If interest rates were to suddenly spike, as they did in the UK in the summer of 2022, Dutch pension funds would most likely have sufficient liquidity to pay additional collateral to maintain their interest rate hedges, according to Dutch pension regulators DNB and AFM.

However, money and repo markets should be functioning “as normal” for pension funds to stay clear of liquidity issues, the regulators added.

Following the UK LDI crisis in the autumn of 2022, when several British pension funds were forced to sell Gilts at reduced prices to meet their liquidity needs, DNB and AFM decided to investigate how Dutch pension funds would be prepared to deal with such a scenario.

While DNB said at the time that it would be “a challenge” for Dutch pension funds to deal with interest rates rising as fast as in the UK in September 2022, the two regulators have now concluded this is not likely to be the case.

A year ago, the Financial Stability Committee, which comprises DNB, AFM and the Dutch ministry of finance, asked the two regulators to conduct a joint study on the issue.

Stress scenarios

In their study, the two regulators asked pension funds and their asset managers how they would cope with a set of different stress scenarios, featuring rising interest rates, fluctuating currencies and lower liquidity in money and repo markets. Because pension funds tend to have limited cash positions, they need to sell short-duration bonds or access the repo market to generate liquidity.

In the most extreme scenario, interest rates rose by up to 77 basis points in one day, with money market liquidity drying up. In this scenario, pension funds would rely on the repo market for their liquidity needs, whereby they would sell their bonds to banks temporarily in exchange for cash.

In this most extreme scenario, repo markets alone could not meet all pension funds’ liquidity needs, according to DNB and AFM.

“The total amount of liquidity pension funds need to generate from the repo market in this scenario is higher than total trading volumes in March 2020,” they said in their report. But this scenario is unlikely to occur, they added.

Central clearing

Liquidity needs are likely to evolve over the next few years because of two factors: the switch to central clearing of interest rate derivatives and the switch to a defined contribution (DC) system.

The phasing out of bilateral contracts for interest rate swaps, whereby bonds can be used as collateral, will increase liquidity needs. This is not yet visible because the central clearing obligation only applies to new derivatives contracts.

On the other hand, the switch to a DC system between 2025 and 2028 is likely to reduce the need for liquidity.

In the new pension system, duration of swaps will be lower because interest rate risk will no longer be hedged for younger pension participants. Because of the uncertainty surrounding these two factors, DNB and AFM will repeat their study in a few years’ time.

This article was first published on Pensioen Pro, IPE’s Dutch sister publication. It was translated and adapted for IPE by Tjibbe Hoekstra