Liquidity Risks of Derivatives Portfolios of Pension Funds Under Various Stress Scenarios

Liquidity Risks of Derivatives Portfolios of Pension Funds Under Various Stress Scenarios

2 Liquidity Risks of Derivatives Portfolios of Pension Funds Table of Contents Summary 3 1 Introduction 5 2 Explanation of Stress Scenarios 6 3 Derivatives Portfolios and Liquidity Position of Pension Funds 8 3.1 Interest Rate and Currency Sensitivity of the Derivatives Portfolio 8 3.2 Liquidity Position 8 4 Results of Stress Scenarios 10 4.1 Margin Requirements 10 4.2 Impact on Liquidity Position 11 5 Role of European Money Markets 14 5.1 Importance of the Repo Market 14 5.2 Use of Money Market Funds 15 5.3 Long-term Developments in Liquidity Needs 18 6 Financial Stability Considerations 19 7 Conclusion and Recommendations 23

3 Liquidity Risks of Derivatives Portfolios of Pension Funds Summary This report presents the findings of a study by the AFM and DNB into the liquidity risks arising from the derivatives portfolios of pension funds, following a recommendation by the Financial Stability Committee (FSC). A number of pension funds and involved pension administration organizations (PUOs) were asked to calculate four stress scenarios, involving significant interest rate and currency shocks and pressure on the accessibility of the repo market. The results of this study provide insight into the sensitivity of the liquidity position of pension funds to certain shocks on margin requirements, which liquidity instruments are then deployed, and what assumptions pension funds make in this regard. The study shows that pension funds are able to meet margin requirements in the stress scenarios without a mass sale of assets. Pension funds face large margin requirements due to their extensive derivatives portfolios in the event of interest rate and currency shocks. The study shows that they use various liquidity sources to meet these margin requirements. Some adopt a 'waterfall method' indicating which sources are accessed when. Often, direct available liquidity such as cash, deposits, and maturing reverse repos is used first. Additionally, Pension Funds use other liquidity sources such as repo transactions and withdrawals from money market funds. They also use the flexibility of bilateral derivatives contracts by posting high-quality debt paper as collateral instead of cash. In none of the scenarios is it necessary to resort to a mass sale of short-term debt paper (or other assets). The results do show that pension funds are dependent on assumptions about the functioning of repo markets and money market funds, meaning that in extreme scenarios they may be forced to sell more assets. It is notable that in worst-case scenarios, large pension funds are dependent on the repo market for a significant part of their liquidity needs. The maximum (daily) amount that pension funds expect to raise from the repo market is higher than what was traded on a daily basis in March 2020.1 Additionally, pension funds assume the availability of liquidity from money market funds. In extreme scenarios, for example when the repo market dries up almost completely or when money market funds are partially locked, it cannot be excluded that pension funds may need to sell several billion in assets. This can lead to market effects and procyclicality. A stronger macroprudential framework for the non-banking sector, particularly money market funds, can make this sector more resilient in times of stress, thereby improving access to liquidity for investors – including Dutch pension funds. Furthermore, liquidity pressure will increase in the coming years due to the decreasing possibility of meeting margin requirements with high-quality debt paper, although the new pension contract may bring some relief. The exemption for mandatory central clearing of derivatives for pension funds has now expired, meaning that liquidity pressure from margin requirements will increase. However, this happens gradually, as the clearing obligation only applies to new transactions. In contrast, the new pension contract could exert downward pressure on liquidity needs if interest rate hedging shifts to shorter maturities. It is therefore uncertain what future liquidity needs will be. Therefore, it is wise to repeat the analysis in this report in a few years when the central clearing obligation has a greater impact on liquidity pressure and there is more clarity on the impact of the new pension contract.

1 During the Covid crisis in March 2020, there was high demand for cash (dash for cash), which increased pressure on the repo market, among other things.

4 Liquidity Risks of Derivatives Portfolios of Pension Funds

5 Liquidity Risks of Derivatives Portfolios of Pension Funds 1 Introduction Previous studies by the AFM and DNB have concluded that liquidity risks arising from the derivatives portfolios of pension funds are significant. This topic was discussed in the Financial Stability Committee (FSC) in February 2023, and a number of possible policy options were explored. The FSC endorsed the presented findings and made a recommendation to the AFM and DNB to 'map out, on a risk-based basis and therefore primarily focusing on large pension funds and involved asset managers, what liquidity effects may occur in the event of a sharp rise in money market interest rates and the temporary drying up of the repo market'. At the request of the FSC, the AFM and DNB therefore conducted further research into the liquidity risks of a number of pension funds and involved pension administrators (PUOs). This report presents the findings on liquidity risks based on various stress scenarios. The pension funds and PUOs calculated four different stress scenarios in a liquidity stress test, involving significant interest rate and currency movements and restrictions on the accessibility of the repo market. The results of the stress test provide insight into the liquidity position and the liquidity instruments used to meet margin requirements in the stress scenarios. The analysis in this report has a macro(prudential) perspective: the liquidity risks and potential contagion effects are assessed at the macro level, and the research is therefore not primarily focused on individual institutions or supervision. Good liquidity management at the micro level, however, also contributes to limiting liquidity risks at the macro level.

6 Liquidity Risks of Derivatives Portfolios of Pension Funds Pension funds and PUOs were asked to calculate four stress scenarios in a liquidity stress test. The results of the liquidity stress test provide an image of the liquidity effects that may occur in the event of strong shocks in interest rates and currencies, combined with the partial drying up of the repo market. We distinguish between an adverse scenario and a worst-case scenario for both the interest rate and currency shocks and the available liquidity on the repo market. This results in four stress scenarios (see Table 1). The interest rate and currency shocks are calibrated to the maximum historical movements over a two-day horizon over the past 15 years. In the study, we use the same (cumulative) magnitude of interest rate and currency shocks for the adverse and worst-case scenarios. 2 The interest rate shock in the worst-case scenario is larger than the interest rate shock in the system-wide exploratory scenario of the Bank of England (Launch of the scenario phase of the system-wide exploratory scenario | Bank of England). We only assume in the worst-case scenario that this shock occurs entirely in one day, whereas the same shock unfolds over two days in the adverse scenario (see Table 2). The focus in all scenarios is on a short horizon, because previous research shows that margin pressure from derivatives portfolios can lead to problems especially in the case of strong shocks on a one-day horizon. Furthermore, we assume that the interest rate shocks are parallel and identical for both swap and government bond rates, distinguishing between different geographic areas. The currency shocks are calibrated for the most important exchange rates, namely euro-dollar (USD), euro-pound (GBP), and euro-yen (JPY). Table 2 shows an overview of the interest rate and currency shocks in the four scenarios.2 2 Explanation of Stress Scenarios Table 1 Stress scenarios consisting of interest rate and currency shock and the partial drying up of the repo market Adverse repo market scenario Worst-case repo market scenario Adverse interest rate and currency shock Scenario 1 Scenario 2 Interest rate and currency shock on both days (two-day horizon) Maximum repo volume per existing trading relationship: EUR 325 million Maximum repo volume per existing trading relationship: EUR 100 million One trading relationship not available One trading relationship not available Worst-case interest rate and currency shock Scenario 3 Scenario 4 Interest rate and currency shock on one day (one-day horizon) Maximum repo volume per existing trading relationship: EUR 325 million Maximum repo volume per existing trading relationship: EUR 100 million One trading relationship not available One trading relationship not available

7 Liquidity Risks of Derivatives Portfolios of Pension Funds Table 2 Interest rate and currency shock in the four stress scenarios Interest rate and currency shock adverse scenario (scenario 1 and 2) Daily parallel interest rate shocks - absolute changes (basis points) Currency shocks - relative changes Geographic Area Basis Points Currency Description Percentages EU 18 USD 1 EUR per x USD -2.2 UK 38 GBP 1 EUR per x GBP -2.3 US 22 JPY 1 EUR per x JPY -3.8 Japan 17 Other 21 Interest rate and currency shock adverse scenario (scenario 3 and 4) Daily parallel interest rate shocks - absolute changes (basis points) Currency shocks - relative changes Geographic Area Basis Points Currency Description Percentages EU 36 USD 1 EUR per x USD -4.4 UK 77 GBP 1 EUR per x GBP -4.5 US 44 JPY 1 EUR per x JPY -7.5 Japan 33 Other 42 The scenarios for the European repo market are based on historical repo transactions of pension funds. The European repo market is crucial for pension funds and administrators to generate liquidity in times of increased margin requirements. However, the available volume on the repo market is uncertain and dependent on sentiment in financial markets. Given the high dependence on the repo market and the uncertainty regarding the available volume on this market, the scenarios contain restrictions regarding the availability of liquidity on the repo market. Thus, the transaction volume with trading relationships is capped at EUR 325 million and EUR 100 million in the adverse and worst-case scenarios, respectively. It is also assumed that pension funds can only trade with existing trading relationships and that one existing trading relationship is not available for trading. This concerns the trading relationship with the largest transaction volume.

8 Liquidity Risks of Derivatives Portfolios of Pension Funds 3 Derivatives Portfolios and Liquidity Position of Pension Funds 3.1 Interest Rate and Currency Sensitivity of the Derivatives Portfolio The derivatives portfolios of pension funds are sensitive to changes in both interest rates and currencies. The total interest rate sensitivity of the derivatives portfolio (DV01) – aggregated for the involved PUOs – amounts to more than EUR 500 million per basis point change in the swap rate (see Table 3). Furthermore, PUOs mostly use FX forwards to hedge currency risk (mainly EUR/USD). The currency sensitivity (PV01) arising from EUR/USD forwards per basis point change in the exchange rate amounts to approximately EUR 22.3 million for the PUOs. For EUR/GBP and EUR/JPY, the sensitivity is considerably smaller, respectively EUR 2.4 million and EUR 1.1 million. Table 3 Interest rate and currency sensitivity total derivatives portfolio (millions of euros per basis point) Sensitivity DV01 501.1 PV01 (EUR/USD) 22.3 PV01 (EUR/GBP) 2.4 PV01 (EUR/JPY) 1.1 Pension funds can clear interest rate swaps centrally through a central clearing counterparty (CCP) or bilaterally with an involved trading partner. This is relevant for liquidity risk arising from margin requirements, because for centrally cleared contracts, margin requirements must always be met in cash (and sometimes intra-day margin requirements can be requested). Meeting margin requirements in cash creates additional liquidity pressure and places higher demands on liquidity management than for bilateral contracts, where pension funds can also meet margin requirements in the form of high-quality debt paper (securities) (and sometimes partially a day later, depending on contractual agreements with the counterparty). The possibility of meeting margin requirements with high-quality debt paper will gradually decrease in the coming years due to the mandatory central clearing (EMIR) of derivatives (see paragraph 5.3). 3.2 Liquidity Position Pension Administration Organizations (PUOs) use multiple sources of liquidity to meet margin requirements. A distinction can be made between liquidity sources that are directly available and liquidity sources that are available with less certainty. Directly available liquidity consists of instruments with a maturity of maximum one day and that can be deployed within that term. This includes cash, deposits, and maturing reverse repo transactions (i.e., cash that has been invested short-term in exchange for high-quality collateral, much of which matures within a day). Additional liquidity sources that are available with less certainty in the short term consist of repo transactions, withdrawals from money market funds, and the sale of short-term high-quality debt paper (i.e., bonds with a maturity of less than 1 year and a minimum rating of AA). In this way, PUOs spread counterparty risk and are not dependent on a specific type of liquidity source. Figure 1 shows the total liquidity position of the involved PUOs, noting that the liquidity position of PUOs mainly consists of short-term debt paper, deposits, reverse repos, and money market funds. It is also notable that relatively little cash is held due to low returns.

9 Liquidity Risks of Derivatives Portfolios of Pension Funds Not all liquidity sources are directly liquid in all circumstances. For example, deposits and reverse repos typically have a maturity of one or several days, within which the funds cannot or can only be made liquid with difficulty. Positions in money market funds can usually be bought or sold daily under normal circumstances, although this possibility can be restricted or suspended in the event of very large withdrawals during times of market stress. At the same time, such scenarios usually involve increased margin requirements. Finally, short-term debt paper can be sold, but this will likely be accompanied by greater market impact in stress scenarios (as was visible in March 2020).

0 5 10 15 20 25 Short-term high-quality debt paper Deposits Reverse repos Money market funds Cash Figure 1 Total available liquidity sources of involved PUO (millions of euros)

10 Liquidity Risks of Derivatives Portfolios of Pension Funds 4 Results of Stress Scenarios 4.1 Margin Requirements As a result of the interest rate and currency shocks, the margin requirements – aggregated for the involved PUOs – amount to approximately EUR 30 billion in all scenarios, although the horizon within which they must meet these obligations differs. In all four stress scenarios, the total interest rate and currency shocks are equal, and thus the total margin requirements are also equal. However, the horizon within which PUOs must meet these obligations differs. Thus, the adverse scenarios (scenario 1 and 2) for interest rate and currency shocks unfold over a two-day horizon, while the shocks in the worst-case scenarios (scenario 3 and 4) occur entirely in one day. Incidentally, margin requirements – depending on the applicable regulations regarding the CSA (credit support annex) for derivatives – must be met within one or two days after an interest rate or currency shock. This is also visible in the results, which show that the total margin requirement of EUR 30 billion in scenarios 1 and 2 (adverse scenarios) is paid over three days. Thus, PUOs must pay approximately EUR 11.1 billion on T+1, EUR 14.9 billion on T+2, and EUR 4 billion on T+3 (see Figure 2). In scenarios 3 and 4 (worst-case scenario), the margin requirement amounts to approximately EUR 22.2 billion on T+1 and EUR 7.6 billion on T+2. In these scenarios, the liquidity pressure on the first day is therefore considerably greater. Incidentally, the largest part of the margin requirements is attributable to interest rate derivatives. The total margin requirements of EUR 30 billion consist of EUR 18.2 billion (61%) from obligations arising from interest rate derivatives and EUR 11.8 billion (39%) from currency derivatives (see Figure 2).

0 5 10 15 20 25 T+1 T+2 T+3 0 5 10 15 20 25 T+1 T+2 Daily margin requirements in scenario 1 and 2 (two-day shock) Daily margin requirements in scenario 3 and 4 (one-day shock) Interest rate swaps Currency derivatives Figure 2 Margin requirements arising from interest rate swaps and currency derivatives (millions of euros)

11 Liquidity Risks of Derivatives Portfolios of Pension Funds 4.2 Impact on Liquidity Position In the least severe scenario - scenario 1 - PUOs mainly use directly available liquidity and repo transactions to meet margin requirements. In scenario 1, the interest rate and currency shocks occur over a two-day horizon and the repo market functions relatively well. In this scenario, more than 25% of the margin requirements are met with directly available liquidity (i.e., deposits, maturing reverse repos), mainly on the first day after a shock (see Figure 3). It is also notable that PUOs make extensive use of repo transactions. Thus, in three days, approximately 30% of the required liquidity is raised via repos. Pension funds also use the remaining flexibility in bilateral contracts by meeting the remainder of the margin requirements, approximately 24%, in the form of high-quality securities. Finally, approximately 11% of the required liquidity is withdrawn from positions in money market funds, and 7% of the margin requirements are met by selling debt paper. In scenario 2, restrictions on the repo market increase, causing PUOs to make more use of the possibility to meet (bilateral) margin requirements with high-quality debt paper. In scenario 2, there are the same interest rate and currency shocks, but the repo market dries up further. As a result of greater restrictions, pension funds can execute fewer repo transactions to meet liquidity needs. This causes total repo usage in this scenario to drop to 17% of the required liquidity (see Figure 3). Pension funds and administrators compensate for this by posting more high-quality debt paper (securities) as collateral (9% extra of the margin requirements), supplemented by a greater reliance on their directly available liquidity (approximately 3% extra) and selling more positions in money market funds (approximately 2% extra). In scenario 3 – where the interest rate and currency shocks occur on one day – it is notable that pension funds meet a larger part of the margin requirements with repo transactions and high-quality collateral. In scenario 3, the interest rate and currency shocks occur over a one-day horizon and the repo market functions relatively well. Two developments stand out in this scenario. First, repo transactions are used more on T+1 (28% of the margin requirements on T+1 instead of 11% in scenario 1), while additionally more use is made of the possibility to meet collateral in securities. Incidentally, pension funds expect to be able to execute withdrawals from money market funds faster in this scenario. In the most severe stress scenario – scenario 4 – PUOs mainly use the possibility to meet margin requirements with high-quality collateral and withdraw significantly from money market funds. In scenario 4, the interest rate and currency shocks occur over a one-day horizon and the repo market dries up further. The consequence is that PUOs can conclude fewer repo transactions and become more dependent on other sources of liquidity, which must be made liquid faster. In this scenario, PUOs use more direct liquidity (mainly reverse repos) to meet margin requirements, and on T+1 almost 44% of the margin requirements are met with high-quality collateral. Additionally, PUOs expect to meet 23% of the margin requirements via withdrawals from money market funds.

12 Liquidity Risks of Derivatives Portfolios of Pension Funds The daily withdrawals from money market funds are high in this scenario. Thus, they expect to be able to raise almost 40% of the required liquidity on the second day after the shock from money market funds.3 In summary, the results show that the involved PUOs are able to meet margin requirements in all stress scenarios without a mass sale of assets. PUOs use various liquidity sources to meet margin requirements, and in none of the scenarios is it necessary to resort to a significant sale of short-term debt paper (or other assets). Some PUOs adopt a waterfall method that dictates which liquidity sources are accessed when. Generally, directly available liquidity, repo transactions, and withdrawals from money market funds are used earlier than the sale of short-term debt paper (or other assets). PUOs state that they have sufficient decision-making authority in times of stress to deal flexibly with unexpectedly high margin requirements. If, in the case of large liquidity stress and an insufficient liquidity buffer, the PUO must resort to selling securities, this could lead to problems in practice if coordination with pension funds is required and this takes (too) long. 3 The use of money market funds varies between PUOs. However, the results do show that PUOs are dependent on assumptions about the functioning of repo markets and money market funds, as well as the possibility of meeting margin requirements with high-quality debt paper. Ve