The repo market could “shut down” under stress conditions with pension funds most at risk, according to a new Northern Trust whitepaper.
Pension funds are caught between sustained low interest rates and “the unintended consequences of a variety of market regulations,” explained authors Mark Austin and Steve Irwin.
“In times of market stress, the repo market could shut down, or a bank may not be able to provide an investor with direct cash,” the paper continued.
Therefore, funds must diversify their portfolios’ liquidity sources in order to gain the “strongest protection” against future market turbulence.
According to the whitepaper, some pension schemes are increasing their allocation to cash to as much as 7 percent of their portfolios.
In previous environments, investors could earn as much as 2 to 3 percent by holding cash, but, today, they must settle for no returns, or even suffer negative rates.
“Cash has gone from being a benign by-product of investing to arguably the essential facet of a lot of investment strategies.”
Turning to regulation, Irwin and Austin cited the US Dodd-Frank Act, the European Markets Infrastructure Regulation and the EU’s Solvency II Directive as all bringing unintended consequences through their liquidity requirements.
A separate report by the Dutch asset manager APG and the Dutch pension fund provider PGGM, two of Europe’s largest pension funds, along with the Insight Investment and MN, estimated that if European pension funds were required to centrally clear derivatives trades and post cash for variation margin, the total collateral required for a 1 percent rate shift would range from €205 billion to €255 billion. In more stressed scenarios, it could reach €420 billion.
“If interest rates in the current market environment move by a quarter of a percent—which some industry participants argue would not be uncommon—then, collectively, European pension funds would be required to post intra-day margins of approximately €55 billion, stated Northern Trust’s paper.
"So, while more central clearing has de-risked the market, it has unintentionally given investors new kinds of liquidity challenges.”
By way of possible solutions to what the paper describes as the “liquidity conundrum”, funds should identify “unusual sources of liquidity”, such as securities available for repo activities or securities lending.
Funds should also maintain a liquidity ladder to forecast needs and match them with known cash flows, while modelling the asset liquidity profile and stress testing it to understand the true benefit and cost of embedded funding costs, as well as margin requirements on derivatives positions.
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