Written by Eward Sonneveld, a securities finance specialist previously at Robeco.
What did you do on 17 August 2018? Many of us may have been relaxing worry-free on the beach with a cold drink on a well-deserved holiday. However for many Pension Scheme Arrangements (PSAs) it was the first day they ran afoul of the EMIR central clearing obligation. On 17 August the second exemption for PSAs lapsed. In all fairness EMIR Refit may grant another three-year exemption with the possibility of a further two years. Problem solved, right?
Unfortunately, not so: the CCP is coming to you much sooner than that. PSAs typically use interest rate swaps (IRS) to balance the duration of their portfolios. Traditionally this was a non-centrally cleared OTC business, but most IRS volume is now cleared through a CCP. The broker dealer banks prefer to trade centrally cleared IRS because of the preferential balance sheet treatment. Over the last couple of years we have seen pricing divergence between cleared and non-cleared interest rates swaps (IRS), making OTC trading less attractive. Eventually market illiquidity in the OTC segment will slowly but surely squeeze PSAs into central clearing submission.
One of the main reasons many PSAs have been postponing trading centrally cleared IRSs, is the need for posting cash margin. CCPs require initial margin be posted in cash or non-cash, for example eurozone government bonds, and variation margin in cash only. The latter has caused concerns that there is a need for cash buffers to meet margin calls. And cash buffers come at the expense of investment performance. The concern is therefore real. “Enhanced” liquidity management can be a solution to this concern.
Liquidity management is quite a broad and generic term for anything related to managing cash payments and receipts, often involving multiple currencies. Most financial companies already incorporate this activity within the Treasury or asset & liability management (ALM) desk and it may be (partially) outsourced to the global custodian. The biggest challenge in relation to variation margin is that margin calls are generated in the early morning and variation margin usually needs to be posted “sameday” before noon. Your custodian most likely cannot offer that instant liquidity and if it does it is going to be through a very expensive credit line.
Enhanced liquidity management is liquidity management with the ability to generate cash on a “sameday”-basis and with near real-time settlement. In order to be efficient and effective it requires access to those instruments that are most suited for that purpose; repo coming first. In setting up a liquidity management function for variation margin purposes, there are five important challenges that need to be addressed:
- Which repo dealers are “committed”?
- How to address repo market liquidity risk?
- What stable eligible collateral is available?
- How to streamline the process: margin call, repo transaction, settlement?
- What are the contingency plans for when the repo market fails?
1) Very few repo dealers are willing to commit to repo liquidity but leveraging existing mutually beneficial relationships can take you a long way. Consider the pros and cons of paying for a committed repo line if you are offered one. 2) Repo market liquidity fades around reporting dates and most notably over year-end. Mitigate liquidity risk by spreading your counterparties based on geography and reporting dates. 3) What collateral do you have to offer? Your HQLA government bonds will be in demand. If your bonds are with an external manager, will you have access to your holdings real-time? Can you do substitution without compromising settlement of cash sales or repo settlement? 4) “Sameday” repo is not common practice in the European repo market, let alone on the same day before noon. You do not want to leave anything to chance: establish a clear division of responsibilities and a watertight procedure. Do not forget to involve your external manager in the process if you use one. 5) And what if repo market liquidity dries up completely? Have your contingency plans ready! Can you sell government bonds for settlement TODAY and have it settled before noon? Do you want to keep market exposure in the bond? Can you buy bond futures?
Speak to your collateral or liquidity manager if you do not have an in-house repo capacity. The same five issues equally apply. Failing that, now is a good time to start having discussions with potential clearing members and your fiduciary manager. Enhanced liquidity management for margining purposes is becoming integral part of their offerings. The service provider must be able demonstrate how they can secure liquidity year-round and the service level agreement (SLA) needs to be very clear where your responsibility stops, and their responsibility starts. Involve your external manager, depository and fiduciary risk manager in the conversation.
The importance of enhanced liquidity management in a centrally-cleared world cannot be overstated. Missing a margin call is simply not an option. It may be argued that in-house liquidity management is the most optimal solution that gives you the control that is required.
Eward Sonneveld is an experienced Asian and European securities finance, cash, collateral and liquidity management specialist with an integrated approach towards efficient and effective asset optimisation. Most recently he was a securities finance specialist at Robeco asset management. He is currently available for new opportunities.