The year of the election – unpredictable events need vigilance at banks

The year of the election – unpredictable events need vigilance at banks

  • Export:

By Alex Knight, Head of EMEA, Baton Systems

Pre-empting and managing the unknown has always been a conundrum in financial markets. When asked what the greatest challenge for a statesman was, Prime Minister Harold Macmillan replied ‘events, dear boy, events’. Today we ask have events ever been as impactful on markets as they are today?

This period of market madness started with the March 2020 market reaction to the Covid-19 induced lockdowns. Since then, we have witnessed periods of frenzied trading conditions, from the commodities volatility of 2022, the gilts crisis that ended Liz Truss’s premiership, the US Treasuries meltdown and the most severe banking crisis since 2008. 

Without a crystal ball it’s hard to know what will rock markets in 2024. But this year will be marked by a number of elections, famous for moving markets. It will be the first year in which both the US and UK electorates get the chance to make their voice known through the ballot box since 2016. And we all know what happened then.

The lessons of Brexit and Trump's victory in 2016 still echo loudly, urging investors to be vigilant in the face of potential political turbulence with numerous elections taking place. But it’s not just investors closely monitoring their portfolios who should be weary. Banks must also be aware of how political risks can have notable effects on their treasury and risk functions, across trade funding, liquidity and collateral management.

Take foreign exchange (FX) rates, for example. FX markets are highly sensitive to unexpected political outcomes that can lead to significant movements in currency values. The value of sterling fell 10% the day after the Brexit referendum which would have hit investor’s portfolios. UK-based banks would have experienced valuation changes influencing their funding needs, creating short-term funding squeezes.

In essence, during a period of pronounced FX market volatility, shortages in impacted currencies can occur impacting the ability and cost to fund obligations as banks are forced to enter into new arrangements to source the currency they owe. With the rest of the market in shortage, higher costs can occur. Increased market volume also creates pressure on the actual funding process because you are likely to be settling larger amounts with more counterparties because there is more activity. Again, with higher costs attached.

Large margin calls are also front of mind for bank treasury and risk teams. The collateral required to be posted to cover a foreign currency position or for cleared derivatives can spike significantly during periods of market volatility. The recent BIS and IOSCO review of the processes to post initial and variation margin, inspired by the March 2020 and commodities 2022 meltdowns, highlight how urgently this needs to be looked at.

Take an example of two banks entering into an interest rate swap that is centrally cleared. As part of the agreement, both sides will need to post collateral to the central clearing house to cover any potential losses. Initially, everything is stable. But then due to an unforeseen emergency monetary policy in response to a political crisis, interest rates start to fluctuate – which directly impact the value of the interest rate swap agreements which are marked to market based on the previous interest rate.

For one of the banks, this results in a loss on the valuation of its interest rate swaps. The central clearing house, which oversees these transactions, determines that due to the increased volatility and the loss in the valuation of the bank's swaps, additional collateral is needed from both parties to cover potential future losses (initial margin) and the negative mark to market for the party on the losing side of the trade (variation margin). The banks, facing the need to post more collateral, might not have sufficient liquid assets readily available. This hypothetical scenario is even more pronounced if multiple banks are in a similar situation. If several banks need more collateral due to changes in market conditions, then this creates a broader liquidity squeeze and an entire multitude of wider problems.

This type of situation underscores the increasing importance of understanding the exposures and holdings across central counterparties (CCPs) and counterparties along with the latest collateral schedules and eligibility for those CCPs. This is not easily available to banks in the calmest of markets, let alone when turmoil is unfolding across multiple asset classes.

Commentators are acutely aware of the caution on both sides (Labour and Conservative) in the UK election to maintain a sense of sensible spending. The same is true, to a lesser extent, in the US where unfunded government spending plans are being tightly controlled to avoid spooking the market in both currencies and government bond markets. As we saw in September 2022, when the economic ramifications of Kwasi Kwarteng’s mini-budget unfolded in a matter of minutes, political events can have drastic implications on FX and government bond markets, in turn putting significant pressure on banks to manage liquidity, funding and collateral.

The year of the election is part of a prolonged period of geopolitical unpredictability and it demands a seismic shift in the way financial institutions approach oversight of their liquidity, funding gaps and collateral positions. A focus on intraday funding dynamics and collateral requirements are not merely reactive measures, but proactive imperatives for financial institutions seeking to thrive in a world where the only certainty is uncertainty.

  • Export:

Related Articles