Liquidity Lockdown: The Buy-Side Battle Plan for Managing Margin and Collateral

Introduction

The Financial Stability Board (FSB) recently proposed measures to enhance the liquidity preparedness of non-bank financial institutions for potential margin calls and collateral needs during times of market-wide stress.

The proposal aims to address systemic liquidity risks that could arise from the collective response of non-bank entities to liquidity shocks that require sudden access to cash or collateral.

The critical points of the FSB proposal include:

• Requirements for non-bank entities to regularly assess their liquidity risks from margin calls and collateral demands. This includes stress testing their ability to meet payment obligations.
• Guidance on liquidity risk management, such as maintaining sufficient liquid assets and diversifying funding sources.
• Enhanced reporting and disclosures around liquidity risks, margin practices, and collateral reuse activities.
• Policy recommendations to address data gaps on leverage and interconnectedness that can amplify liquidity strains across the financial system.

The proposed measures are intended to boost the liquidity resilience of non-bank entities like hedge funds, pension funds, insurance companies, and central counterparties. Their collective response to liquidity shortfalls can have destabilising effects that transmit risks across borders.

Liquidity Risks

Non-bank financial institutions like hedge funds and asset managers face significant liquidity risks that banks do not. These stem primarily from their business models and activities:

• Dependence on short-term funding: Many non-banks rely heavily on short-term funding sources like repos that can dry up quickly in a crisis. This creates rollover and maturity mismatch risks.
• High leverage: Non-banks tend to use more leverage than banks, so they have less buffer when funding disappears. Highly leveraged positions can force fire sales and spiral losses.
• Mismatched assets and liabilities: Asset managers often offer daily liquidity to investors while holding potentially illiquid assets. This creates asset-liability mismatches that are vulnerable to runs.
• Collateral re-use: Re-using the same collateral across multiple transactions can work in regular times but lead to shortages in stressed markets.
• Derivatives exposures: Non-banks like hedge funds use extensive derivatives for hedging and speculation. These can require significant margin calls in volatile markets.
• Interconnectedness: Financial institutions are closely linked, so problems at one non-bank can spread rapidly to others in a crisis.

These liquidity risks can make non-banks prone to liquidity shortfalls in times of market stress. While banks have access to central bank liquidity, non-banks lack this safety net. This can create fire sale dynamics and systemic risk if non-banks are forced to sell assets or unwind positions to meet obligations.

Margin Calls Can Trigger Liquidity Issues

Margin calls occur when the value of a trader's collateral falls below the minimum required by the exchange or clearinghouse. This can require the trader to post additional collateral intra-day or at EOD.

For large leveraged firms, even small market moves can trigger substantial margin calls that must be met immediately. This can force traders to sell other assets rapidly to raise cash, creating a dangerous liquidity spiral.

Some critical risks around margin calls:

• Procyclicality: As asset prices fall across markets, it triggers higher margin calls, forcing more firms to sell into the falling market, exacerbating the drop. This positive feedback loop creates systemic risk.
• Cliff effects: Under stress, small changes in collateral value can push firms over the margin call threshold all at once. This nonlinear dynamic makes liquidity planning difficult.
• Herding: When volatility strikes, many firms simultaneously sell the same assets to cover margin. This coordinated herd behaviour reduces liquidity exactly when it's needed most.
• Loss spiral: Meeting margin calls often means first selling your most liquid assets. This asset depletion makes it progressively more challenging to meet future margin calls, accelerating losses.
• Cross-margining restrictions: Firms often face limits on using collateral pledged for one exchange to meet margin calls on another exchange. This silo effect constrains liquidity mobility.

To manage these risks, buy-side firms need robust contingency plans for potential margin call shocks across asset classes. Stress testing liquidity needs under crisis scenarios and pre-arranging backup funding lines are essential. The risks around procyclical margin spiral effects also require a macroprudential perspective.

Collateral Optimisation

Non-banks can optimise their collateral in several ways to improve liquidity management and preparedness for margin calls:

• Diversify the collateral portfolio across multiple asset classes and geographies to reduce concentration risk. This makes the portfolio more resilient to shocks in specific markets.
• Analyse the liquidity profile of collateral assets. Prioritise assets that can be quickly liquidated with minimal price impact, such as cash and high-quality government bonds. Avoid illiquid assets that may be difficult to sell during stress events.
• Monitor collateral eligibility criteria across counterparties. Optimise collateral so a higher proportion is eligible at central counterparties and trading venues that may have more conservative haircuts.
• Proactively substitute near-term ineligible collateral with eligible assets to avoid frantic fire sales during volatility. Develop protocols for collateral substitution.
• Use collateral optimisation tools to identify "locked" collateral that cannot be rehypothecated or reused across other margin and clearing obligations. Aim to minimise locked collateral through netting agreements.
• Establish contingent collateral arrangements with liquidity providers, such as securities lending facilities against less liquid assets. This provides backup collateral that can be called upon if needed.
• Consider collateral upgrades to transform less liquid collateral into highly liquid assets such as cash or government bonds through repo or derivative transactions.
• Leverage analytics to forecast potential future exposure and collateral requirements under various market stress scenarios.

By taking a strategic approach to collateral optimisation, non-banks can mitigate liquidity risks and avoid cliff-edge margin calls during periods of system-wide stress. The key is being proactive in managing collateral holistically across the organisation.

Operational Efficiency

The buy-side needs to focus on operational efficiency to better manage liquidity risks during times of stress. This includes assessing current processes and infrastructure to identify areas for improvement. Some key considerations:

• Review margin and collateral management workflows: Are they optimised to minimise delays and errors? Manual processes should be automated where possible, and staff should be trained on procedures.
• Evaluate technology systems: Can your order management, portfolio management, and risk systems talk to each other? Are they configured to provide real-time visibility into liquidity needs? Upgrade outdated platforms.
• Assess data capabilities: Do you have access to quality market data? Can you aggregate positions across portfolios/entities? Clean and integrate data for a single source of truth.
• Streamline reconciliations: Daily cash, positions, and collateral reconciliations are crucial. Identify and fix breaks in the reconciliation process.
• Improve counterparty relationships: Discuss best practices for managing margin calls, negotiate optimal collateral terms, and understand each other's operations and pain points.
• Stress test for liquidity shocks: Model various market stress scenarios, estimate potential outflows, and test contingency funding plans.
• Review account setup: Assess how assets are held and segregated. Evaluate custody arrangements. Understand the implications of accessing collateral.
• Train staff on liquidity risk: Educate portfolio managers, traders, and operations teams and promote a firmwide culture of liquidity risk management.

By assessing operational efficiency, the buy-side can better prepare for market stresses and avoid liquidity crunches that put their funds and firms at risk. Smooth operations are vital for navigating volatile markets.

Data Gaps

The FSB identified several data gaps that must be addressed to improve liquidity preparedness. A key issue is the lack of consistent global data on non-bank financial institutions' liquidity risks.

Without comprehensive data, regulators have an incomplete view of potential systemic vulnerabilities. The FSB notes gaps around leverage, liquidity profiles, counterparty exposures, and collateral reuse. There is also limited transparency in non-bank entities' relationships with banks and other financial institutions.

More granular data is needed on non-bank funding sources, maturity mismatches between assets and liabilities, and contingency plans. Many jurisdictions lack reporting requirements to capture this information.

The FSB recommends authorities enhance data collection and reporting to close these gaps. With better data, regulators can more accurately monitor risks and vulnerabilities, and non-banks can make more informed liquidity management decisions.

Bridging data gaps will require coordination between national regulators. Jurisdictions will need to align on reporting standards and data sharing, an essential prerequisite before other policy measures can be effective.

Proposed Solutions

The FSB has proposed several measures to help non-bank financial institutions better manage liquidity risks related to margin calls and collateral during market stress events.

The key proposals include:

• Enhancing liquidity preparedness through more rigorous contingency planning, liquidity stress testing, and buffers of high-quality liquid assets. Firms should assess potential liquidity needs from margin calls and develop plans to meet those needs, even during extreme volatility.
• Promoting central clearing of derivatives to concentrate liquidity risks in utilities better equipped to manage them.
• Improving transparency through more granular reporting of initial margin and potential future exposure. This data would help firms and regulators identify concentrated exposures and liquidity pressures.
• Introducing minimum standards for initial margin models to limit procyclicality. This would help avoid cliff-edge margin calls during periods of high market volatility.
• Updating other collateral and margin practices to limit procyclicality. Potential measures include minimum transfer amounts, margining frequencies, and rounding thresholds.
• Enhancing cooperation and coordination across regulatory jurisdictions to ensure consistent adoption of standards globally.

The FSB will finalise its policy recommendations after a public consultation period on the April 24 discussion paper. The measures aim to balance limiting systemic liquidity risks and avoiding unduly constraining trading activity. Overall, the goal is to make non-bank entities more resilient to margin calls and collateral shocks during times of market turbulence.

Conclusion

The FSB proposal highlights key liquidity risks that non-banks should know and start planning for now. Margin calls and collateral optimisation are already more critical in the current intertest rate environment, this will exacerbate in times of market stress. Operational efficiency around liquidity management and collateral will be a key competitive advantage.

Non-banks should focus planning on the following areas:

• Review liquidity risk management frameworks to ensure sufficient liquidity buffers and tools to meet margin calls and collateral demands during stress events. Stress testing will be critical.
• Optimise collateral usage through efficient collateral sourcing, posting, and reuse. Leverage technology and central clearing solutions where possible.
• Shore up any data gaps in trade, position, and collateral reporting that could delay responses to margin calls. Ensure timely visibility into liquidity needs.
• Evaluate the feasibility of implementing proposed solutions like pre-arranged funding arrangements for non-banks.
• Provide feedback to regulators during the consultation period on how proposed measures could impact operations. Highlight any challenges or concerns.
• Final policy measures are expected to be implemented in 2025 at the earliest. Use this lead time to improve liquidity preparedness proactively.

The FSB proposal is a call to action for non-banks to evaluate their liquidity risk management. Taking steps now to prepare for future market stress will ensure continued access to derivatives markets and support financial stability.

If you seek support in evaluating your liquidity and collateral risks, Margin Reform provides bespoke expertise to guide your needs. Our consultancy services are designed to help you mitigate risks and streamline performance.

We recognise the importance of effective risk management in today's fast-paced financial environment. We have a wealth of experience in the margin collateral and liquidity domains. Let us help you navigate your challenges and provide tailored solutions to your requirements.

For more information or to schedule a consultation, please contact us at [email protected] . We look forward to hearing from you soon.

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