Marcus Cree, Senior Risk Strategist at OpenGamma
The last two weeks have seen massive disruption due to the ongoing Coronavirus pandemic, with huge market swings and a dramatic increase in volatility across the globe. This has caused margin rates, both Initial Margin (the measure of risk) and Variation Margin (the measure of daily change), to jump dramatically in an unprecedented manner set to teach fund managers an important lesson in Murphy’s Law – that is, everything that can go wrong, will go wrong.
Those who lived through the 2008 Global Financial Crisis (GFC) might be experiencing an eerie sense of Groundhog Day at the moment. The liquidity issues that the whole banking sector experienced as a result of the credit crisis were similarly unanticipated and thus under prepared for.
This was further inflamed by the fact that, back then, banks were not stress testing extreme events, but instead relying on a backward-looking risk system to govern how much liquidity was needed. When a previously unimagined ‘black swan’ event occurred, there was simply not enough liquidity in the system to survive the impact. The result was a series of bailouts and a new approach to stress testing for the entire banking community.
The present market volatility that the Coronavirus pandemic has set off has seen margin rates spike and left fund managers in a similar situation. And while post-GFC regulation may have made banks more resilient to financial shocks by mandating the development of liquidity contingency plans, fund managers are still exposed. Just this weekend, one of ABN Amro’s hedge fund clients could not meet their margin calls on US options and futures trades due to ‘extreme stress and dislocation’, forcing them to close out the position and take a $200 million loss (see press release). Without the right precautions being put in place now, we’re likely to see more and more funds facing similar losses over the coming weeks and months. COVID-19 could well be shaping up to be the buy-side’s very own GFC-like turning point.
The very nature of initial margin means it is intrinsically linked to market volatility. The overall IM number represents the amount of cash that could be lost between a member being unable to fund their VM and a successful flattening of the position by the clearing house. In practise, that means looking at what can happen at the ‘edge of normal’ market conditions, so if market volatility continues to rise, so too will IM. This has big implications for fund managers’ liquidity management, as margin rates are likely to rise each time new volatility regimes are encountered.
A rise in margin rates is a very probable reality for the next couple of months as we move forward into the unknown of an unprecedented health crisis. While many fund managers may be praying for a swift end to the pandemic and a return to normal, the only thing that can be certain is that nothing is certain. The only smart way for fund managers around the world to respond is by taking a Murphy’s Law approach to their liquidity management by assuming that anything bad that can happen, will happen.
Following this line of thinking, fund managers must begin deploying a range of forward-looking stress tests to anticipate potential changes in both the VM and IM. By anticipating all eventualities, they can then prepare themselves to take the actions required to mitigate the effects of a worst-case spike in margin. This will not just create a constant liquidity buffer but properly model what the liquidity need could be and then build a contingency plan to meet such a scenario. The effectiveness of the stress testing depends on working through levels of potential impact and knowing ahead of time that, should such shocks come to pass, the firm will be able to automatically roll into action to meet those needs.
Obviously, liquidity events are not simple to deal with or plan for, but without taking a Murphy’s Law approach and modelling all possible – though improbable – extremes, firms are walking into unprecedented events like the Coronavirus pandemic blind. Instead of just modelling the past, fund managers must learn from its mistakes and add the crucial plank of stress forecasting to their risk management regime. This is particularly critical in a world that is so interconnected, where disruptions on supply, demand or both can impact markets worldwide. Firms that fail to employ such a forward-looking approach to stress testing will find themselves caught unaware of sudden changes in margin rates and rapidly struggling to turn a profit.