Joe Midmore, chief commercial officer at OpenGamma
Following the recent UK Gilts crisis, what would you say have been the biggest impacts?
Top of the list would have to be the renewed regulatory focus on shadow banking leverage. The events in September last year caught everybody by surprise – liability driven investment strategies (LDI) have been an important part of pension scheme allocations for nearly a decade, against a backdrop of near-zero interest rates. The unprecedented volatility in the Gilt market and the knock-on impact on pension fund liquidity has resulted in heightened regulatory scrutiny on required measures to improve resiliency – that’s probably the biggest impact.
What wider questions has the crisis raised about existing pension systems?
It is, unfortunately, not exclusive to pension funds but more generally, how regulators can limit excessive risk taking to protect stability in financial markets. Beyond that, it has also exposed the need for improved liquidity risk management frameworks for the industry as a whole. We’ve seen similar instances play out across different segments (for example energy & power utilities), but the Gilt crisis best highlights some of the frailties in the financial system. There are two principal areas where liquidity risk management can be improved. Organisational structure – clearer roles and responsibilities that explicitly focus on funding and liquidity management – and secondly, dedicated technology to assist with these functions. It’s probably fair to say both components, have somewhat been underinvested in across the industry for some time.
Does the UK pension fund space have a better understanding now of the capital that they need to meet cash flow requirements?
It is improving, but without the appropriate technology and personnel in place, funding and liquidity risk management is a complex problem to solve for. Modelling and forecasting market shocks that result in increased variation and initial margin requirements is challenging enough. Overlaying that with exposures to wrong-way risk e.g., pricing pressure on the very physical assets pension funds hold, is well understood in hindsight, the real question is how to manage through those or any future unforeseen risks more efficiently.
What systems or technology could have been put in place, or should be put in place, that might have helped avoid the worst consequences of the crisis from a trading perspective?
As with any crisis, the sooner you can see the crisis unfold, the sooner you can manage those risks and exposures. Margining is generally a T+1 process across the industry. The ability to understand market exposures and funding risks on a T+0 basis, provides invaluable advance notice to manage funding requirements. From a technology perspective, the ability to manage intraday funding and liquidity risk, is vital. Unfortunately, margin has been considered an operational by-product of taking risks, but the reality is posting margin is very much an integral part of managing leverage. This operational component is becoming increasingly relevant to managing resiliency and therefore, visibility around that on T+0 is really important.
Secondly, access to liquidity risk management tools that allow you to stress test your portfolio and to use historical volatility data to understand the sensitivities within your portfolio that are subject to potentially funding risk – that’s incredibly important.
On a more simplistic level, I would say one of the key issues back in September was the sheer number of margin calls this incident caused for pension funds as well as LDI managers. There was a significant increase in the movement of physical assets that created a bottleneck for collateral mobility to take place efficiently to meet margin calls. The ability to automate that process with technology that independently checks margin numbers called by both parties and automates collateral instructions, is a now high on the priority list. Market events that we’ve seen over the last few years have cruelly exposed operational frameworks that are no longer fit for purpose.
More specific to pension funds, there has been an absence of a centralised asset inventory view that has a real-time risk management framework built around it, with collateral optimisation algorithms that automate instructions on best assets to meet margin calls.
How did traders handle the pressure of Gilts volatility and what were the main pain points?
The main pain point was having to liquidate assets to meet variation margin calls, which typically have to be met in cash. The increase in variation margin having to be met in cash put pressure on fund managers having to liquidate assets or investments in order to provide sufficient liquidity. That had a negative downward effect on the valuation of the underlying assets (mainly Gilts) that created the perfect storm and eventually resulted in the Bank of England having to step in.
While liquidating assets in a downward market is stressful in anyone’s book – a lot of the pressure was operational in nature because meeting margin calls requires a physical movement of assets, be it cash or assets. The industry continues to operate on a fairly antiquated framework where it takes one, if not two or three days, to physically move assets. That transitory period of the movement of assets can create liquidity stress, particularly at a time when there are a heightened number of margin calls and collateral processes happening simultaneously. They are subject to failure, which inevitably causes additional risk management headaches. One initiative that could favour might be the rise of tokenisation of assets to remove the need to physically move assets in stress events such as this one.
What lessons can/should be learned from the crisis?
Improved liquidity risk management. It’s all very well having a levered strategy but the need to manage the inherent risks more dynamically is now a non-negotiable requirement. There has to be an appropriate liquidity and funding risk framework to be able to support the amount of leverage that is being taken through, for example, an LDI strategy. I think it’s better alignment of leverage and the liquidity risk management requirements to be able to support these types of strategies. It’s a model that has existed for many decades in the hedge fund community – highly levered strategies have survived solely on understanding what the funding and liquidity requirements are to sustain the leverage that they’re running in their strategies.