Ukens kommentar fra The Macro Compass

Welcome to the Dark Side of Derivatives

Actually, before we jump right in.
On October 17-18 I will be a speaker at the Digital Asset Summit in London – it’s an excellent conference that combines the worlds of macro and digital assets and it features high-quality speakers and attendees (macro/crypto funds, family offices, banks and many more).
If you want to grab a ticket, you can get a 20% discount using the code ‘‘TMC’’ – here is the link.

Now, back to it.

Let’s start with some context first.
The size of the global pension fund industry is estimated to be in the $35-40 trn area. It’s a very large and systematically important industry not only because of its size, but also because of its social impact – most of us look forward to retirement after decades of hard work.

We recently got some scary headlines coming from the UK: pension funds were about to blow up, and the Bank of England had to backstop them by limiting the relentless rise in 30-year yields.

Let’s look into the very dynamics behind such episodes of acute stress.

1. How Does It Exactly Work?

Pension funds are in the business of accumulating premiums today and investing them (assets) such that they will be able to pay out pensions (liabilities) in the future.
Pension funds’ liabilities are hence a promise to pay a stream of retirement cash flows in the far future (~20-30y), which organically exposes them to interest rate risks: the discounted value of these liabilities increases if rates go down, and vice versa.

To guarantee solvency, these risks need to be hedged at least to a certain extent.
But funds must generate returns, too.

Here is how a stylized pension fund balance sheet looks like:

Let’s talk about the hedging part first.

20-30 year government bonds would be an obvious candidate as an asset to buy in order to hedge the interest rate risk of a 20-30 year pension liability, right?
Indeed, that’s correct.
But as yields kept moving lower for a decade, that also meant pension funds were locking in all their cash in low-yielding products.

Hence, a more ‘‘convenient’’ instrument became increasingly popular: swaps.

A receiver interest rate swap is nothing else than an agreement to receive cash flows at a fixed rate against the obligation to pay cash flows at the prevailing floating rate over time – ok, but where is the trick?

The beauty of a swap is that there is basically no principal investment up front.
These derivatives are mostly cleared through a Clearing House, which requires an initial margin (often paid by posting bonds as collateral) and variation margins (mostly settled in cash every day).

Most importantly, that means the cash that would have been invested in long dated safe bonds can now been deployed in higher yielding investments – which in a low-return environment were vital for pension funds to be able to deliver the return necessary to service pension payouts in the future.
Together with other factors, this led swaps to become so popular as a hedging tool that they now trade at a premium to government bonds (!).

Ok, so pension funds are sitting on a very large amount of 30-year receiver swaps to hedge long-dated liabilities.
And as this requires very little upfront investments, cash can instead be directed towards higher expected return assets like stocks, EMs, credits etc.

Then, this happens.

Now, institutional investors’ risk models (trust me: first-hand experience) are mostly based on 5-10 years historical volatility and hence unprepared to deal with such moves.
The amount of cash required to meet margin calls when the move in interest rates is 6-8x standard deviations is very large.

And remember where this cash has been invested?
Mostly in riskier assets that Clearing Houses won’t accept as collateral.
Pension funds also don’t have direct access to the Central Bank, which makes it impossible for them to post collateral and receive funds to meet margin calls this way.

All of a sudden, the most typical liquidity problem arises.
The only way out is to liquidate assets (bonds, stocks, all!) and meet margin calls to avoid a liquidity problem morphing into a solvency issue.

Government bonds – the most liquid assets – are first in line, and large sales only compound the problem: rates keep rising, and market makers whose risk warehousing capacity has been crippled by regulation are unable and unwilling to help.
A domino-like, vicious circle unfolds.
The Central Bank is forced to step in and stop the bleeding by effectively purchasing as many long-end bonds as necessary to limit the cascading risks.

A huge, systemically important sector like the pension fund industry was effectively experiencing an acute liquidity crisis on the verge of morphing into a solvency crisis.

Serious stuff.

Now, how likely is this to happen in Europe or the US?

2. Yes, It Can Happen Elsewhere Too, But…

Is this only a UK pension fund industry problem?

Well, the UK certainly has a lot of idiosyncratic features that compounded the issue, and in particular:

• ~1.8 trillion worth (!) of Defined Benefit pension schemes, which require pension funds to make more extensive use of a liability-driven investment (LDI) approach and hence more derivatives and return-seeking strategies;

• Most importantly, a gigantic pension fund industry both compared to the size of its economy (119% of GDP as per 2020) and to the size of its high-quality bond market.

Here is how pension fund asset as % of GDP rank amongst OECD countries.

As you can see, there are many more jurisdiction with a humongous pension fund industry – but the devil is sometimes in the details.
Take The Netherlands, for instance – at >200% of GDP, should Dutch (and Europeans) be worried?

Yes, and no.

Yes: because a sharp move in 30-year European rates could spark very similar dynamics amongst Dutch pension funds too.
And yes, also because there are many more non-rates derivatives involved here: FX forwards used to hedge foreign bonds and equity investments, commodity derivatives, futures and so on. Volatility is picking up everywhere, and margin calls could pop up where you least expect them.

No: mainly because the size of the European pension fund industry as a % of the (decently rated) European bond and repo markets is much smaller than in the UK, and hence the magnitude of such an episode could be more contained.