Monique Jager-Smeets, head of institutional risk management at KAS BANK explains why liquidity risk is increasingly important for trustees
This blog was brought to you by:
“Going under” due to a lack of cash to meet very short term margin requirements, it’s happened before with renowned parties such as the US insurance giant AIG and the investment fund LTCM, and we certainly hope it won’t happen again.
With the advent of central clearing for derivatives due to EMIR (European Market Infrastructure Regulation), a lack of ready cash is also becoming a real danger for pension funds. Effective liquidity management is going to be essential in order to manage this risk properly and ensure you don’t put the scheme in an unforeseen dangerous situation.
Early in this century the trade of derivatives grew enormously worldwide. The vast majority of derivatives contracts were concluded bilaterally - between two parties. The arrangement of providing collateral, the assets you offer up to secure the trade if anything were to go wrong, was typically done privately between these two parties.
This method, called the Over-the-Counter (OTC) derivatives trading, has been rather opaque. That became painfully apparent after the failure of Lehman Brothers in 2008, when virtually nobody knew that the market was exposed nearly entirely to one of the largest derivatives traders in the world. This lack of clarity caused a huge crisis of confidence, which resulted in the drying up of liquidity in the market and the long and deep financial crisis we’ve all experienced.
In response, the G20 countries agreed to far-reaching legislation to reduce the risks of derivatives trading and to ensure it is kept under a more watchful eye.
In Europe, this has led to the European Markets Infrastructure Regulation (EMIR) - the equivalent to the US Dodd-Frank Act. Contrary to some reports, EMIR applies to all parties dealing in derivatives, including pension funds and insurers. So it is important that we understand what it does and how it might have further effects on managing pension fund cash.
One of the most significant measures to be implemented under EMIR is the mandatory central clearing of derivatives, including bilateral derivatives. So, rather than privately arrange the transaction, it must be registered with a Central Counterparty Clearing House and they identify the obligations of both parties on either side of the trade. They also ensure more protection for both parties by holding the collateral that you post.
Central Clearing should minimise counterparty risk by centralising the handling of transactions with a limited number of approved counterparties who maintain links with the clearing houses. These Central Counterparties (CCPs) will also be structured so that the chance of a snowball effect from the bankruptcy of one of the members of the CCP is very small.
Collateral in cash
One of the measures taken in the CCP structure to make it as robust as possible is the increase in the collateral that must be deposited by negotiating parties at the CCP. To date you only deposit enough collateral to mitigate the risk at the time of the contract. This doesn’t take into account any future fluctuations in rates, which could leave you or the other party exposed to potential un-realised losses or gains, because the collateral posted wasn’t enough to cover this change.
If your derivatives are centrally cleared by a CCP, besides posting collateral to cover the value “initial margin”, you will also need to post collateral to absorb the impact of any future changes - “variation margin”. Then, if a counterparty cannot meet its obligations, the CCP will close the position and then settle using this collateral
Most important to note for liquidity purposes, variation margin under EMIR should always be satisfied in cash.
Implications for pension funds
Central clearing and the cash requirement for variation margin has particularly strong implications for pension funds. Your scheme will have to maintain a significantly higher liquidity buffer to meet their margin requirements at the CCP when you use derivatives. This means that the money for the variation margin cannot be used for investment in other investments, which could mean missed opportunities for seeking yield or utilising this cash where you might need it elsewhere.
Moreover, the margin call is made at least daily, possibly even several times a day to decide what cash you need to post for the variation margin.
These are not insubstantial amounts that you need to consider. In a swap of £500 million an interest rate increase of 1% could require £100 million in cash for a variation margin. This means that you always have to hold or be able to release a large stock of cash in a very short time.
This means a new challenge for pension funds in order to manage their liquidity risk. This concerns issues such as liquidity needs, sources of liquidity, defining responsibilities regarding liquidity management, ensuring continuity and management of stressful situations such as soaring interest rates.
The biggest challenge is undoubtedly going to be the management of liquidity in stressful situations. Banks have traditionally been the appropriate parties to meet urgent liquidity needs, but because of stringent regulations in the area of banks’ balance sheets (leverage ratio) and bank liquidity (such as liquidity coverage ratio) they cannot provide sufficient liquidity as they would have done in the past.
Other sources of liquidity, such as reverse repo and securities lending are not expected to provide sufficient liquidity in the event of stress.
Should we shun derivatives?
Can pension funds avoid this liquidity risk by not using derivatives anymore?
In theory yes, but in practice the avoidance of derivatives is not a practical option. Pension funds typically have long-term liabilities which are interest rate sensitive in their nature. In this scenario there is really no other option than to use interest rate derivatives, to mitigate interest rate risk.
Liquidity as a new asset class
Despite the potential drawbacks to following the EMIR clearing rules before you need to, it is likely that entering derivatives contracts using the new regulatory framework will be cheaper for pension funds.This has everything to do with how derivatives are priced. We are already seeing that there is a price variation between cleared and non-cleared derivatives. Cleared transactions and the use of cash as collateral are now becoming increasingly common in the market.
Whilst it is currently a challenge for pension funds to start to adopt the new system, in the long term liquidity risk will become fait accompli, whether it is accounted for it now in your discussions or not.
If pension funds want to continue to use derivatives the clearing system will make liquidity risk the norm. It will be a challenge to effectively manage this risk and to limit the missed yield. Liquidity is thus the new asset class for pension funds and it will take its place within investment strategy moving forward.
The challenge to UK schemes is to make sure you are well prepared for when the full impact of EMIR inevitably hits.
Monique Jager-Smeets is head of institutional risk management at KAS BANK