Could further margin chagrin arise a year on from the gilt crisis?

Could further margin chagrin arise a year on from the gilt crisis?

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By Joe Midmore, CCO of OpenGamma

September 23 marked a full year since the Truss government’s disastrous ‘mini’ Budget sparked mayhem in British sovereign bond markets. Within three days, yields for the 30-year gilt spiked 120 basis points – one of the greatest leaps ever seen in such a short space of time.

Of course, a significant contributor to the sell-off were firms that employed a Liability Driven Investment (LDI) approach, a leveraged strategy whereby institutional investors – typically defined benefit pension funds – invest in sovereign bonds and derivatives to hedge against their liabilities. Following the unexpected rise in yields, many of these firms suffered a sudden worsening of their derivative positions and were subsequently presented with staggering margin calls. Many liquidated their gilts to meet these, driving prices lower and perpetuating the ‘doom loop’.

While the Bank of England’s intervention, days after the mini-Budget, was successful in averting a full-blown market catastrophe, there has been little involvement from central banks and regulatory authorities in the year following the crisis. The UK government has announced plans to reform the LDI market, but no substantial measures have yet been implemented.

This may be partly due to the general market consensus on the crisis, with many analysts branding it a black-swan event. Less than a year on from the gilt crisis, however, the emergence of unexpected wage growth data in June saw short-term British gilt yields soar past their mini budget levels. Indeed, it appears black-swan mating season could be upon us. The prudent move for investment firms in this context is to assess how vulnerable they remain to a similar incident emerging in the future. After all, while history seldom repeats itself, it often rhymes.

Margin risks remain 

According to a European Securities and Markets Authority report published earlier this week on the risks and vulnerabilities present in the EU financial system, many firms remain potentially exposed to sudden spikes in their margin requirements.

It warned that ‘increasing interest rates present market risks and liquidity risks for the asset management sector’, and that, ‘the use of interest rate derivatives contracts should continue to be closely monitored’. To accurately gauge the margin-related risks, it is important to fully comprehend the technicalities surrounding margin requirements tied to contracts like interest rate and FX derivatives.

To reduce the risk of default and maintain market stability, firms are required to post both initial margin and variation margin. Initial margin is the sum of money investors must provide when they open a contract, while variation margin refers to the amount of cash a trader must deposit or withdraw from their margin account on a daily basis in reflection of the change in the value of their positions. Essentially, if the value of their positions declines dramatically, they will owe significantly more variation margin.

With this in mind, it is easy to see how pension funds quickly came unstuck last year. Unlike more volatile commodities-based derivatives, few pension funds would ever have foreseen that their characteristically safe and steady sovereign bond-related derivatives would suffer a bout of extreme volatility and drive their variation margin sky-high. But as we have witnessed, nothing is certain in black-swan mating season. Take the soaring yields of the US 10-year Treasury, for example, which this week hit 16-year highs off the back of the Fed’s latest policy meeting.

Moving forward, as firms adapt to weather more turbulent conditions for markets, characterised by rising rates and elevated economic uncertainty, institutional investors must re-evaluate their exposure to ‘typically’ safe investments. More specifically, they must pay closer attention to their liquidity management practices. Without safeguards from central banks, or margin exemptions for those institutions more likely to have portfolios heavily weighted toward fixed income instruments, such as pension funds or insurance firms, efficient liquidity management becomes vital.

Institutional investors need to be able to accurately forecast their margin requirements, stress test to ensure their ability to keep the ship steady in choppy waters, and ideally model their margin obligations in order to pay them in the most efficient manner. This requires significant expertise – something that these types of institutions simply aren’t likely to have in-house when one considers that LDI strategies have only come to the fore in the last decade or so. Firms that don’t adapt to changing market conditions could be leaving themselves open to further margin chagrin over the coming months and years. 

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