Matt Roberts-Sklar and Sheila Torrance explain why there is increased attention on liquidity risk from margin calls
When the COVID-19 crisis hit in March 2020, large asset price moves and increased volatility led to sizeable margin calls on derivatives for a range of non-bank financial sectors. The use of derivatives – in particular by insurers, pension funds, and liability driven investment (LDI) funds prudently hedging FX, interest rate and inflation risk – exposed them to sudden demands for high levels of liquidity to meet margin calls. While the margining system is a vital part of stopping counterparty credit risk from spreading in a stress, liquidity risks need to be appropriately managed to prevent them contributing to a ‘dash for cash’ in a severe market stress.
Derivatives are important for the re-distribution of different types of risk from those who do not wish to bear them to those that do. But – as we saw in the 2008 financial crisis, and in 2020 – derivatives increase interconnectedness. Without margining requirements, derivatives can spread counterparty credit risk across the financial system. To address this, in the wake of the 2008 crisis, there were extensive reforms to over-the-counter derivatives markets. ‘Standardised’ derivatives (eg interest rate swaps) moved to being centrally cleared and hence margined. And requirements to margin non-cleared derivatives were introduced.
Regular exchange of variation margin, which is driven mechanically by changes in asset prices, protects market participants in the case of counterparty default. Initial margin protects not only market participants but also, for cleared derivatives, all the members of clearing houses from the failure of one or more of their members. This is a key part of risk management by derivatives market participants. Despite large asset price moves and increased volatility, cascading counterparty credit risk from derivatives counterparties was not a concern in March 2020.
When faced with a margin call, liquidity is needed to meet it. The total size and composition of derivatives exposure and the sensitivities to market movements mean stress testing for simultaneous market shifts is paramount to understanding liquidity risk. Being prepared for sudden, large margin calls is part of broader liquidity risk management that all firms should be – and many are – doing.
For banks, there have been extensive reforms to liquidity regulation to include a prescribed set of standards with detailed regulatory reporting of granular data. This includes taking into account liquidity risk from margin calls. However, this is not generally the case for non-banks.
For insurers, in the UK the PRA issued supervisory statement 5/19 on liquidity risk management for insurers in 2019 (bit.ly/2KNZQg4). As part of its Holistic Framework for Systemic Risk, the International Association of Insurance Supervisors (IAIS) recently published an application paper on liquidity risk management. The IAIS is also working to develop standardised metrics for monitoring liquidity risk at the firm level, beginning with a factor-based ‘Exposure Approach’.
This is particularly important as some insurers have increased their use of derivatives. For example, in recent years UK life insurers have turned to the US dollar corporate bond market for access to deeper pools and for yield income to help fund their annuity business, and gain the capital benefit of the Solvency II matching adjustment. Derivatives play an increasing role in hedging the associated FX and interest rate risk, building on established uses such as in hedging inflation-linked liabilities from annuities and pensions. Benefits of such uses include reducing volatility in the solvency capital requirement.
The growth in the bulk annuity market, with insurers taking on defined benefit pensions from corporates wishing to off-load this liability from balance sheets, looks set to continue given very low long-term interest rates and the COVID-19 recession. Hymans Robertson estimated the total value of transactions at £43.8bn in 2019, a sharp increase from £24.2bn in 2018 and £12.2bn in 2017. Modelling by The Pension Policy Institute suggests a potential buy-out market of £770bn over the next decade. As the pension transfer to insurers grows, so too will investments that are likely to require derivatives to hedge the associated risks, and so too will the need for improved liquidity risk management.
Micro and macro
Managing liquidity risk is obviously important for individual firms, and also from a microprudential perspective. Financial history teaches us that liquidity can cause distress for even a solvent firm.
But – as exemplified in the March 2020 stress – liquidity risk from margin calls can also have broader systemic implications. Macroprudential authorities worry about how resilient the financial system is to bad things happening, and work to support the system to cushion rather than amplify those shocks. In the context of margin calls, the systemic angle comes from the actions non-banks take to get liquidity to meet actual or anticipated margin calls. Even where non-banks may think they are holding liquid assets, in the interconnected market-based financial system one firm’s liquid asset is often another’s liability. This means the actions of some firms can lead to further actions by other firms and so on, multiplying liquidity demands across the system.
In March 2020, insurers, pension funds and LDI funds faced simultaneous large margin calls on their interest rate and FX hedges (see Figure 1). As noted in the Bank of England’s August 2020 Financial Stability Report (bit.ly/38mrV6s), actions taken by firms to meet these margin calls or to raise liquidity in anticipation of future margin calls may have added pressure to gilt and repo markets and to money market funds. Substantial interventions by central banks globally were needed to stabilise markets.
Analysis of what happened in March is ongoing, but we can already draw some lessons from the stress, building on previous work:
- Macroprudential authorities need to consider the actions firms took in the stress in the context of the resilience of the system as a whole, and look to build resilience where it’s needed.
- The importance of the application by firms of severe stress testing for simultaneous market shifts; and also the review of liquidity risk appetite to the extent and composition of derivatives exposure to margin calls.
- Review of assumptions by firms of the time to monetise liquid assets in severe market stress and the valuation.
- Regulators need better data to monitor liquidity risks from margin calls. This was one of the conclusions of the Bank of England’s Financial Policy Committee’s in-depth assessment into potential risks from leverage in non-banks in 2018. More recently, a letter from Christine Lagarde, the Chair of the European Systemic Risk Board, to Gabriel Bernardino, Chair of the European Insurance and Occupational Pensions Authority, pointed to a lack of consistent data for assessing the magnitude of liquidity risks, and strongly encouraged the development of a liquidity monitoring framework be finalised and implemented promptly.
The first of these lessons emphasises the importance of this topic to the Financial Stability Board’s (FSB) agenda on non-bank financial intermediaries. As set out in its holistic review of the March stress (bit.ly/3nEC4C0), the FSB will be examining the frameworks and dynamics of margin calls in centrally cleared and non-cleared derivatives markets, the liquidity management preparedness of market participants to meet margin calls and the impact of firms’ actions on the system.
The introduction of mandatory margining and clearing has certainly brought many benefits, which are to be applauded and safeguarded. But those benefits have increased the importance of managing liquidity risk, which needs to be managed by firms and monitored by authorities. Central banks and other regulators were starting to look at this before the COVID-19 stress, and are paying even more attention to this now, both from a microprudential and from a macroprudential perspective.
Matt Roberts-Sklar is a senior manager in the Financial Stability Strategy and Risk Directorate at the Bank of England
Sheila Torrance is a manager in the PRA Insurance Directorate at the Bank of England