The first LTRO repayment opportunity is fast approaching. David has already considered how it may or may not impact European lending rates, including the chances of Eonia rising significantly if the repayment is larger than expected. Yet as we also noted, this is hardly the key concern. The key concern really is whether a large repayment will once again lead to conditions that bifurcate the eurozone collateral market. Some say no, the underlying conditions are different now. But others suggest the unwinding of the original Sarkozy carry trade could create a different reality. Indeed, the LTRO's early repayment options provide an excellent opportunity for banks to take profit on Sarko carry deals. Thus, a larger than expected repayment by the Sarko carry-trade holding component could lead to selling pressure on the collateral positions associated with the trade, inadvertently leading to the re-bifurcation of the market. So what conditions might prompt banks into a larger than expected unwind? Overall, there are three main scenarios. One, things are so crappy in the market that the underlying collateral backing the trades is now being threatened. Two, risk-appetite is so good banks believe they can easily get a higher yields elsewhere. Three, LTRO funding is looking expensive and the locked in yield no longer justifies the opportunity cost because funding can be secured much more cheaply. Here's Don Smith from ICAP making some of the same points (our emphasis): The evidence suggests that many Spanish and Italian banks (which accounted for around two thirds of total LTRO funding), engaged in the so-called "Sarkozy trade" - the carry trade which involved the purchase of high yielding Italian and Spanish government debt with LTRO funds secured with said purchases as collateral at the ECB. A major consequence of this of course was downward pressure such a strategy would impart to peripheral government yields, thus directly addressing one of the most damaging manifestations of the sovereign debt crisis. At the time, these countries faced something of a death spiral related to the interplay between rising government yields and plunging solvency outlook. The financing of these positions, could in theory be transferred from the ECB to much cheaper (albeit shorter maturity) repo market funding (Italian GC rates are currently around 20bp mid for one-year maturity.) But this option perhaps exists for only a small proportion of the largest peripheral banks. Initial margin costs for low credit banks will cut the benefits of such a switch. On balance, sentiment regarding the Eurozone sovereign debt crisis has not yet improved to a level which would encourage the large swathe of smaller peripheral Eurozone banks to shift, just yet, out of the EC's LTRO and thereby put pressure on repo market funding and peripheral repo rates. But it would be a surprise not to see at least some upward move in particularly Italian GC rates once the LTRO repayments begin on 30th Jan and we are perhaps just beginning to see the start of this process. And as Smith notes, if any market is liable to come unstuck, it's probably Italian general collateral (GC) above all: Related links: Paying back the LTRO early... or not - FT Alphaville European bank debt is attractive again (but not *that* attractive) - FT Alphaville Eurozone liquidity and menacing straws - FT Alphaville