In May 2021, the Netherlands’ financial markets regulator AFM had warned pension funds that use derivatives to hedge interest rate risk that they may encounter liquidity problems if interest were to rise further. A year on, interest rates have indeed gone up significantly, but such problems are nowhere to be seen.
After the outbreak of the coronavirus pandemic in 2020, interest rates initially dropped. As a result, pension funds that had (partially) hedged their interest rate risk received cash from counterparties with whom they had concluded derivatives contracts.
But soon after, interest rates rose back up again forcing pension funds to provide collateral instead. According to a report AFM wrote last year, this interest rate rise was so abrupt that the cash positions of pension funds nearly halved in a matter of weeks.
This year, interest rates have risen even faster, to the highest levels since the global financial crisis. As a result, pension funds had to meet margin calls at a much larger scale than in 2020.
However, liquidity problems seem not to have occurred. In response to questions from IPE, the Netherlands’ largest pension asset manager APG said it did not suffer any issues in pledging collateral this year.
A spokesman for the country’s second largest provider PGGM said the large moves in interest rates and foreign exchange markets this year has been a “challenge” for its clients.
“But the liquidity buffers we maintain for our clients proved sufficient and each time we managed to replenish them,” he added. “We have developed scenarios that account for larger volatility in interest rate and FX markets than we have seen until now.”
Max Verheijen of Cardano, which implements the interest rate hedges of many pension funds in the Netherlands, is not familiar with any liquidity problems.
“It turned out there weren’t any, despite the large collateral calls for some pension funds,” he said. “The calls can be met in cash or in bonds. In the case of cash calls, pension funds used the repo market to provide bonds as collateral to generate cash cheaply.”
As a result, Verheijen believes the AFM’s fear that pension funds could get in trouble if interest rates rise was a miscalculation, “at least for the time being”.
The AFM said in a response that “international developments have indeed led to increased interest rate volatility.” But according to the regulator, this volatility was lower than in March 2020.
The increase in interest rates this year was much larger but also more gradual, an AFM spokesperson said. “In March 2020 shocks were bigger and things only just worked out.”
Jens van Egmond, head of LDI strategy Europe at BlackRock, did not perceive any liquidity problems with pension funds either despite the interest rate increases.
“And if there were to be a moment pension funds could have got into trouble, that would have been now,” he said. “Because the dollar rose at the same time as interest rates, pension funds that have hedged their currency risk also needed to pay collateral for this at the same time, increasing liquidity needs.”
Better safe than sorry
Van Egmond does not, however, believe in hindsight that AFM’s warning was unnecessary. “It’s better to be safe than to be sorry. The AFM is right to emphasise the importance of sound rebalancing policies for pension funds.”
Not all pension funds had detailed on paper how they would make sure to maintain sufficient liquidity in times of rising interest rates, noted Van Egmond. “I’m quite sure some funds have made their policies more explicit following AFM’s warning.”
PGGM also believes AFM’s warning made sense with a view of the “dysfunctional repo market” in times of stress. “Banks have a monopoly on ECB liquidity but do not pass this on via the repo market at crucial moments,” a spokesperson told IPE.
At the same time, EU regulation pushes pension funds and other market participants to make more use of (central) clearing leading to an increase in cash needs for collateral.
“This is a toxic cocktail that concerns us in times of market stress. We believe this is what the AFM has been asking attention for and we fully support this,” he said.
AFM said the stability risks of pension funds’ large portfolios of interest rate derivatives retain the “undiminished attention” of the regulator.
“We have agreed with DNB and the Ministry of Finance to look at the desirability of additional policy options to manage liquidity risks.”