Investors are cashing out of Italian-exposed ETFs and shorting bank stocks ahead of a crucial referendum in the country on Sunday.

Billed as a key event for political stability and Italy’s future, the vote sees Prime Minister Matteo Renzi’s political career pinned on asking Italians if they support his plan to overhaul the country’s national constitution.

A "yes" vote on December 4th should reinforce Renzi's mandate and allow him to push forward with his economic reforms. However if Renzi were to lose by a hefty margin, he’d likely step down.

That could mean the populist Five Star Movement, the country’s largest opposition group, make some significant gains.

Statistics from Markit show Italian shorting activity is up 10% from a year ago with banks leading the way.

“After its poor track record of predicting election results in recent months, the market is taking no chances with regards to Italy’s upcoming referendum as both equities and credit investors are actively seeking protection heading into Sunday’s vote,” analyst Simon Colvin wrote on Wednesday.  

The average demand to borrow the Italian constituents of the Stoxx 600 index now stands at 3% of shares outstanding.

Two thirds of the Italian financials which feature in the index have 3% or more of their shares out on loan.

Shares in Union DI Banche Italiane (UBI) and Banca Popolare Di Milano are among those in demand.

Insurance firms Unipolsai Assicurazioni and Assicurazioni Generali also have more than 3% of their shares now out on loan to short sellers betting on a price drop. 

ETF fail to stem outflows 

IHS Markit’s analysis shows that Italian exposed ETFs are continuing their bad run after outflows in each of the first three quarters of the year. A record €720m was withdrawn in Q3.

“These outflows, combined with the plunging equity values, means that the capital invested in Italy through ETFs has shrunk by a massive 40% since the start of the year,” Colvin concluded.

Italian law prohibits the publication of official opinion polls in the two weeks leading up to an election, so there’s little guidance for markets.

“Polls suggest the vote will fail, and if it does, PM Renzi will likely resign,” said David Folkerts-Landau, chief economist at Deutsche Bank. 

"The sell-off in Italian assets indicates that this outcome is being priced, but as long as immediate elections and a eurosceptic government are possible, market stress can build further."

Joel Kruger, FX strategist at LMAX Exchange, added: “The rise of populism around the globe, as reflected by the shocking outcomes in the EU referendum and US election are fueling an added layer of intensity to the Italian referendum that may in fact be overstated."