# Fear the repo: funds face up to rate-contingent liquidity risks

When interest rates rise, pension funds, life insurers and other big users of the swap market will find themselves in a harsh new environment, created by the move to central clearing. The long-dated, fixed-rate receiver positions they put in place to hedge their liabilities will slide out-of-the-money, compelling them to post billions of dollars in cash variation margin to central counterparties (CCPs). If rates rise far enough, some funds estimate the resulting margin calls will eat up more than 20% of their assets – a contingent liquidity risk that is entirely new to the industry.

Many firms plan to manage this risk in the repo market, where they can exchange ineligible securities for cash. Others are taking a different path – cutting their use of swaps, or selling ineligible securities so they can hold a cash buffer.

Aberdeen Asset Management is one example. The firm has already started reducing swaps exposure in favour of bonds in some well-funded liability-driven investment (LDI) portfolios. “Sourcing duration through swaps will be a much more expensive exercise. Initial margin will eventually be required both in clearing and in the bilateral space, and clearing houses require variation margin to be paid with cash – but raising cash in the repo market or holding higher cash balances reduces portfolio returns. In some cases it makes sense to get duration from alternative instruments such as long-dated gilts and linkers,” says Stephen Booth, the company’s London-based global head of fixed-income derivatives.

Legal & General Investment Management (LGIM), meanwhile, has built cash buffers into some of its credit funds, which originally comprised highly rated corporate bonds, plus a duration overlay made up of interest rate or inflation swaps. “We had a lot of credit funds, and were able to post the corporate bonds as collateral when trading bilaterally, but this won’t work in the future. So we’ve had to allocate a portion of fund assets to cash or gilts to meet margin calls on the swaps,” says Simon Wilkinson, the firm’s head of LDI.

Both approaches have problems. Long-dated bonds are a less precise hedge for duration risk than over-the-counter swaps, according to some market participants, while running a buffer of cash instead of being fully invested in securities means giving up returns – possibly as much as a full percentage point, according to PGGM, a Dutch pension fund that has looked at, and rejected, the idea.

###### We've had to allocate a portion of fund assets to cash or gilts to meet margin calls on the swaps

Which might make it seem like the repo market is the better choice. And for many funds, it is – as long as it works. The big fear is that, constrained by regulation and faced with surging demand for cash, the market will break down when it is most needed – unable to handle the funds’ liquidity needs.

“The macro viability of this regime has not been thought through properly,” says Henrik Olejasz Larsen, chief investment officer at Danish pension fund Sampension in Copenhagen. “Central clearing will force huge numbers of swap users to rely on the repo market, which is going to create further inter-linkages, and it remains to be seen whether the market will be able to support all these users hitting the market at once looking to transform their assets.”

Larsen says the fund has €20 million of PV01 – the per-basis-point sensitivity to interest rates. If the entire swap portfolio was backloaded into a CCP, Sampension has enough liquid assets available to cope with a catastrophic 500-basis-point rise in rates – but only if it is able to repo those assets, he adds.

Strictly speaking, none of this is new – funds have been warning for some time that central clearing essentially switches counterparty risk with liquidity risk – but the dangers now feel more real. In Europe, mandatory clearing is supposed to start for at least some market participants in 2014, although it may slip into 2015 (Risk November 2013, pages 16–19). And this year has seen the first significant run-up in market interest rates for some time, with the prospect of more to follow.

For now, European pension funds are protected by a temporary clearing exemption, which is set to expire in August 2015 and could be extended for a further three years. But they are being protected during a period when the majority of their positions are significantly in-the-money – the result of record low central bank rates. By the time the exemption expires, that is likely to have changed.

Collateral posting could also be a lot closer for some firms. Rather than sitting on big, positive mark-to-market values – and counterparty exposure to their dealers – some funds have chosen to re-coupon their swaps, which requires the dealer to crystallise its paper loss, but also means restriking the trade at prevailing market rates. Put simply, rates may not have to rise far before some funds feel the pinch.

According to Max Verheijen, head of trading at Cardano, a risk management and advisory firm that puts hedges in place for pension funds, one of its clients faced a margin call in June, as markets reacted to fears that the US Federal Reserve would rein in its bond-buying programme. The client had frequently re-couponed in recent years, realising mark-to-market gains, but reducing the point at which it became a net poster of collateral.

Contingent funding obligations are likely to be magnified by the bifurcation of many LDI hedging portfolios into interest rate and inflation swaps – with funds receiving inflation in the latter. In the bilateral word, there is a natural offset here, because rising rates will typically happen in tandem with rising inflation. But only interest rate swaps can be cleared at present, and although CCPs plan to extend the service to inflation swaps, there are concerns about whether clearing houses would be able to handle the risks associated with the market. As things stand, the result would be a liquidity mismatch: pension funds would be posted securities as collateral on their bilateral inflation swaps, while needing to stump up cash on their cleared interest rate swaps.

“It is a big concern for LDI funds,” says Andrew Giles, chief investment officer, solutions, at Insight Investment in London. “If you’re operating a bifurcated portfolio, then you have the problem of operating two sets of mismatching variation margin flows. This exposes funds to nominal rate moves rather than real rates, and magnifies the cash funding burden.”

So, how much liquidity risk are pension funds and insurers running? According to fund managers, the variation margin calls in stressed environments can be enormous as many LDI funds run swaps portfolios with huge sensitivities to rates. According to Insight’s Giles, there are LDI managers in the market overseeing collective portfolios of more than £100 billion in swap notional, which translates into a PV01 of £200 million if an average duration of 20 years is assumed. Many funds stress their portfolios to work out how much collateral would have to be posted in the event of a large rate move, with Insight Investment typically using a shock of at least 100bp, says Giles. That implies a collateral call of £20 billion, assuming a £200 million PV01.

And a 100bp move is hardly a worst-case scenario. During the fixed-income volatility seen in May and June, market interest rates leapt by more than 200bp. In 1994, the US Federal Reserve Board hiked rates by 300bp in the space of a year.

According to Giles, the OTC collateral movement during the May to August period for the firm was £4.7 billion based on a sell-off in real yields of around 45bp.

Meanwhile, Ido de Geus, head of treasury and client portfolio management at PGGM Investments – who declines to provide the PV01 of the fund’s portfolios – says it would expect variation margin calls of around €5 billion–10 billion based on historical moves of around 100bp. He says the firm had a maximum collateral outflow of around €2 billion during the May-June period.

Added up across the market, funds are facing huge potential cash needs to deal with contingent collateral calls in a central clearing environment – and the sector is now exploring different solutions. None are straightforward.

The most obvious response is to set aside a cash reserve to meet collateral demands in the event of a sharp move in rates. But the potential collateral moves based on a 100bp move in rates could in some cases be equal to more than 20% of the assets held by the funds – meaning the resulting liquidity buffer would be an enormous drag on yields.

For instance, PGGM estimates that holding the potential liquidity buffer solely in cash would knock as much as a percentage point off the fund’s return. “That seems small, but it’s huge in an asset-liability management context. We would have to start charging higher premiums or lower pension payments. It is not a trivial matter,” says de Geus.

According to another pension fund manager, which oversees a large client portfolio with a PV01 of €13.5 million and a fund asset value of €18 billion, a 100bp move in rates would require 7.5% of its assets to be posted as collateral. That would jump to 11.25% of assets in the event of a 150bp rise in rates. The opportunity cost of holding 11.25% of assets in cash instead of government bonds would be around 0.33%, he estimates.

Funds that take this approach could, of course, try to replace the lost yield. Some pension funds in the US, which had to start clearing swaps in September, have chosen to hold cash buffers and make up for the lost yield by selling index credit default swaps (CDSs), replacing the lost credit exposure without upfront payments, according to Sean Kurian, derivatives portfolio manager at JP Morgan Asset Management in Ohio. “There are a few pension funds that are holding cash liquidity buffers but still maintaining required yield by selling index CDSs in order to synthetically gain exposure to credit,” he says.

One UK asset manager is considering the same strategy. “It makes sense – if you are forced to hold more cash, you sacrifice the yield. Using index CDSs allows the fund to achieve the desired credit exposure while managing the contingent liquidity burdens on the swaps,” says the fund manager.

Index CDS contracts are already cleared in the US, and will require cash variation margin payments of their own. But Kurian says the volatility of long rate duration is usually significantly higher than that of credit spreads, so the risk of large, volatile margin calls on cleared index CDSs is lower. In addition, a rising-rate environment normally indicates the economy is in rude health – under those circumstances, the likelihood is that credit spreads will narrow, reducing margin numbers for the CDS positions.

US pension funds will typically be facing smaller funding burdens than their European counterparts anyway – pension liabilities in the US are discounted using a credit spread rather than the risk-free rate, meaning the duration of their liabilities is lower than for a comparable European fund. The end result: smaller swap portfolios, and less liquidity risk in a cleared environment.

Despite this, some funds in Europe are choosing to hold cash buffers. According to LGIM’s Wilkinson, the firm is currently clearing swaps for a number of pooled fund strategies, and the funds have allocated enough of their assets to cash to cover a potential 60bp rate move. But because the PV01 of the portfolios are relatively small, the asset allocation in cash is only a few per cent. “The duration sourced through the swaps is not big relative to the value of government bonds held, so we are able to hold some assets in cash without sacrificing fund returns, and we’ve also got the ability to repo out other assets, such as gilts, to meet a bigger move in rates. But this level of cash would not be so comfortable in funds with large holdings in assets other than government bonds,” he says.

For everyone else, the obvious solution is the repo market. In theory, this allows firms to remain fully invested in assets while sourcing cash liquidity. In practice, that is only the case if the repo market can cope with the demands placed on it by fixed-rate receivers during a period of surging interest rates. The big fear for many funds is that the market would break down under that kind of stress.

Repo is already under regulatory pressure. Proposed revisions to the Basel III leverage ratio would make the transactions far more capital-intensive, and Europe’s much-discussed financial transaction tax would also dent liquidity (Risk October 2013, pages 16–21). In addition, both the Federal Reserve and the Financial Stability Board have been making noises about a fresh round of regulation for repo.

“There are significant liquidity issues associated with central clearing, and what worries us is that the different regulations will affect available liquidity for investment funds. Usage of the repo market will be affected by the Basel leverage ratio and bank balance-sheet usage. If you are a long-only asset manager and you don’t have the translation mechanisms to turn assets into cash, then you need to start having serious discussions about the structural composition of your portfolio in case this mechanism doesn’t work,” says Jan-Mark Van Mill, head of trading at Dutch pension fund manager APG Asset Management in Amsterdam.

PGGM’s de Geus is also worried. “The whole concept of central clearing only works on the premise that the repo markets function properly. Everybody will be highly dependent on it, and there are some important questions to be asked as to how deep the market really is,” he says.

The Basel III leverage ratio, which treats repos on a gross rather than net basis, will not help, say banks. According to a worked example, shown to regulators, banks claim applying the 3% leverage ratio to a simple reverse-repo agreement would require a 50bp spread just to equal the cost of capital, assuming the bank’s loan is 100% collateralised by US Treasuries, the corporate tax rate is 40% and the after-tax cost of capital is 10%. The typical market spread for this transaction today is 5bp.

Insight Investment’s Giles puts it simply: “Funds will be forced to use repo to fund variation margin calls, which means transferring the counterparty credit risk from the swaps to repos, but also introduces significant liquidity and roll risk. We feel repo doesn’t sit well with bank capital and leverage regulations, so it is likely to become scarcer rather than more freely available. In many ways, the counterparty risk on swaps has inadvertently been replaced by a more volatile liquidity risk that is extremely difficult to manage and potentially systemic.”

If these fears are enough to scare hedgers away from the repo market, funds could instead act to remove the source of the liquidity exposure – limiting their use of swaps and turning to alternative forms of duration. Some firms are already taking this route, but others see it as problematic.

“To a certain extent this is happening,” says Insight’s Giles. “Some funds are sourcing long-dated illiquid investments that exhibit sensitivity to rates and have embedded inflation exposure, such as social housing, infrastructure debt, ground rents and long-dated leases. And yes, this can reduce the collateral strain, but these assets can never replace core swap hedges, which offer granularity and precision and, most importantly, enable clients to meet their shorter-term cashflow commitments and manage their liability risks without tying up all their assets in illiquid investments.”

And there may not be enough of these assets to go round. “There are definitely not enough long-dated Danish government bonds to satisfy the duration of our portfolios, so we have to source duration through the swap market,” says Sampension’s Larsen.

Insurers face a different dilemma. Under the proposed Solvency II directive, liabilities are discounted using a swap-based discount curve – currently Euribor. If an insurer was to start hedging the duration of the liabilities using long-dated bonds instead of swaps, it would be taking on basis risk in the form of the asset-swap spread – the difference between the yield of the bond and Euribor, essentially a credit spread. If rates remain stable but the creditworthiness of the bond issuer deteriorates, the asset-swap spread would widen, meaning the value of the bond would fall, depleting the insurer’s own funds.

“Insurers face two choices – you can keep hedging duration with swaps and take the liquidity risk associated with collateral calls, or you can hedge using long-dated bonds but take the risk of the asset-swap spread widening,” says Simon Hotchin, head of the strategic solutions group for Europe, the Middle East and Africa at HSBC in London.

Another possible solution to managing contingent liquidity risks is to insulate the portfolio by trading payer swaptions. This will protect the firm in the short end if rates spike. If rates rise, the fund will receive collateral on the swaption positions and can then post it out on its duration hedges. But this strategy depends on the collateral being received on the uncleared swaptions being cash – if the counterparty has the ability to post bonds under its bilateral collateral agreement, the strategy doesn’t work.

Fund managers see the argument, but those who spoke to Risk for this article say they have yet to implement it.

BOX: Ucits’ derivatives use hamstrung by collateral rules

Large asset managers have called on European regulators to revise rules that prohibit Ucits funds from using received cash collateral to meet central counterparty (CCP) margin requirements – a restriction they say will constrain legitimate use of derivatives by the funds.

Ucits funds will be required to clear standardised over-the-counter derivatives once mandatory clearing rules come into force in Europe – an obligation that will result in them having to meet regular variation margin calls from the clearing house in cash. The problem is, like pension funds, many have small allocations to cash and tend to be fully invested in other assets.

One possible solution is to repo out those securities in exchange for cash, which could then be posted to the clearing house. However, current Ucits rules prevent them from reusing received cash collateral.

Asset managers say this means they will either need to allocate a much larger proportion of their assets to cash – a move that would hamper overall returns for the fund – or limit their use of derivatives.

“We believe this will constrain the legitimate use of derivatives in Ucits funds and have lobbied actively on this issue. We’re hopeful the decision can be overturned when the Ucits VI review is undertaken. In general, we feel the Ucits rules need to be updated to better reflect the new environment following the introduction of mandatory clearing. In the meantime, absent access to repo funding, we will need to ensure any Ucits funds that make extensive use of OTC derivatives will have direct access to sufficient cash to meet potential variation margin calls,” says Andrew Giles, chief investment officer, solutions, at Insight Investment in London.

Other managers echo those concerns. “If the rules aren’t changed, Ucits funds will not be allowed to use repo to generate cash for meeting CCP variation margin payments, and therefore will have to adjust their strategies by either holding more cash or more short-term liquid securities that can be sold when a variation margin payment needs to be met. But this is far from ideal and will create a drag on performance. We are hoping the rules can be amended,” says Gilles Dauphine, head of insurance and pension solutions strategists at Axa Investment Managers in Paris.

The European Securities and Markets Authority (Esma) confirmed in a question and answer paper earlier this year that cash collateral received by Ucits funds can only be invested in a limited number of instruments, and cannot be used to meet clearing obligations under the European Market Infrastructure Regulation.

Specifically, cash collateral can be placed on deposit with certain credit institutions, invested in high-quality government bonds and used for reverse repo transactions provided the transaction is with a credit institution subject to prudential regulation, or invested in short-term money-market funds.

An Esma spokesperson says the regulator has no plans to change the Ucits directive to allow for cash collateral to be used to meet margin calls.

BOX: How likely is a repo market squeeze?

Some funds are already monitoring the risk of the repo markets seizing up, and the possibility they may be forced to unwind repos at short notice and implement alternative hedging strategies. The UK’s Pension Protection Fund – which manages underfunded corporate schemes in the event of the sponsor becoming insolvent – uses six liquidity indicators, including the spread between Libor and government bond rates, the Vix volatility index and Markit’s iTraxx crossover index. These generate either a green, amber or red rating, with either of the latter two triggering an immediate contingency plan: the PPF convenes an emergency committee meeting, where actions are agreed to reduce funding needs. These steps are then executed over a one-month period if the rating is amber, and one week if red, says Jean-Pierre Charmaille, the PPF’s chief risk officer.

“At this stage we may decide using repo is too much of a risk, scale down both the repo and swaps books, and source duration from elsewhere,” he says. According to a 10-year backtest of the PPF monitoring framework, a red rating was attributed during the period from November 2008 to March 2009.

The big question is whether a repeat is likely. According to a December 2008 repo survey conducted by the International Capital Market Association (Icma), the overall volume of repos and reverse repos on the books of 61 financial institutions slumped from €6,504 billion in June 2008 to €4,633 billion in December, almost a 30% drop. And one repo trader, who estimates overnight European government bond repo volumes to be €500 billion, says liquidity will continue to drain from the market if the Basel III leverage ratio is implemented as proposed. In that situation, the market could be overwhelmed by massed demand from fixed-rate receivers in the event of a rate spike, he says – but the market ought to be able to cope if the level of liquidity remains as it is today.

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