Derivatives positions held by pension funds have a liquidity risk associated with them, particularly in relation to margin calls triggered by interest rate changes. During the Joint Inquire UK and Inquire Europe Spring Seminar, Kristy Jansen presented her findings from her paper, ‘Pension Liquidity Risk’, where she and two other co-authors investigate how these margin calls affect pension funds’ asset holdings and market prices, highlighting potential systematic risks and implications for financial stability.
For those who were unable to attend her presentation, a summary has been made:
“What we are trying to understand in this paper is whether there is a systematic link between hedging activities of pension funds and their exposure to liquidity risks. We typically do not think of pension funds being as exposed to liquidity risks as banks or mutual funds. However, we’ve had examples in the past, like the UK pension crisis of 2022, that challenged the view quite a bit. Little is known about the risk of margin calls associated with pension funds’ derivatives positions and whether such margin calls pose a substantial liquidity risk. Moreover, if margin calls trigger liquidity shocks, how do pension funds react to these shocks and do their reactions have an adverse effect on market prices?
Our study uses regulatory data from the Dutch pension system over the 2012 to 2022 period, identifying a link between pension funds’ use of interest rate swaps and their asset allocations.
As a starting point for our analysis, we identify key points about pension funds and their use of interest rate swaps. Firstly, these funds predominantly receive fixed rates in long-term swaps, with net positions comparable to the Dutch banking system. Secondly, they rely more on swaps than bonds to hedge duration risk. Lastly, the median margin call linked to a one percentage point rise in interest rates amounts to 7.52% of pension funds’ assets under management, exceeding their cash positions by several orders of magnitude.
Our analysis uncovers three key findings: Fist, pension funds with tighter regulatory constraints use swaps more aggressively; Second, in response to rising interest rates, triggering margin calls, pension funds predominantly sell safe and short-term government bond; Third, we demonstrate that this procyclical selling adversely affects the prices of these bonds.
The findings of our research cast doubt on the widely held belief that pension funds are long-term investors immune to liquidity risk and draw attention to the unforeseen repercussions of regulatory mandates and swap collateralization requirements”.
View the research in full via: Joint Spring Seminar 2024, United Kingdom • Inquire Europe (inquire-europe.org)