The triggers forcing investors suddenly to hand over cash are many and varied.
In perhaps the textbook example — the UK’s pensions hedging crisis last autumn — it stemmed from a fiscal shock that triggered a sharp rise in bond yields. For Silicon Valley Bank, which failed in March, it was a curious failure to hedge interest-rate risk ahead of a widely anticipated series of rate rises, mixed with deposit flight. Neither was a pleasant experience for those involved.
Hedge funds group Man says such events are becoming an increasingly pressing issue among its clients, and at a function this week, chief executive Luke Ellis, seeing out his final months before he hands the reins to Robyn Grew, outlined what he called his “favourite” example.
The head of a sovereign wealth fund, he said, was greatly amused by the “stupid” mess that UK pension funds had landed in with their liability-driven investment strategies, which blew up in spectacular fashion last September when the country’s shortlived government under Prime Minister Liz Truss embarked on vast unfunded tax cuts and a wave of borrowing.
UK government bonds fell hard, their yields soared, and the more they soared, the more cash LDI managers had to find, often asking their pension fund clients to cough up, to meet calls to provide more so-called margin — collateral on trades. And what did they sell to meet those margin calls? Gilts of course. So the yields soared further, and round and round it went until the Bank of England stopped the rot. It is not hard to imagine the schadenfreude of the unnamed fund manager.
Then, Ellis recalled, “a week later he got a phone call from the government saying ‘we need 10 per cent of the sovereign wealth fund because we need to buy some weapons’”. Karma is a liquidity mismatch.
“Liquidity management is incredibly important,” Ellis said. “In the real world, you have to be able to change your mind.”
This is not entirely a function of the new world order with its higher inflation and higher interest rates. Recall that in March 2020, when Covid hit the markets, investors took immediate and heavy losses and, similarly, had to sell assets fast to plug the gap. The golden rule in this situation is that fund managers do not sell what they want to sell. They sell what they can sell. Three-and-a-bit years ago, that triggered an alarming sell-off in US government bonds, supposedly the safe retreat for these moments of stress. It was a mess.
But several things make this whole issue more pressing. One is that even quite staid investors have found themselves with arguably oversized positions in assets that are hard to sell — in infrastructure, real estate, private markets and the like. Buying illiquid assets seemed like an excellent idea when bonds yielded nothing, or even less, and institutional investors needed something to generate decent returns.
It seems a less good idea when you have to sell in a hurry, and find you cannot offload your holding in, say, a toll road by lunch time, at least not at a price you can stomach. What is more, last year’s slump in values in public markets — government bonds and publicly listed equities — means that illiquid assets account for a larger portion of overall portfolios.
In addition, a growing slice of the investment world is falling under post-2008 margin requirements. For investors that means, among other things, that if hedging positions move against them on any given day, they have to pay up potentially large sums. Industry body ISDA said last month that users of derivatives handed over $1.4tn in margin payments last year, up from $1.3tn in the year before. That tally has been creeping higher for some years but now the growth is accentuated by additional volatility running through global markets struggling to absorb interest rate rises, and by the greater number of derivatives users becoming subject to the regulations, including several hundred smaller firms in September 2022.
From later this month, this will suck in EU pension funds too. They have had years to prepare for this, and have done so. Still, it could crimp fund performance, which in a year like 2022, for example, would have been adding insult to injury. “In a high returns environment you can swallow that but when interest rates are thin, it becomes more material,” says Jamie Gavin, head of European prime brokerage clearing at Société Générale.
Requirements on funds to put derivatives trades through clearing houses and pony up margins solve an ugly problem, namely the counterparty risk that ripped through the system in 2008-2009 with domino strings of failing companies. Few would argue with that. The flip side, though, is that it heaps more margin calls on a wider set of institutional investors.
“The requirement to source large volumes of cash and high-quality liquid assets to meet margin requirements may be making the financial system more susceptible to liquidity events, which should be looked at,” says Scott O’Malia, ISDA’s chief executive.
Freeing up cash so your boss can buy some tanks may be an extreme and somewhat unusual example of the challenges in the typically unsexy world of liquidity management. But big investors of many stripes will need to be savvy about how to cobble together cash in a hurry and avoid mini LDI-style shocks.
