have stepped up their presence, even as the underlying cash bond markets have shown signs of stress during extreme episodes of volatility.

Average daily turnover so far this year for short-term BTP futures contracts have surged 40 percent to nearly 70,000 contracts compared to 2017 while longer-term BTP futures have also grown substantially, according to futures exchange, Eurex.

The rise in turnover has also been accompanied by surging yields and growing open interest or the amount of positions left outstanding, indicating speculators are comfortable in taking outright short bets, according to market players.

For example, open interest on short-dated BTP futures peaked at a record 280,000 contracts on Oct. 25 and has consistently averaged around 275,000 contracts in the last two weeks.

"Clearly today there are a number of investors, including large hedge fund investors who are taking large short positions on Italian debt through both the short and long-dated BTP futures," said Mark Dowding, head of developed markets at BlueBay Asset Management.

In contrast to the growing popularity of bond futures, turnover in credit default swaps has declined as the increased scrutiny by regulators in the wake of the euro zone crisis dimmed its allure for taking speculative bets.

For example, net outstanding dollar value of credit default swaps (CDS) contracts on Italy has declined by more than a quarter to less than $12 billion in the week ending November 6, compared to the beginning of 2017, according to data from post-trade provider Depository Trust & Clearing Corporation.

"In a world where investors can't take naked short positions by buying sovereign CDS, Italian futures are the instrument to use if you want to implement a short view," Dowding added.

TAKING BETS

A portfolio manager at a macro-hedge fund in London said he uses futures to take bets on Italian debt because the margining system in futures contracts makes it less capital intensive than purchasing bonds.

Margining refers to the practice in futures markets, wherein investors have to cough up only a chunk of the notional value contract, allowing them to take bigger positions. In cash or CDS trading, on the other hand, traders have to put up the entire amount in order to take a view.

Despite more capital needed to trade credit default swaps compared to futures, these derivatives, designed to protect against the risk of debt default, were widely used by investors looking to hedge the possibility of sovereign default, especially in Greece, during the 2010-2012 debt crisis.

CDS were used also to take directional bets on a market, sometimes even when the investor did not own the bond prompting regulators to bring in rules banning "naked" CDS trading -- purchasing CDS contracts in a purely speculative manner without having exposure to the underlying asset.

The increased scrutiny on CDS trading by regulators fuelled appetite for trading bond futures as investors welcomed their transparent settlement mechanisms and liquidity, particularly during times of market stress.

So this year, when a severe Italian bond selloff kicked off in May, futures trading exploded where open interest has increased every month barring May, June and September this year.

Seamus MacGorain, a fixed income portfolio manager at JP Morgan Asset Management, said futures trading activity also tends to spike during periods of volatility because that is usually accompanied by across-the-board liquidity declines.

Decline in liquidity is evident from widening bid-offer spreads -- the difference between prices what investors pay to execute a trade with wider spreads indicating falling liquidity.

In September for instance, monthly weighted average bid-offer spreads on five-year bonds stood at a chunky 13 basis points, the Italian Treasury's website says.

Those spreads were a fraction in the futures markets, according to a bond trader.

"Italian bond market liquidity fell during summer's market volatility, and continues to be impaired," MacGorain said.

(Reporting by Abhinav Ramnarayan and Saikat Chatterjee; Editing by Sujata Rao and Alison Williams)