In the first article of our ‘Preparing for the Unpredictable’ series, titled ‘Liquidity Preparedness for Margin and Collateral,’ we explored the basics of liquidity resilience, focusing on how buyside firms can prepare for sudden market disruptions.

This second article in our ‘Preparing for the Unpredictable’ series focuses on stress testing. This essential tool helps buyside firms anticipate and manage volatile markets. Stress testing has moved from a best practice to a regulatory suggestion, with recent updates from authorities like the FSB in July 2024 further emphasizing its significance in managing margin and collateral impacts.

By proactively addressing the challenges of stress testing, buyside firms can meet upcoming regulatory requirements, strengthen their risk management strategies, and contribute to the overall resilience of the broader financial system.

Liquidity risk in financial markets comprises two types: market liquidity risk—the ability to buy or sell assets at current prices—and funding liquidity risk—the capacity to meet financial obligations using liquid assets.

In margin and collateral management, liquidity risk often refers to funding liquidity risk. This is the risk that a firm must use available collateral to meet margin requirements.

We measure this liquidity risk by subtracting margin obligations from available collateral value. This basic calculation can evolve into more complex measures, considering expected future collateral values and margin obligations to assess risk levels over time accurately

Focusing on the margin aspect of liquidity risk first, two critical types of margin requirements can fluctuate during volatile market conditions:

Variation Margin—This reflects the daily change in the present value of a derivative position. Sharp market movements on a single day can cause significant swings in this liability, which can occur in volatile markets.

Initial Margin– This is an additional buffer held to account for the potential default of one of the parties in a derivative trade. It is calculated using a model and typically experiences less frequent daily changes, but in the event of a significant market move, the required margin can increase significantly.

Understanding the impact of a market move on Variation and Initial Margin is essential when evaluating potential liquidity risk in margin and collateral.

The LDI crisis in the UK highlighted how the collateral asset side of liquidity risk is often underestimated in analyses. Collateral assets like government, inflation-linked, and corporate bonds tend to have highly correlated price movements with interest rate markets.

This exposes holders of interest rate derivative positions to “wrong-way risk” scenarios, where margin liabilities rise just as the value of collateral assets declines.

For buyside firms that trade derivatives, actively managing the risk of changes in the value of Variation Margin, Initial Margin, and Collateral Assets from market movements is crucial for maintaining stability in volatile markets.

The FSB’s July 2024 report emphasizes the importance of stress testing for this purpose, proposing enhanced measures to ensure that buyside firms are better prepared to manage liquidity risks related to margin and collateral during market disruptions.

Stress testing is a key tool for assessing how volatile markets affect a firm’s ability to meet its margin and collateral obligations

This approach is now a regulatory focus and a best practice in risk management.

Recent events like the COVID-19 pandemic, the Russia-Ukraine conflict, and the UK’s mini-budget crisis have tested buyside firms’ liquidity preparedness, highlighting the need for robust, ongoing stress testing

Furthermore, the FSB’s latest proposals, BCBS IOSCO’s 10-point plan on margin transparency, and the BoE’s ongoing initiatives highlight the pressing need for buyside firms to integrate stress testing into their broader risk management strategies.

This proactive approach prepares firms for future margin and collateral challenges.

Stress testing margin requirements is essential, but buyside firms face challenges like setting up stress scenarios, accessing historical data on volatile events, and applying these to complex initial margin models.

However, best practices can help firms navigate these challenges effectively:

Robust Scenario Design

• Develop stress scenarios that reflect a range of potential market conditions, including both historical events and hypothetical shocks that could impact margin and collateral.
• For instance, consider how currency changes affect emerging markets or how inflation impacts interest rate portfolios. These scenario elements can help predict margin requirements and collateral value shifts.

Consistent Margin and Collateral Risk Management 

• Incorporate margin and collateral stress testing into the overall risk management framework, aligning it with existing processes for a cohesive approach.
• Evaluate stress impacts across all derivatives in the portfolio. This ensures resilience against liquidity shocks affecting margin calls and collateral management.

Understanding Collateral Liquidity Tolerance

• Run various stress tests, from minor to significant shocks, to find the point where collateral resilience is at risk.
• Integrate these practices into daily operations to maintain visibility on emerging risks. This approach also helps avoid sudden shifts from low to high risk for margin and collateral needs.

Regular Review and Update

• Keep the stress testing framework dynamic by reviewing and updating it regularly to reflect market changes and emerging risks.
• Adjust testing practices based on the current portfolio structure and recent market trends. This helps ensure accurate assessments of liquidity resilience related to margin and collateral.

Buyside firms must pressure test margin requirements and collateral obligations to ensure resilience in adverse market conditions. Recent guidance from BCBS, IOSCO, the BoE, and the FSB, especially the updates from July 2024, underscores the importance of integrating both margin and collateral impacts into a firm’s liquidity framework.

By overcoming the implementation challenges of stress testing, buyside firms can meet upcoming regulatory expectations and enhance their risk management capabilities, ultimately contributing to the overall resilience of the broader financial system.