Liquidity Risk of Margin Calls in March 2020

Liquidity Risk of Margin Calls in March 2020 An Analysis of Derivative Portfolios Managed by Dutch Asset Managers December 2021 Occasional Paper

2 Liquidity Risk of Margin Calls in March 2020 Contents Summary 3 Executive Summary 4 1 Introduction 5 1.1 Interest Rate Derivative Portfolios 5 1.2 Foreign Exchange Derivative Portfolios 8 1.3 The COVID-19 Shocks of March 2020 8 2 Research Methodology 12 2.1 Data Request 12 2.2 Analysis of Primary Liquidity Position 12 2.3 Analysis of the Use of Secondary Liquidity 15 2.4 Interest Rate Shock Tolerance Analysis 16 2.5 Stress Scenario Analysis 16 3 Results 18 3.1 Margin Calls 18 3.2 Liquidity Position and Primary Liquidity 19 3.3 Use of Secondary Liquidity 22 3.4 Interest Rate Shock Tolerance 23 3.5 Stress Scenario 25 4 Conclusions and Recommendations 33 4.1 Conclusions 33 4.2 Recommendations 33 Bibliography 35

3 Liquidity Risk of Margin Calls in March 2020 Summary The shocks in the interest rate and foreign exchange markets in March 2020, resulting from the worldwide outbreak of the COVID-19 pandemic, led to significant collateral requirements (margin calls) for the funds of Dutch asset managers. Dutch asset managers manage large derivative portfolios to hedge interest rate and foreign exchange risk, including for Dutch pension funds. Managers must be able to quickly create liquidity to meet margin calls in derivative portfolios and are therefore exposed to liquidity risk. In this study, we investigated this risk using a data survey of five Dutch managers of derivative portfolios. By analyzing margins and the available liquidity of managers, we examined how significant the risk was in March 2020. Additionally, we conducted a stress scenario analysis to illustrate how much worse the situation could have become, for example, if the ECB had not intervened.

In meeting the margin calls, the managers encountered the limits of the liquidity in their portfolios. At the peak of the crisis in March 2020, the 30-year swap rate rose by 40 basis points in six days, and the euro fell sharply against the US dollar. As a result, the five managers in the study had to deposit a cumulative EUR 29 billion in margin calls within seven days. They generated the necessary liquidity mainly by selling short-term debt, withdrawals from money market funds, and repo transactions. In doing so, they had an involuntary but significant impact on the liquidity of money markets. If the ECB had not introduced the PEPP on March 18, which halted the rise in interest rates and supported the money market, the liquidity pressure on managers would have increased further.

The stress scenario analysis shows that in the event of greater stress than the COVID crisis, managers could have encountered serious liquidity problems. In the stress scenario used by us, interest rates rise by a further 70 basis points from March 20, 2020, an interest rate increase comparable to that of the Great Financial Crisis of 2008. This results in additional margin calls of EUR 26.2 billion. This would be expected to lead to additional sales of short-term debt, withdrawals from money market funds, and repo transactions. It is doubtful whether the money markets could have provided this extra liquidity. This could have led to negative consequences for these managers, their clients, and the financial markets in which they operate.

We see three directions for solutions for the identified vulnerabilities that can be investigated further. First, we consider it worthwhile to research whether there is an optimal ratio between the liquidity of the liquidity portfolio and the interest rate and exchange rate sensitivity of the derivative portfolio. This ratio should strike a balance between the cost of liquidity and the manageability of liquidity risk. Second, reforms of money markets are desirable. The liquidity of money markets is crucial precisely during periods of market stress. The events of March 2020 have shown that they did not fulfill this function flawlessly. Third, a workable solution should be sought for the use of high-quality government debt (with or without liquidity transformation) to meet margin calls.

In March 2020, it was a narrow escape for managers of derivative portfolios and their clients, partly due to central bank intervention. In the event of future market stress, this problem could arise again, and there is no guarantee that it will end well. It is our impression that a combination of the three aforementioned solution directions is the most successful recipe for an adequate solution to vulnerabilities resulting from margin calls in derivative portfolios.

4 Liquidity Risk of Margin Calls in March 2020 Executive Summary The shocks in the interest rate and foreign exchange markets in March 2020 caused by the worldwide outbreak of the COVID-19 pandemic resulted in significant collateral requirements (margin calls) for Dutch asset managers. Dutch asset managers manage large derivative portfolios to hedge interest rate and foreign exchange risk, including for Dutch pillar 2 pension funds. As asset managers must be able to quickly generate liquidity in order to fulfil margin calls in the derivative portfolios, they are exposed to liquidity risk. In this study we have examined this risk based on a data survey among five Dutch managers of derivative portfolios. By analysing the margin calls in these portfolios and the liquidity available to managers, we were able to assess the amount of the liquidity risk in March 2020. In addition, we performed a stress scenario analysis to gain insight how much further the situation could have deteriorated, for instance if the ECB had not intervened.

Managers reached the limits of the liquidity in their portfolios in fulfilling the margin calls. At the height of the crisis in March 2020, the 30-year swap rate jumped by 40 basis points in six days, while the euro fell sharply against the US dollar. Consequently, the five managers in our study had to post EUR 29 billion in margins cumulatively within seven days. They were able to generate the necessary liquidity mainly by selling short-term debt instruments, redemptions from money market funds and repo transactions. In this way, they had an inadvertent but significant impact on the liquidity of money markets. If the ECB had not introduced the PEPP on 18 March, which halted the rate rise and supported the money markets, the liquidity pressure on asset managers would have further increased.

Our stress scenario analysis shows that stress greater than the COVID crisis could have plunged asset managers into greater liquidity problems. In our stress scenario, interest rates continued to rise after 20 March 2020 by a further 70 basis points, a rate rise similar to that during the global financial crisis of 2008. This would have required asset managers to post additional margins worth EUR 26.2 billion. Asset managers would likely have responded through further sales of short-term debt instruments, redemptions from money market funds and repo transactions. It is doubtful whether the money markets would have been able to continue to offer the extra liquidity. This could have had negative consequences for these asset managers, their clients, and financial markets in general.

We have identified three possible areas for improvement to help address the identified vulnerabilities that could be researched further. First, we believe it would be worth researching whether there is an optimal ratio between the liquidity of the liquidity portfolio and the interest rate and foreign exchange sensitivity of the derivative portfolio. Such a ratio should strike a balance between the cost of liquidity and the containment of the liquidity risk. Second, reform of the money markets is required. The liquidity offered by money markets is crucial, especially in times of market stress. The events of March 2020 have demonstrated that these markets could not adequately fulfil this crucial role. Third, we must continue the search for a workable solution to enable the use of high-grade government bonds (through liquidity transformation or otherwise) in order to post margins.

Asset managers of derivative portfolios had a narrow escape in March 2020, in part thanks to central bank intervention. The identified problems could recur in response to future market stress and there is no guarantee that the outcome will be as positive next time around. We believe that a combination of the three areas of improvement mentioned earlier is the most promising recipe for an adequate solution to the vulnerabilities caused by margin calls in derivative portfolios.

5 Liquidity Risk of Margin Calls in March 2020 1 Introduction In March 2020, the worldwide outbreak of the COVID-19 pandemic caused great volatility on financial markets. This was also the case for European interest rate and foreign exchange markets. These movements had significant consequences for the management of interest rate and foreign exchange derivative portfolios by Dutch asset managers.

Due to the volatility in the interest rate and foreign exchange markets, margin flows on the derivative portfolios of Dutch asset managers increased strongly. Managers received a lot of margin at the beginning of March 2020 due to a fall in interest rates, but from mid-March they had to deposit margin due to the rise in interest rates. This increased the liquidity risk for managers. Calm returned relatively quickly afterwards. This does not mean that the risk of a recurrence of such scenarios is still lurking. Because the derivative portfolios are very large and move homogeneously, there is potentially a stability risk. Therefore, the AFM has conducted research into this. Through conversations with five large Dutch asset managers and an analysis based on a data request with these parties, the AFM has gained insight into the risks that played a role in March 2020.

The remainder of this chapter describes the characteristics of interest rate derivative and foreign exchange derivative portfolios and the market shocks in March 2020. Chapter 2 describes the research methodology, including the data used and the analyses performed. Chapter 3 presents the results of the research. This chapter is divided into the analysis of the actual situation in March 2020 and the analysis in a stress scenario. Finally, the conclusions and recommendations are discussed in Chapter 4.

1.1 Interest Rate Derivative Portfolios Dutch asset managers manage large derivative portfolios to hedge the interest rate and foreign exchange risk of, among others, pension funds. The maturity of pension fund investments does not match the maturity of the obligations. A fall in interest rates therefore causes the present value of pension obligations to increase more than the value of the investments. Pension funds are therefore exposed to interest rate risk. They partially hedge this with interest rate derivatives. The interest rate derivative portfolio has positive exposure to long-term interest rates to reduce the maturity mismatch. The value of interest rate derivatives increases as a result of interest rate cuts and decreases due to interest rate increases. The specific composition of the interest rate derivative portfolio depends on the other assets of the pension fund (such as fixed-income investments) and the obligations of the pension fund. The latter is largely determined by the age and life expectancy of the participants in the pension fund. Nevertheless, interest rate derivative portfolios in the Netherlands can be considered a homogeneous group with a comparable positioning, as they all hedge against a fall in interest rates.

To hedge interest rate risk, managers use interest rate swaps. In an interest rate swap, a fixed interest rate, the swap rate, is exchanged for a variable interest rate, often Euribor, over a fixed amount, the notional value of the derivative, for a certain period. Pension funds are looking for a hedge against the interest rate risk of their participants and therefore enter into swaps where they pay the variable interest rate and receive the fixed interest rate (See Figure 1). These swaps increase in value if the fixed interest rate falls and decrease in value if this interest rate rises.

1 In the remainder of the report, we use the terms margins, collateral, and security interchangeably. In all cases, we mean the securities provided by parties in a financial transaction.

6 Liquidity Risk of Margin Calls in March 2020 Interest rate swaps bring counterparty risk with them. Market movements create value in the swap contract, which leads to an obligation of one counterparty to the other and thus to the risk that the counterparty cannot meet its obligation. This counterparty risk is mitigated as much as possible by means of collateral. The party for which an obligation arises will have to deposit collateral with a value equal to the market value of the swap. This mitigates counterparty risk bilaterally.

Figure 1: Schematic representation of an interest rate swap. Source: AFM

Counterparty risk can be controlled by using central clearing counterparties (CCPs), or central counterparties. CCPs play an important role in the settlement of interest rate derivative transactions. They stand between both counterparties of a transaction by taking over the obligations of both the buyer and the seller of the derivative. Central clearing of derivatives becomes more efficient and safer in this way. CCPs can net all transactions of a party in a derivative into one position at the end of the trading day. This reduces the number of open positions, the size of the collateral that must be held, and the total value that must be settled. Furthermore, the counterparty risk that market participants face in derivative contracts is largely eliminated. If a counterparty goes bankrupt during the life of a derivative contract, it can cause problems for the other party. In the case of central clearing, the CCP takes over the obligations. To hedge the risk that the CCP faces, counterparties are asked to deposit margin and a contribution to the default fund.

2 The Lehman Brothers bankruptcy is still the best example of this. For reference, see for example: https://www.theguardian.com/business/2008/oct/11/lehmanbrothers-royalbankofscotlandgroup

Variable Interest Rate (EURIBOR) Pension Fund Counterparty Receives Receives Pays Pays Fixed Interest Rate (Swap Rate)

7 Liquidity Risk of Margin Calls in March 2020

Figure 2: Simplified representation of the central clearing process. Source: AFM

To hedge the risk that a counterparty cannot meet its obligations, CCPs have various layers of defense, one of which is the deposit of margin. The CCP distinguishes between initial margin and variation margin. The initial margin is intended to cover the credit risk that the CCP faces in the event of the bankruptcy of a counterparty. To cover losses from price fluctuations, variation margin is requested. When the value of a clearing member's portfolio changes, the CCP will request additional margin or return margin.

In addition to initial and variation margin, CCPs have various means to limit risks. For example, in volatile market conditions and when the development of positions warrants it, a CCP may decide to ask counterparties to deposit additional margin during the day: intraday margin calls. A CCP can also increase the initial margin when volatility in the valuation of the contract and the collateral increases and/or the liquidity of the contract and the collateral decreases. Using these instruments, however, increases the liquidity pressure on clearing members and their clients. When managers have to meet intraday margin calls at different times during the day, the pressure on liquidity management is intensified.

Pension funds were not yet required to clear centrally in March 2020 (ESMA, 2020). Consequently, pension funds could still trade their interest rate swaps bilaterally and handle the collateral management, without the intervention of a CCP, with the specific counterparty. Nevertheless, pension funds cleared about 24% of the notional value of outstanding contracts. However, the same dynamics apply to non-cleared interest rate derivatives (see Table 1) as to the cleared variant.

Margin requirements limit counterparty risk, but they do lead to liquidity risk, the risk that a manager cannot meet the margin requirements in time. Market participants must take this into account by ensuring sufficient liquidity. In addition, counterparty risk arises if a manager receives cash collateral. The cash margin received on the account confronts the manager with counterparty risk with respect to the bank where this account is held. Managers will therefore spread their funds as much as possible over counterparties and more senior claims. This can be done, for example, by means of a reverse repurchase agreement (reverse repo), in which they receive pieces in exchange for the cash outlay. Other possibilities are deposits at other banks, money market funds, and investing in short-term debt. When negative value arises in the interest rate derivatives due to interest rate movements, the manager will have to deposit margin.

Client Executing broker Central Counterparty (CCP) Transaction Deposit IM and VM to CM Client accepts the counterparty risk on the CCP Broker accepts the counterparty risk on the CCP Deposit IM and VM to CCP Deposit IM and VM to CCP (after netting) Clearing Member (CM)

8 Liquidity Risk of Margin Calls in March 2020

Table 1: Effects of an interest rate change. Source: AFM

Due to the size and homogeneity of the interest rate derivative portfolios in the Netherlands, the liquidity and counterparty risks are potentially stability risks. These risks affect the financial health of a large group of pension funds. The liquidity demand also affects the functioning of the European money market.

1.2 Foreign Exchange Derivative Portfolios Pension funds invest a large part of their wealth outside the euro area but have pension obligations in euros, so they are exposed to foreign exchange risk. They partially hedge this risk with foreign exchange derivatives. The foreign exchange derivative portfolios managed by Dutch asset managers for pension funds have positive exposure to the euro and negative exposure to other currencies, mainly the US dollar. In this way, they protect themselves against depreciation of foreign currencies.

Foreign exchange forward transactions (FX forwards) are often used to hedge foreign exchange risks. FX forwards are mainly traded bilaterally. Counterparty risk is mitigated as much as possible by exchanging collateral. In this way, the market value of the FX forward is "settled" on a daily basis, reducing the counterparty risk of the parties. This means that foreign exchange derivative portfolios face similar risks as interest rate derivative portfolios.

Pension funds are sometimes confronted with simultaneous collateral calls for interest rate and foreign exchange derivatives, a "double whammy". This is the result of a common positive correlation between the US dollar and the euro interest rate. At the moment when interest rates in the euro area rise abruptly, it sometimes happens that the US dollar becomes stronger against the euro. This was also the case in March 2020. This may be the result of a "flight to safety" to US dollars.

1.3 The COVID-19 Shocks of March 2020 The worldwide outbreak of COVID-19 and the corresponding lockdown measures taken by governments led to great unrest on the financial markets. This was also noticeable in the interest rate and foreign exchange markets. The money markets, essential for the liquidity management of managers, were also affected.

1.3.1 Interest Rates, Currencies, and Margin Calls In the period from early February to mid-March, swap rates fell significantly (see Figure 3). For example, the 30-year swap rate fell by more than 60 basis points in this period to -0.26% (a monthly decline that occurred only twice before 2008). The falling interest rate meant that large pension funds, which are recipients of the fixed interest rate in the interest rate swap, received margin. These swaps became more valuable. The received cash margin was then invested in various liquidity instruments.

However, from mid-March, interest rates began to rise sharply. For example, in just under two weeks, the 30-year

Change in fixed interest rate Effect on value of fixed interest rate receiving interest rate swap Effect on margin flows Effect on risks for managers Interest rate rises Decreases in value Managers pay margin Increased liquidity risk Interest rate falls Increases in value Managers receive margin Increased counterparty risk

9 Liquidity Risk of Margin Calls in March 2020

swap rate rose by 52 basis points to 0.26% (the largest 11-day increase since May 2015 during the 2nd euro crisis). This meant that managers had to deposit a lot of margin and use and liquidate liquidity instruments to generate sufficient liquidity in time.

On March 18, calm was restored when the ECB announced the Pandemic Emergency Purchase Programme (PEPP). The ECB made EUR 750 billion available for the purchase of government and corporate debt, causing interest rates to fall and volatility to decrease. Swap rates also stabilized, reducing the liquidity pressure from margin calls on managers.

Figure 3: 10-, 20- and 30-year swap rates. Source: Macrobond

In the foreign exchange market, there was great demand for dollars in March, causing the cost of dollar financing to rise sharply. Although the EUR/USD exchange rate rose in the period from late February to early March, it began to fall sharply after the first week of March. By March 20, the EUR/USD rate had fallen from 1.14 to 1.07 (see Figure 4). After the US Federal Reserve (Fed) established swap lines with other central banks to resolve the dollar shortage, the exchange rate stabilized.

Figure 4: 1 and 3 month EUR/USD forward rates and EUR/USD exchange rate Source: Macrobond

-0.4% -0.2% 0.0% 0.2% 0.4% 0.6% 0.8% 1-1-2020 1-2-2020 1-3-2020 1-4-2020 1-5-2020 10 year 20 year 30 year 1,02 1,04 1,06 1,08 1,1 1,12 1,14 1,16 0 10 20 30 40 50 60 70 1-1-20 1-15-20 1-29-20 2-12-20 2-26-20 3-11-20 3-25-20 4-8-20 4-22-20 5-6-20 USD/EUR exchange rate Forward rate in Basis Points 1 month 3 month EUR/USD Exchange rate FED Swap Lines PEPP Announcement

10 Liquidity Risk of Margin Calls in March 2020

1.3.2 Drying up of the European Money Market The money market is an important market for the liquidity management of managers. They can raise or place cash in the short term here. Parties trade in short-term debt or money market funds. In addition, managers can do (reverse) repo transactions to raise or place cash in the short term. During March, liquidity in the money markets deteriorated considerably.

1.3