Assessing the liquidity preparedness of investment funds to meet margin calls in derivatives markets
Published as part of the Financial Stability Review, May 2024.
Recent episodes of liquidity stress in financial markets have highlighted the need to monitor the liquidity preparedness of funds to meet margin calls in the derivatives market.[2] Spikes in margin calls can lead to liquidity strains in the investment fund sector and to procyclical asset sales during times of market stress. This scramble for liquidity can spread to other parts of the financial system and the real economy, potentially transforming liquidity stress at the individual entity level into a system-wide issue, as happened during the market turmoil in March 2020 and the UK gilt crisis in September 2022.[3] This box proposes four novel indicators of fund-level liquidity preparedness to meet margin calls, aimed at identifying potential pockets of vulnerabilities that may require higher cash buffers and/or more diversified high-quality liquid assets (HQLA).[4]
Over 15% of euro area open-ended investment funds and exchange-traded funds (ETFs) seem to be inadequately prepared to cope with plausible spikes in margin calls. The first indicator is the ratio of the stock of initial margin posted by these investment funds to their cash holdings. This measures the share of these holdings that could be depleted to meet plausible variation margin calls,[5] making it an ex ante metric aimed at gauging liquidity preparedness against reasonably anticipated liquidity needs.[6] A ratio above 100% suggests that the cash holdings might not be sufficient and that other assets may well need to be sold. The median ratio between the first quarter of 2022 and the end of 2023 comes in at around only 20%, although it did increase towards the end of that period. As of December 2023, around 20% of bond and mixed-asset funds and 10% of equity funds had a stock of initial margins amounting to over 80% of their cash holdings (Chart A, panel a). This high share can raise some liquidity concerns, as it is similar to that observed in March 2020 when a spike in market volatility coupled with large outflows led to significant procyclical asset sales by funds.
Chart A
Euro area investment funds’ cash holdings seem adequate overall to cover variation margin needs, but pockets of risk remain in the upper tails
a) Ratio of initial margins posted to cash holdings | b) Ratio of margin flows (initial and variation) to cash holdings |
|---|---|
(Feb.-Apr. 2020, Q1 2022-Q4 2023; percentages) | (Feb.-Apr. 2020, Q1 2022-Q4 2023; percentages) |
 |  |
Sources: ECB (EMIR), EMIR sector enrichment based on Lenoci and Letizia*, LSEG Lipper and ECB calculations.
Notes: The sample includes euro area-domiciled mutual funds and ETFs reporting in both EMIR and Lipper. The samples considered for 2020 and 2022-23 do not overlap completely. “Pandemic” refers to the period between February and April 2020. The whiskers refer to the 15th and 85th percentiles. For confidentiality reasons, the percentiles of the distribution are calculated by averaging values across four entities. Panel a: the chart shows the distribution of the maximum over the quarter of the ratio of the stock of initial margin posted to cash holdings as at the end of the month, at fund level. Panel b: margins flows are calculated as the weekly (Wednesday-Wednesday) difference between the stock of margins defined as the sum of initial and variation margins posted minus variation margins received (meaning that outflows have a positive sign). Therefore, margin flows might, by design, suffer from distortions around the contract closure, when the stock of related variation margin posted is reset to zero, without a corresponding exchange of cash. The ratio is calculated by first dividing the maximum weekly flows over the month by the cash holdings as of the previous month, at fund level, and then taking its maximum over the quarter. Cash posted to meet margin requirements is reflected in both the numerator and the denominator of the ratios.
*) See Lenoci, F.D. and Letizia, E., “Classifying Counterparty Sector in EMIR Data”, in Consoli, S., Reforgiato Recupero, D. and Saisana, M. (eds.), Data Science for Economics and Finance, Springer, Cham, 2021.
In addition, for more than 20% of funds, the actual maximum weekly flow of margins posted in a given quarter amounts to over 80% of their cash holdings. The second indicator is the ratio of the flow of initial and variation margins posted to cash holdings. It measures how much of the realised changes in margin calls could have been covered by cash. As such, it is an ex post metric aimed at comparing liquidity preparedness against actual liquidity needs. The realised median margin flows amounted to 20% of funds’ cash holdings between 2022 and 2023, but this share started increasing towards the end of that period. In the fourth quarter of 2023, around 25% of bond and mixed-asset funds posted margins larger than 80% of their cash holdings, mainly due to the increased volatility in the bond market following monetary policy tightening (Chart A, panel b).
Chart B
Euro area investment funds can rely on high levels of HQLA holdings to meet margin calls, but these assets may become illiquid in periods of stress
a) Ratio of initial margins posted to HQLA | b) Ratio of margin flows (initial and variation) to HQLA |
|---|---|
(Feb.-Apr. 2020, Q1 2022-Q4 2023; percentages) | (Feb.-Apr. 2020, Q1 2022-Q4 2023; percentages) |
 |  |
Sources: ECB (EMIR, CSDB), EMIR sector enrichment based on Lenoci and Letizia*, LSEG Lipper and ECB calculations.
Notes: The HQLA stock at fund level is calculated in line with the methodology set out in a previous issue of the Financial Stability Review**; it comprises cash, Level 1, Level 2A and Level 2B holdings. “Pandemic” refers to the period between February and April 2020. The whiskers refer to the 15th and 85th percentiles. For confidentiality reasons, the percentiles of the distribution are calculated by averaging values across four entities. Panel a: the chart shows the distribution of the maximum over the quarter of the ratio of the stock of initial margin posted divided by the HQLA stock as of end of the month, at fund level. Panel b: margins flows are calculated as the weekly (from Wednesday to Wednesday) difference between the stock of margins defined as the sum of initial and variation margins posted minus variation margins received (therefore outflows have a positive sign). Therefore, margin flows might, by design, suffer from distortions around the contract closure, when the stock of related variation margin posted is reset to zero, without a corresponding exchange of cash. The ratio is calculated by first dividing the maximum weekly flows over the month by the HQLA stock as of the previous month, at fund level, and then taking its maximum over the quarter. HQLA holdings posted to meet margin requirements are reflected in both the numerator and the denominator of the ratios.
*) See Lenoci, F.D. and Letizia, E., op. cit.
**) See the box entitled “Assessing liquidity vulnerabilities in open-ended bond funds: a fund-level redemption coverage ratio approach”, Financial Stability Review, ECB, November 2023.
As they might not have sufficient cash to cover margin calls, it is important that funds rely on diverse and reliable sources of liquidity and collateral.[7] The third indicator is the ratio of the stock of initial margin posted by funds to their HQLA holdings.[8] This gauges the share of HQLA holdings that might be needed to meet plausible variation margin calls, and to what extent a buffer for any potential increase in the initial margin requirements is already used.[9] The median ratio is low, with initial margins posted amounting to less than 5% of funds’ HQLA stock (Chart B, panel a). Similarly, the final indicator, which sets initial and variation margin flows against HQLA holdings, suggests that the realised changes in margin calls could, on average, comfortably be covered by HQLA (Chart B, panel b). However, this might not hold true for those funds at the upper tails of the distribution, especially bond and mixed-asset funds. In addition, some of the securities included in the HQLA holdings may become illiquid in periods of stress, as happened in March 2020. Their resulting forced sale to cover margin calls would impact prices quite significantly, which could potentially further feed market stress.
The new indicators of funds’ liquidity preparedness for margin calls reveal some vulnerabilities in the fund sector that could lead to procyclical behaviours and amplify market-wide stress. A “dash for cash” driven by large margin calls could lead to asset fire sales or a rapid unwinding of derivative exposures, which might further fuel already high price volatility and lead to disorderly market functioning. In the event of extraordinarily large market moves, the failure of funds to meet margin calls could spread to other market participants, such as banks acting as clearing members of central counterparties or dealers in the bilaterally cleared OTC space. This suggests that it is important to ensure that adequate cash buffers and diverse and reliable sources of liquidity and collateral are in place. The indicators proposed in this box are valuable monitoring tools for strengthening the governance and liquidity risk management of investment funds, enhancing contingency planning and governance, and performing liquidity stress tests.
University of Bologna, Bologna, Italy.
See “Non-banks’ liquidity preparedness and leverage: insights and policy implications from recent stress events”, Financial Stability Review, ECB, May 2023; “Lessons learned from initial margin calls during the March 2020 market turmoil”, Financial Stability Review, ECB, November 2021; Jukonis, A., Letizia, E. and Rousová, L., “The impact of derivatives collateralisation on liquidity risk: evidence from the investment fund sector”, Working Paper Series, No 2756, ECB, December 2022; and Ghio, M., Rousová, L., Salakhova, D. and Villegas Bauer, G., “Derivative margin calls: a new driver of MMF flows”, Working Paper Series, No 2800, ECB, March 2023.
Stress in the UK gilt market also stemmed from collateral calls in the repo market. See, for example, Dunne, P., Ghiselli, A., Ledoux, F. and McCarthy, B., “Irish-Resident LDI Funds and the 2022 Gilt Market Crisis”, Financial Stability Notes, Vol. 2023, No 7, Central Bank of Ireland, September 2023.
The post-global financial crisis reforms have greatly increased collateralisation of trading in the derivatives market. While this has reduced the counterparty credit risk, it also increased the liquidity needs of market participants, especially in times of market stress.
While variation margins are paid in cash, initial margins can also be met with non-cash collateral.
Initial margin requirements aim to cover potential changes in contract valuation in the interval between the last margin collection and the liquidation of positions, in case a counterparty defaults. Since they are calculated mostly based on the expected volatility of the underlying asset, they are also an objective proxy of plausible variation margin calls over the margin period of risk.
See “Liquidity preparedness for margin and collateral calls: Consultation report”, Financial Stability Board, April 2024.
The funds in the sample have a quite diverse composition of HQLA stock. For example, in the fourth quarter of 2023, the stock was composed in aggregate of 6% cash, 27% Level 1 assets, 13% Level 2A assets, and 54% Level 2B assets.
HQLA excluding cash may be (i) used to meet the part of a margin call pertaining to higher initial margin requirements, (ii) pledged as collateral in the repo market to source additional cash, or (iii) sold.