Nobby Clark and Piyo Zhang, directors within HSBC’s Client Solutions Group, discuss sourcing and managing liquidity for insurance firms and pension funds amid difficulties presented by upcoming regulatory changes
New financial regulation is throwing up new questions and challenges for market participants across the industry. A significant concern among clients – particularly UK-based insurance firms and pension funds – is how sourcing liquidity to meet margin payments could impact their underlying business as a whole.
Insurance and pension firms have historically not needed to factor in the cost of sourcing collateral for margin payments in their asset allocation strategies, focusing instead on headline returns. Following post-crisis regulation, there has been a sea change in mentality on new liquidity‑related issues.
Some have contemplated changing their business models to accommodate the new rules. Variation margin requirements under the European Market Infrastructure Regulation (Emir) for cleared derivatives are typically required in cash, which most insurance and pension funds do not typically carry in large quantities. To meet those obligations, some firms hold part of their portfolio in cash, but there is a cost in terms of a drag on their overall fund performance.
HSBC, through strategic investments and its insights programme, The dealing room of tomorrow, has prepared itself to meet these challenges head on with intuitive solutions, and is ready to help clients meet their obligations without creating performance headaches.
“We have had some really good feedback from clients. Using internal tools and analytics we can clarify the cost of liquidity and help clients challenge the way they might interact with other parts of their own organisation,” says Nobby Clark, managing director, Client Solutions Group at HSBC. “We see this as part of a long-term commitment to client interaction. The more we understand each other’s constraints, the better we can make use of solutions to satisfy our joint regulatory requirements.”
Addressing the matching adjustment requirement
The drivers of change have come in different forms. Firstly, Solvency II – a European Union directive that primarily focused on capital obligations for insurance firms – contains the ‘matching adjustment’ rule, which requires firms that adopt it to have fixed, predictable sterling-denominated cashflows to match their annuity liabilities in the UK.
While relatively straightforward, particularly if you already have sterling‑denominated investments, the matching adjustment rule can become more complicated with funds that seek diversification and better risk-adjusted returns by investing abroad. For example, an insurance firm buying a US dollar‑denominated asset would be introducing a non-matching asset into its portfolio. This can be solved by trading a cross-currency swap to recreate that fixed sterling cashflow, but it results in collateral obligations for the insurer.
“As soon as you have implemented a cross-currency swap, and the market moves, we will need the insurance firm to post or receive collateral. In the past few years there has been a drive to standardise collateral terms, and in the bank’s ideal world all clients would post and receive cash,” says Clark.
This is different from Solvency I where insurance companies were able to use instruments such as FX forwards to hedge or even leave their investments unhedged if they were happy with the risk. Under Solvency II, however, they need to put in place cross-currency swaps in order to get that cashflow into sterling and benefit from the matching adjustment rules.
“The concern for the insurance companies is that, if the mark-to-market moves against them, they need to have sufficient liquidity to post credit support annex (CSA)-dependent collateral against those cross-currency swaps. So, while they are satisfying their requirements for the matching adjustment rule, diversifying their revenue universe and improving their returns, there is a drag to the extent they must now post cash as collateral for the derivatives they are hedging on overseas investments,” says Clark.
As a solution to this problem, HSBC can set up a special-purpose vehicle (SPV), which could own a portfolio of the firm’s overseas assets. This SPV would then enter into a cross-currency swap to exchange all the US dollar-denominated cash flows for sterling ones.
“The SPV differs from a bilateral contract in that our only recourse is to the assets within the SPV as opposed to a bilateral contract where we would have recourse to the entity plus the collateral that offsets that exposure,” says Clark. “One of the reasons we look at the portfolio approach is because we have been discussing ways in which clients could, under some circumstances, substitute the assets within the SPV and maintain the fixed sterling cashflows for their matching criteria.”
“We have structures that are ready and waiting to be capitalised on by our insurance company client – if it’s the solution they prefer,” says Piyo Zhang, a director within HSBC’s Client Solutions Group.
Central clearing for derivatives: The case for pension funds
Unlike insurance companies, pension funds were granted a temporary mandatory clearing exemption for over-the-counter derivatives in the final Emir regulation to address concerns with the sourcing of collateral. Central clearing requires the posting of initial and variation margin, with central counterparties demanding the latter in cash.
However, since September 1, 2017, pension funds have been required to post variation margin to bank counterparties for non-cleared derivatives, which the dealer community has often preferred to receive in the form of cash. For FX forward transactions, counterparties will need to begin posting margin in January 2018, the same time the second Markets In Financial Instruments Directive (Mifid II) comes into effect. Pension funds may face difficulties closing out the settlement of a hedge they have put in place on overseas assets.
Take, for example, a pension fund that invests in US dollar equities with a hedge ratio of 60% implementing its hedge ratio on a GBP/USD forward contract and rolling that contract for three months. The risk they are exposed to is if GBP/USD depreciates, which has happened since the Brexit vote, and also the net asset value (NAV) of the trade. In this example, the NAV will actually perform well because the fund will have hedged only 60% of the overseas investment rather than 100%. The US dollar assets will therefore appreciate significantly in GBP terms and money will only be lost on the 60% hedge.
“The problem comes when that contract requires settling and the pension fund will have to pay out the settlement of the hedge it puts in place. This becomes a liquidity drag or a cashflow drag rather than just a margining requirement,” says Clark. “In all the examples highlighted, there are stages where the liquidity becomes a burden through a requirement to post collateral, and to the extent to which the client can post cash, which can have an immediate liquidity impact. If gilts, then it is delayed, but when the contract comes into settlement, then this cost becomes crystallised.”
There is also concern that forced liquidity events tend to occur when asset prices are depressed, so clients will potentially liquidate at depressed asset prices, locking in deficits or bad performance.
HSBC has developed a range of CSAs to help firms that have been caught out when managing the liquidity impact of settling out-of-the-money contracts and experiencing a liquidity drag on their portfolios. These specific contracts offset the mark-to-market moves and can provide the liquidity when they need it.
“The contracts under this contingent facility offset mark-to-market moves and can provide liquidity when needed. The cost reflects the fact that clients are only using liquidity when they need it,” says Zhang.
A more lateral approach to liquidity management is needed, says HSBC’s Clark. “By thinking about liquidity in broader terms, we’re advocating an understanding of opportunities to buy contingent liquidity and hedge future requirements to help with efficient portfolio management,” he concludes.
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Nobby Clark is managing director of the Client Solutions Group at HSBC Global Banking and Markets. He joined HSBC in 1989, focusing on UK interest rate swaps and options trading sales, and has held various roles since.
Nobby founded the pension solutions team in 2004 with the objective of deepening HSBC’s relationship with its customer base by offering holistic solutions to complex pension issues. He was tasked with providing solutions for managing HSBC’s own pension risk, and was a key member of the sponsor’s negotiating team for the 2005, 2008, 2011 and 2014 actuarial valuations for the UK scheme. He is also a member of the Global Pension Oversight Committee.
Nobby started HSBC’s European credit derivatives trading desk in 1997, which grew to include structured credit trading. Between 1994 and 1996, he worked for HSBC New York as head of the US dollar global swaps trading book.
Piyo Zhang is a director of the Client Solutions Group at HSBC Global Markets. She is responsible for UK insurance and asset management coverage.
Piyo has held various roles within HSBC across areas including insurance mergers and acquisitions, debt capital markets origination and insurance solutions sales. She has a history of working with life offices and asset managers, executing asset liability management strategies and implementing illiquid asset trades.