Liquidity beyond banks

L3.4.09: The risks CCPs bring told the story of September 2022 from the margin side: gilt yields jumped and pension schemes' hedges called for collateral. Now look at it from the schemes'. Most were not in trouble on paper; higher yields made their liabilities cheaper. Their problem was time. In his letter to the Treasury Committee of 18 October 2022, the Bank of England's Deputy Governor, Sir Jon Cunliffe, wrote that LDI funds had raised “tens of billion pounds in capital” from schemes and made “many billion pounds of gilt sales”, and that pooled funds, with many smaller investors, were likely to take longer to raise it than schemes with their own accounts. Liquidity risk is not only a bank problem. Anyone who must pay cash on time, from assets that take time to sell, has it.

Banks have depositors who can leave. Other firms have their own versions. Pension schemes and insurers have margin calls: derivatives and repo that demand collateral when markets move. Investment funds have redemptions: investors who can ask for their money back every day. Clearing houses have payment obligations: they must pay the winners on time even when a loser has defaulted. Each is a liquidity mismatch: a promise to pay fast against assets that may be slow.

1. Pension schemes: the funding side of LDI

Ebbsworth's liabilities are worth £1,600m, with a PV01 of £2.56m per basis point. Its LDILiability-driven investment (LDI): a pension scheme strategy that uses swaps and gilt repo to match the interest rate and inflation sensitivity of its liabilities with less capital than buying the gilts outright. hedge, swaps and gilt repo (the swap with RiskAtoms Bank in L3.4.09: The risks CCPs bring is one part), has a PV01 of £2.0m: it hedges 78% of the rate risk. If yields rise by 250bp the scheme's funding improves, but the hedge calls £500m of collateral. The collateral buffer already in the LDI fund, £200m, covers 100bp. Beyond that the trustees work down a liquidity waterfallLiquidity waterfall: the order, agreed in advance, in which a scheme or fund will use its sources of cash to meet collateral calls, with who may act and how fast each source can be turned into cash.:

Within two days only 3 sources are ready: £310m, £190m short. The LDI manager then has to cut the hedge, selling gilts into a falling market, exactly what happened at scale in 2022. Given until day 3, the scheme meets the call by selling corporate bonds, for £5.88m of sale costs. The same assets support a rise of 155bp within two days, but 472bp within four. The scheme is rich; it is not quick.

Since April 2023 The Pensions Regulator's guidance asks schemes using LDI for a market stress buffer of at least 250bp on top of an operational buffer, top-ups achievable within five business days, a documented waterfall and enough authorised signatories. With TPR's example operational buffer of 100bp, Ebbsworth would hold £700m in its LDI fund rather than £200m.

2. Insurers: the same calls, more sources

Life insurers use swaps, currency forwards and repo to hedge annuity books and foreign bonds, so they face the same calls, alongside claims and policyholders who surrender. An illustrative month in a market stress for a UK life insurer:

Capacity covers the net outflow 2.37 times. Collateral calls are £350m, 47% of the outflows: together the largest item, and the one that arrives first. This is the layout the PRA now asks larger insurers to report every month.

3. Open-ended funds: redemptions

An open-ended fundOpen-ended fund: a fund that issues and redeems units on demand, at a price based on the value of its assets, usually every dealing day. that deals daily promises investors cash within days, but may own assets that take months to sell. When too many ask at once, it can suspendSuspension: stopping all dealing in a fund's units, so that nobody can redeem (or buy) until it reopens. dealing. After the EU referendum, Standard Life suspended its UK property fund on Monday 4 July 2016, and Aviva Investors (whose fund was £1.8bn) and M&G followed the next day. In March 2020 many property funds suspended again, this time because valuers could not put a reliable value on buildings. And in June 2019 the Woodford Equity Income Fund, which had peaked at over £10.1bn in May 2017 and fallen to £3.6bn, suspended with only 8% of its investments sellable within seven days.

4. Clearing houses: paying the winners

A CCP collects variation margin from losers and pays it to winners the same day. If a member defaults, its payment does not arrive but the CCP must still pay. The default fund of L3.4.08: Central counterparties covers the loss; the CCP also needs cash, on the day, in the right currency. It counts only qualifying liquid resourcesQualifying liquid resources: what a CCP may count towards its liquidity need: cash at the central bank or creditworthy banks, committed credit lines, committed FX swaps and repos, and highly marketable collateral with prearranged funding., and a credit line from a member is worthless if that member is the one defaulting.

For a scheme with hedge PV01 $P$, a yield rise $\Delta y$ and sources $i$ of size $A_i$, ready on day $d_i$ at sale cost $c_i$:

For a fund with mid value per unit $m$ and swing factor $s$ (the cost of selling), a redeemer is paid $m(1 - s)$. For a CCP with payment obligations $O_1 \ge O_2 \ge \dots$ on a stress move and resources $R$, of which $L_j$ come from member $j$:

The same shape as a bank's survival horizon in L3.5.05: Liquidity stress tests and survival horizons: what must be paid by when, against what can be raised by when. Only the names change.

Run a redemption wave at the RiskAtoms Property Income Fund. Change its size and length, switch swing pricing on, and add a notice period.

Pension schemes. After the Financial Policy Committee's recommendation of March 2023, The Pensions Regulator issued guidance on 24 April 2023: a market stress buffer of at least 250bp over an operational buffer, top-ups achievable within five business days, a documented waterfall, liquidity facilities only if documented and reviewed, and stress tests that include decision times. The FCA issued matching guidance to LDI managers. Insurers. The PRA's PS15/25 of 30 September 2025 brings in monthly liquidity reporting from 30 September 2026 for larger Solvency II insurers (average assets over £20bn with large derivative or securities financing books), including a cash flow mismatch with counterbalancing capacity and an adverse market scenario. It cites the 2022 LDI episode and the March 2020 dash for cash.

Funds. In the UK, the FCA's rules for funds investing in inherently illiquid assets, in force since 30 September 2020, require liquidity risk plans and clearer disclosure, and suspension when an independent valuer finds material uncertainty over the value of more than 20% of the fund, unless the manager and the depositary agree that dealing on is in investors' best interests. The FSB and IOSCO's policies of 20 December 2023 group open-ended funds by the liquidity of their assets, with redemption terms to match, and expect anti-dilution tools that charge redeeming investors the estimated cost of liquidity. In the US, the SEC has permitted swing pricing for open-end funds other than money market funds and ETFs since 19 November 2018. CCPs. The Principles for Financial Market Infrastructures of April 2012 (CPSS-IOSCO, now CPMI-IOSCO) set the liquidity standard national rules build on: enough qualifying liquid resources for the default of the participant that would cause the largest payment obligation, and a CCP that is complex or systemically important in several jurisdictions should consider holding enough for the two largest. Some national rules, such as New Zealand's, make that a requirement.

• Liquidity risk is any promise to pay fast backed by assets that are slow: margin calls for schemes and insurers, redemptions for funds, payments for CCPs.
• Ebbsworth's hedge calls £500m on a 250bp rise: £310m can be raised in two days, the whole call in three at a cost of £5.88m.
• A daily-dealing property fund hit by 2% a day of redemptions suspends on day 6; swing pricing makes redeemers pay the cost of selling, and a notice period avoids the suspension.
• Wexcombe Clearing House meets Cover 2 when rates rise but is £6.6m short when they fall, because the two defaulters also provide its credit lines.
• New rules follow each episode: TPR's buffers after LDI, the FCA's illiquid asset fund rules and FSB/IOSCO's anti-dilution tools for funds, PRA liquidity reporting for insurers.

Liability-driven investment

Liability-driven investment (LDI): a pension scheme strategy that uses swaps and gilt repo to match the interest rate and inflation sensitivity of its liabilities with less capital than buying the gilts outright.

Collateral buffer

Collateral buffer: cash and gilts held in an LDI fund or mandate to meet collateral calls, measured as the rise in yields it can absorb. TPR's guidance splits it into an operational buffer and a market stress buffer.

Liquidity waterfall

Liquidity waterfall: the order, agreed in advance, in which a scheme or fund will use its sources of cash to meet collateral calls, with who may act and how fast each source can be turned into cash.

Open-ended fund

Open-ended fund: a fund that issues and redeems units on demand, at a price based on the value of its assets, usually every dealing day.

Suspension

Suspension: stopping all dealing in a fund's units, so that nobody can redeem (or buy) until it reopens.

Swing pricing

Swing pricing: moving the price at which investors deal away from the mid value when there are net redemptions (or subscriptions), so that those who trade bear the cost of the buying or selling they cause.

Notice period

Notice period: a delay between asking to redeem and being paid, set so the fund has time to sell assets in an orderly way.

First-mover advantage

First-mover advantage: the gain to investors who redeem early, at a price that does not yet reflect the cost of selling assets, at the expense of those who stay.

Cover 2

Cover 2: a standard requiring a CCP to hold enough resources for the default of the two members that would cause it the largest need, in extreme but plausible markets.

Qualifying liquid resources

Qualifying liquid resources: what a CCP may count towards its liquidity need: cash at the central bank or creditworthy banks, committed credit lines, committed FX swaps and repos, and highly marketable collateral with prearranged funding.