Investment chiefs at two of Denmark’s largest pension funds agree the liability-driven investments (LDI) crisis for UK defined benefit (DB) funds is a warning for pension funds in other countries – such as Denmark.

Not only do pension funds themselves need to ensure they have the liquidity to protect them in strained market conditions, but stress testing may need to be toughened  and regulators may need to consider the push to central clearing, according to the CIOs of Sampension and PFA.

Henrik Olejasz Larsen, chief investment officer of the DKK305bn (€41bn) labour-market pension fund Sampension, said the LDI problems in the UK should sound the alarm not only pension funds in the Nordic country, but for regulators and lawmakers too.

“There has not been a proper analysis of the macro viability of new regulation and the push to central clearing,” he told IPE.

“The Danish central bank has warned about this scenario, but there is not currently an institutional solution in place that can ensure a smooth transformation of bonds into cash if all pension funds at the same time should want to do so,” he said.

In the wake of the mini-budget announced by the brand-new government of UK Prime Minister Liz Truss on 23 September, UK government bond prices fell, forcing some pension funds with LDI strategies to sell assets in order to top up collateral backing interest-rate swap hedges.

Forced sales of Gilts added momentum to the downward bond-price spiral and the Bank of England intervened to stem the losses – action it is due to end today.

Henrik Olejasz Larsen, Sampension

Source: Sampension

Henrik Olejasz Larsen, Sampension

However, UK pension funds have already lost out by having to sell assets in a hurry at very low and discounted prices.

The sudden need to post large amounts of margin to swap counterparts faced by LDI managers in the UK market turmoil following the mini-budget was more dangerous for those pension funds which have decided to channel swap trades through central clearing houses, according to a report in financing publication International Financing Review (IFR).

Because central clearing houses only accept cash as collateral, those pension funds had to sell assets to raise money, whereas others were able to post other assets such as Gilts along with cash, according to IFR.

At PFA, Denmark’s biggest commercial pension fund, group CIO Kasper Ahrndt Lorenzen told IPE  that Danish pension funds risked landing in a similar situation to their UK counterparts in some respects, but that there were also differences between the situations in the two countries.

“The main difference is that fortunately we – Danish funds – operate in the euro market which is larger and more liquid than the UK Gilt market and UK swap market,” he said.

“That being said, LDI investing is LDI investing, so whatever happens in the UK happens over here.

”It’s big swap portfolios, even though the euro swap is more liquid and less volatile compared to Gilts portfolios and UK swap portfolios. There’s a lot of interest-rate volatility in both markets, so it’s something we are well aware of,” Ahrndt Lorenzen said.

PFA had LDI books, he said, and because it had to post liquidity as rates went up, it had to be sure it had liquid investments in place.

“So it’s very similar dynamics that we are looking at in Denmark,” he said.

“Market liquidity is drying up, so you can’t sell illiquid portfolios and other portfolios and at the same time you are more and more out of the money on your swap portfolio as rates go up – and the value of your liquidity if it’s bonds can go down.

“So you need to post more, and the value of the assets you have to post is getting less,” the PFA CIO said.

This was the reason why stress testing was so important, he said.

“If rates move up another 200 basis points – what kind of margin calls, collateral do you have to post? Do you have those assets and cash in hand? Do you rely on market liquidity? Do you rely on repos? What do you rely on?” he said.

“With this gradual un-anchoring of inflation expectations, and extreme policy measures and tougher markets – maybe you have to work with slightly harder stress tests and that’s one side of the equation,” Ahrndt Lorenzen added.

Kasper Ahrndt Lorenzen

Kasper Ahrndt Lorenzen, PFA

The other side, he said, was a pension fund’s asset allocation.

“Of course you have to have your illiquidity and you have your risky assets – but you have to make sure you have good old boring pools of assets too – a pool of cash and maybe repo relationships so you can top up with repos and make sure that liquidity reserve can protect you and line up well compared to your stress test,” he continued.

At Sampension, Olejasz Larsen also said the Danish life and pension sector had the advantage that liabilities were priced based on a euro-swap curve – not on the Danish government bond yield – which he said was more robust to a shift in the demand and supply of government bonds.

“So there is less risk of a self-defeating dynamic as in the UK,” he said.

But Danish institutions that had transferred some or all of their collateral arrangements to central clearing – or were using liquidity alone rather than bonds directly as collateral – faced the challenge of raising liquidity, typically in the repo-market, he added.

“This can also be stressed as banks will have to serve as intermediaries - because pension funds can’t repo bonds directly with the central bank,” he said.

“And banks will have limitations because of regulation, rating criteria and market perceptions of their balance sheets.

“I know of no critical issues, but these could exist under the conditions mentioned above,” he noted.

“In our case we have protected ourselves by not moving to central clearing early, by keeping old collateral arrangements in place, by not re-striking swaps to lower rates to release the embedded value and by having a conservative asset side where a large part can be directly used in standard repo transactions,” Olejasz Larsen said, adding that Sampension also had assets corresponding to free equity beyond the value of liabilities.

“What the situation is in other Danish institutions I cannot be sure,” he said.

“I know that there has been pressure from many counterparty banks to move all existing arrangements to central clearing and use solely cash as collateral,” said the Sampension CIO.

In June this year, the European Commission decided pension funds should have another year before having to centrally clear their derivatives portfolios, in line with a recommendation from the EU securities markets watchdog earlier in 2022.

PensionsEurope argued in March in the Commission’s consultation on the review of the central clearing framework that although it backed the intention to clear all derivatives possible, no solution had been found for the liquidity risks.

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