As a real money manager worried about asset valuations, inflation, and tail risks, you take the prudent decision to manage your tail risks by purchasing out-of-money options.
Your call to hedge tail risks was correct – a global pandemic has just hit the world… Asset prices are collapsing, vol is spiking, and investors are scrambling for liquidity, but at least you’re well prepared with your hedges.
Suddenly the phone’s ringing – your fund administrator is telling you that you have no cash liquidity left. Apparently, you’ve just used up 90% of your unencumbered cash in initial margin calls. You tell your administrator that they’re not looking at the full picture – the market values of your hedges have gone through the roof and you’ve just received a huge amount of cash in variation margin which will more than offset your initial margin calls.
Your administrator then drops the bombshell – UCITS rules don’t allow you to reuse your variation margin in initial margin postings… Paradoxically, you might have been better off not managing your risk…
The regulation
The regulation driving this issue is Paragraphs 43(i) and 43(j) in ESMA’s Guidelines for competent authorities and UCITS management companies, provides guidance of how UCITS funds should be treating collateral received:
i) Non-cash collateral received should not be sold, re-invested or pledged6.
j) Cash collateral received should only be:
– placed on deposit with entities prescribed in Article 50(f) of the UCITS Directive;
– invested in high-quality government bonds;
– used for the purpose of reverse repo transactions provided the transactions are with credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on accrued basis;
– invested in short-term money market funds as defined in the Guidelines on a Common Definition of European Money Market Funds.
Note that the reuse of collateral received is either explicitly prohibited or not permitted for any collateral received.
As a means to manage leverage and liquidity risks where margin recalls cannot be met if a UCITS funds invests collateral received in less liquid assets, the regulation made a lot of sense. A decade later as we are months away from the phase 6 implementation of margin requirements for non-centrally cleared derivatives, this regulation could now be the cause of the very risk it was intending to protect firms against.
We discussed the potential magnitude of these margin requirements in a prior post, Uncleared Margin – The $75bn Question… where we show that the margin requirements of an out-of-the-money swaption can increase from 0 to nearly 80m in a very short period of time. For a realistic hedging portfolio, this can mean significant margin calls in a market stress event, combined with potential redemptions and very real liquidity risks.
What’s needed
Clearly this is an issue that regulators need to look into and assess whether, a decade on, the UCITS regulation on collateral reuse is still fit for purpose where most transactions for most counterparties will be subject for margin postings, and whether carve outs need to be made to avoid creating real liquidity risks.
In the meantime, UCITS managers need to ensure that they are creating and applying liquidity stress tests to their funds, irrespective of whether the regulation requires them to do so, and creating risk management and limit frameworks to prevent a build up of liquidity risk within funds.
The issue is also much broader than just OTM options – any amount of offsetting risks between different counterparties (delta hedging a cleared option, or bilateral FX forward unwound with a different dealer) is likely to result in offsetting margin calls where the collateral requirements are grossed up and cannot be offset. In these cases, it is essential that execution models, limits, and MIS will need be adapted to manage this risk.
If you would like to know more on the topic and look at how JD Risk Solutions can support your risk management, please contact us.