Regulation is constraining pension funds’ ability to manage risk and they should prepare for future illiquidity, writes Carlo Svaluto Moreolo 

At a glance

• The Bank of England’s QE programme has suffered a setback.
• Experts say declining liquidity has brought the market into crisis territory. 
• Risk-reducing regulation is having consequences.
• Pension schemes should review their correlation assumptions.

When a country’s central bank offering to buy domestic government debt gets turned down, something is wrong. 

In August, the Bank of England (BoE) announced that it would expand its quantitative easing (QE) programme by £70bn (€82bn). The announcement came as the BoE cut the rate on secured overnight lending for the first time in seven years, by 25bps to 0.25%. When the Bank approached the market to start buying £60bn worth of Gilts and £10bn worth of corporate bonds, it simply did not find enough sellers. The Bank initially attempted to purchase £1.17bn of long-dated Gilts at prices above market level. It was met with a £52m shortfall. 

This suggests long-term Gilt investors are reluctant to sell because they are worried they will not find similar long-dated assets at acceptable prices. The episode provides evidence that liquidity in fixed income is at dangerously low levels. Experts have long debated whether the European fixed-income market is going through a liquidity crisis.

Some are convinced that this is so. Speaking at the IPE 360 Conference in London earlier this year, Patrick Cunningham, partner at the consultancy and fiduciary management firm Cardano, said: “It will become increasingly evident that we are in a liquidity crisis. This can be measured by any number of ways, for instance bid-offer spreads on corporate bonds. It has not been been perceived as a problem so much because of benign market conditions and loose monetary policy. But, that will change if markets go through a rough patch.”

Whether or not investors are facing a crisis is difficult to establish, not least because assessing liquidity is complex. Furthermore, what should the appropriate levels of liquidity be? Markets are a live entity that develop through time, and the ideal conditions of yesterday may not be the same today. But the fact is that the regulatory activity that began in response to the 2008-09 financial crisis has had a lasting impact on fixed income liquidity. In many ways, regulation has made today’s markets unrecognisable. 

Post-crisis reform packages such as Basel III, Solvency II and the European Market Infrastructure Regulations (EMIR) in Europe, as well as Dodd-Frank in the US, were aimed at increasing the loss capacity and capital adequacy of financial institutions, primarily banks and insurers. The other purpose was to minimise the possibility that governments would have to save those institutions in the case of a crisis. As a result, according to Cunningham, banks have been transformed from “market-makers” to “match-makers”. This is because holding large inventories of risk is onerous on a balance sheet. 

“This withdrawal of banks’ balance sheet from the system has really resulted in a marked reduction in  liquidity, particularly in fixed income. This has coincided with increased demand for liquidity. If you look at assets in regulated bond funds, they quintupled in last decade. Many of these funds they promise daily or regular liquidity even though the underlying instruments are really less liquid. You can make a compelling case that while the banking and insurance sectors have been shored up, the system as a whole may be more fragile than it was principally because it’s significantly less liquid,” argues Cunningham. 

The introduction of new regulatory packages that focus on collateral requirements in derivatives contracts will exacerbate the situation. A upcoming development is the adoption of the Working Group on Margin Requirements (WGMR) rules on non-cleared over-the-counter (OTC) derivatives. This requires posting of collateral as initial margin (IM) by counterparties in certain derivative transactions. Furthermore, from 2017, pension funds will no longer be exempt from trading derivatives through central counterparties (CCPs) under EMIR. The impact on demand for high quality bonds will be significant. 

Patrick Cunningham

The issue, says Vanaja Indra, market and regulatory reform policy expert at Insight Investment, is that cash receives preferential treatment over bonds or Gilts. This is a consequence of rules on banks’ leverage ratios, whereby banks are penalised for holding anything other than cash on their balance sheets. This, has implications for other investors, who need to transform their high quality fixed income assets into cash.

Indra explains: “It does not feel healthy to push the system to a point where any user of derivatives has to post cash as collateral, while there are a lot of long-term investors holding high quality fixed income assets. You are forcing investors into a situation where you are relying in the repo market to transform that collateral. The question is whether the system can rely on that mechanism to be there in stress market conditions.”

Poor liquidity in fixed income is particularly damaging for pension funds’ engaged in liability-driven investment (LDI). The regulatory frameworks are trying to reduce the risks linked to existing hedging strategies. But, this is contrast with the urgent need for pension schemes to take the necessary risk to close their deficits. Craig Gillespie, investment consultant at Aon Hewitt, describes the situation as a “grand bargain” that ultimately keeps the UK economy in the doldrums. “Pension funds are allowed to take significant amounts of risk in order to try to close that funding gap without having a significant negative impact on the economy. But at the same time, you’ve got other legislation coming in to try and reduce risk. These forces are pulling each other in different directions,” says Gillespie. And as long as the deficits in corporate balance sheets rise, firms are unlikely to prosper. 

The prospect of Brexit exacerbates this crisis, as it stirs economic headwinds and foments uncertainty. Practitioners confirm that liquidity was poor after the result. The market bounced back afterwards, but volatility could be the normal state of play in a market that is heavily influenced by politics. 

Cunningham advises pension funds to review the assumptions underlying asset-liability management (ALM) strategies in anticipation of possible market stress. He says: “ALM models rely on combinations of assumptions about returns, risks and correlations. I worry that many of the correlation assumptions that live in these models will not hold in a world where liquidity is much diminished. In periods of stress, pension funds may not be diversified to the extent that they think they are.”