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3 October 2022

How did extreme market movements cause significant margin calls last week?

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The market reaction to the fiscal policy decisions announced in the mini budget by the UK Chancellor last week have been extreme for the UK’s financial Institutions.

In light of these events, we have put together short and informative articles to explore the causes, and address ways where Asset Managers  and Pension Funds in particular could have avoided the worst impacts. Here we look at the underlying cause behind the volatile moves, and in the coming week we will share examples of how firms could have mitigated the level of impact.

The ripple effects from the announced package were a severe and quick decline in GBP, in particular against the USD, together with a jump in yields of more than 1.5% in a matter of days. The Bank of England on Monday issued a statement reflecting on the impact this extreme market reaction had on the stability of financial markets as a whole – “The Bank is monitoring developments in financial markets very closely in light of the significant repricing of financial assets.”

Of particular concern to the Bank of England (BoE) was the change in yield on the 30 Year UK Treasury yield which rose from ~3.6% to over 5%. When compared to the 1.2% from the start of the year, this reflects an alarming rise in yields for a developed market economy.

Margin calls - extreme volatility - BoE

Source Refinitiv

By the middle of last week, liquidity in the long-dated gilt market had completely dried up meaning Gilt traders and Repo desks were unable to access this key source of liquidity for their institutions. This only stabilized after the Bank of England issued another statement (Market Notice 28 September 2022 – Gilt Market Operations | Bank of England) highlighting it will take emergency action to mitigate the crisis.

Margin calls

In the midst of the sudden and volatile moves in the Rates and FX markets, several UK market participants, in particular Liability-driven investing (LDI) funds managing strategies for UK Pension Funds, suffered from unexpectedly large variation margin calls.

The driver behind this was two-fold. LDI strategies by nature run levered positions to match future dated liabilities and this leverage, when combined with market volatility, can have a magnified impact on a firms’ cash positions leading to situations such as forced liquidations or collateral squeezes. This caused the market events to have a spiralling effect where the derivative positions LDI funds held, in the form of Interest Rate Swaps and Repos, suffered MTM losses. To fund these positions, the LDI funds were required to sell UK bonds, making their positions move further against them and exacerbating the already extreme UK Gilt market moves. (UK pensions hit with £100m margin calls as gilts and sterling slide – Risk.net)

The second aspect to this is devaluation of collateral. Pension Funds have large asset holdings in government bonds. Such holdings also end up forming a large part of their collateral pool, which is posted to meet margin call obligations across counterparties. A sudden rise in yields like this corresponds with a fall in bond prices and as such the value of what they hold falls. This impairs the situation, requiring them to top up their collateral obligations.

Whilst it is not uncommon for Central Banks to take action in financial markets, these actions are usually planned and co-ordinated over the course of weeks or months, in response to events such as the Global Financial Crisis (GFC) or Covid Crisis which have systemic impact on financial markets.

For the BoE to take drastic action in such an unexpected and immediate manner and counteracting its strategic plan of quantitative tightening is a cause for caution to financial market participants. While the issues last week have been somewhat isolated to pension funds, LDI’s, Bonds and FX, this is highly likely to trickle down to wider market participants.

It is therefore imperative for firms to have a stable and resilient collateral profiles, and the ability to project the impacts of extreme market movements on their positions to prevent them being caught out by the current highly volatile conditions.

Over the next week, we will dig into techniques funds use to ensure Collateral Resilience. Look out for the lessons learnt from this crisis, as they can form part of a proactive toolkit firms can use to manage their collateral and liquidity risk in stressed markets.

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