(Adds comments, CDS, update prices)
By Ali Kucukgocmen and Jonathan Spicer
ISTANBUL, May 7 (Reuters) - Turkish financial markets tumbled on Tuesday after the elections board ruled to scrap and re-run Istanbul elections, with the lira down 1.3 percent to its weakest level since last year's currency crisis was waning in October.
The Turkish lira stood at 6.1600 against the dollar at 1011 GMT, from 6.0829 on Monday, having earlier hit its weakest level since Oct. 5.
As investors questioned Turkey's commitment to both the rule of law and economic reforms during a recession, bonds and stocks were also sold off.
The main BIST100 share index was down 1.93 percent at 1009 GMT to its lowest in a month, while the main Turkish bank stock index fell 2.77 percent after earlier touching its lowest level since January.
Challenges by President Tayyip Erdogan's AK Party to the March 31 election result in Istanbul, which showed a narrow victory for the main opposition CHP, had already hit the lira in recent weeks. Istanbul, Turkey's main commercial hub, accounts for one third of the country's economic activity.
The High Election Board (YSK) ruled on Monday to hold new elections on June 23. The AK Party said the decision was based on unsigned documents and some ballot box officials not being civil servants, while the opposition slammed the decision as a blow to democracy.
Edward Parker, managing director at Fitch Ratings and head of the group that covers Turkey, said the re-run risks distracting from policies that rebalance and stabilize the economy. "The elections being re-run just pushes out that point in time, and we have another nearly two months of extra uncertainty," he said.
Fitch last week reaffirmed Turkey's sovereign rating at 'BB' with a negative outlook, but Parker said it could be downgraded if "existing weaknesses are aggravated, especially given the volatility in the Turkish economy and currency."
Some investors worried that Turkey's central bank would resort to "back door" measures to stabilize the lira, as it did before the initial election in late March, when it ramped up its use of swaps to fend off a volatile selloff.
The central bank started transactions on Tuesday in its new gold swap market to help its sagging reserves.
Turkey's dollar-denominated government bonds logged their biggest selloff in months on Tuesday, with longer-term debt leading the fall.
Five-year credit default swaps also rose 27 basis points from Monday's close to 461 - levels last seen just ahead of the March 31 elections, according to IHS Markit.
The lira has lost some 14 percent of its value this year, underscoring the difficulty in lowering inflation from near 20 percent and unemployment from near 15 percent.
"The market already feared the vote would be overturned," said Kiran Kowshik, strategist at UniCredit. "Now the rule of law is under scrutiny by markets...and there are questions about whether Turkey can weather its immediate challenges without an external anchor like the IMF."
Adding to concerns over election uncertainty and the central bank, the United States has threatened to impose sanctions on NATO ally Turkey over its planned purchase of Russian S-400 missile defence systems.
The decline in the lira, which lost nearly 30 percent last year, has also sapped confidence among locals, prompting their forex holdings to surge in the six months to April.
Speaking to party members on Tuesday, Erdogan vowed to fend off what he called attacks on Turkey's economy.
"We may have deficiencies but the scene we are facing today is a complete state of sabotage," he said. "So, what are we going to do? From now on, we will do what we did to terrorists." (Reporting by Ali Kucukgocmen and Jonathan Spicer; Additional reporting by Tom Arnold in London; Editing by Dominic Evans and Andrew Cawthorne)