A steep rise in Gilt yields after the UK government’s “mini-budget” on September 23 forced LDI managers to post huge amounts of margin to their swap counterparties as the value of their positions declined. Many LDI funds had to sell Gilts or other assets to meet those demands, contributing to a self-reinforcing doom-loop of bond sales, rising yields and further margin calls.

That dynamic was particularly dangerous for pension schemes that funnel swaps trades through central clearinghouses, which only accept cash as collateral, forcing these funds to liquidate assets to raise money. Pension schemes that don’t clear their swap trades via clearinghouses, on the other hand, can often post other assets such as Gilts along with cash as collateral.

Legal & General Investment Managers, one of the largest LDI managers, has previously said it clears swaps via clearinghouses on behalf of pooled LDI funds and some individual clients.

Consultants say the Gilt market meltdown exposed the potential dangers of such policies and may prompt regulators to review plans to force pension funds into derivatives clearing.

“Post-[the collapse of] Lehman Brothers, regulators solved one crisis by requiring institutions to clear, but they arguably sowed the seeds of a future crisis, which is in liquidity and collateral management. Regulations are always backwards looking and, unfortunately, this scenario was predictable,” said Simon Hotchin, a former senior markets banker now consulting in the pensions and insurance space.

“A lot of pension funds don’t necessarily have the systems or experience to deal with that – it’s not a risk that’s been on their radar. Clearing has pushed that liquidity risk onto a part of the financial system where they have much less ability to understand and manage it, and don’t naturally run with large allocations to cash,” he added.

Regulators may note the irony in clearing contributing to a near-crisis in financial markets after forcing large swathes of derivatives trades through these institutions following the collapse of Lehman Brothers and bailout of AIG in 2008. By acting as middlemen in derivatives trades, clearinghouses are designed to stop losses cascading through the financial system if one of the parties involved defaults.

Cash call

Clearinghouses require variation margin, which covers mark-to-market changes to positions, to be posted in cash to minimise their own risks. That contrasts with transacting swaps bilaterally with bank trading desks, industry insiders say, which can afford greater flexibility to clients by allowing them to post Gilts or other bonds as margin.

Pension funds aren’t currently required to clear derivatives, but some schemes have done so voluntarily to secure better terms on their trades. Frank Turley, group treasurer at Legal & General, told a Risk.net roundtable in 2014 that LGIM cleared for some segregated clients and most of their pooled funds within liability-driven investments.

“Taking a high-level view, central clearing is reducing counterparty exposure but is resulting in an increase in liquidity risk,” Turley said at the time.

“For standardised OTC derivatives such as interest rate swaps our firm’s preference is to voluntarily centrally clear given reduced [transaction] costs and increased price and valuation transparency,” LGIM said in a 2018 note, in which it names LCH as its main clearinghouse.

LGIM declined to comment for this story. LCH, which (like IFR) is owned by LSEG, also declined to comment.

Deadline delay?

Many pension funds have lobbied for exemptions from mandatory derivatives clearing. Insight Investment, another large LDI manager, said in a 2020 note that central clearinghouses asking for cash variation margin would force pension funds either to “materially increase their cash allocations or to establish access to short-term liquidity by other means that could introduce more risks and costs”. One potential solution that could be explored would be for central banks to provide “emergency liquidity arrangements in stressed market conditions”, Insight noted.

Regulators have listened to these arguments, but until recently have still looked determined to push ahead with mandatory clearing, with the European Securities and Markets Authority recommending earlier this year that pension funds begin clearing in June 2023. Hotchin noted that, following Brexit, the UK should now be free to depart from this stance, “which would clearly help the current situation”.

In the meantime, pension funds will be laser-focused on how best to cope with the liquidity risk created by derivatives exposures more broadly. Many banks had also looked to prod clients towards cash-only collateral agreements in recent years, complicating matters for these investors too during periods of market stress.

Calum Mackenzie, an investment partner at insurance company Aon, said there would be a post-mortem after recent events as the industry looked to draw lessons. “One of the things we will look at is … the collateral process … was it effective and did it work? And did prior regulatory changes have any effect on the collateral process,” he said.

Hotchin said some insurers had been moving back to collateral agreements that allow a wider range of assets to be posted on their bilateral swaps trades with banks.

That “fits much more naturally within the asset allocation strategies run by these institutions. If you’re just posting cash then it has knock-on implications for how you invest your assets and creates huge opportunity costs, even if it saves you money on execution”, he said.

This article by Chris Whittall first appeared in IFR. 

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