Dutch pension funds can meet margin calls on derivatives, but depend on functioning money markets

The liabilities of Dutch pension funds – consisting of future pension benefit payments –  are largely due in the distant future. Market interest rates determine how much pension funds must set aside to be able to pay future pension benefits. Interest rate fluctuations therefore greatly affect the financial position of pension funds. Importantly, pension funds seek to keep their funding ratio stable, which is why they use derivatives, such as interest rate swaps. In an interest rate swap, a pension fund and its counterparty agree on a certain interest rate at a future date, subject to the obligation to exchange collateral. For example, when interest rates rise - and the pension fund's liabilities fall in value - the value of derivatives also falls. So while pension funds find derivatives useful to hedge interest rate risks, they come with liquidity risks. If a derivative falls in value, a pension fund must typically provide collateral within one or two days under what is known as a margin call.

Liquidity risks must be identified with an eye to financial stability

From a systemic stability perspective, it is important to properly assess the extent of these liquidity risks. The collateral pension funds must provide in the event of changes in the value of derivatives can be cash or high-quality debt securities such as sovereign bonds. In an extreme scenario, a pension fund could be forced to sell off some of its assets if it cannot meet these margin calls. Due to the large size of the Dutch pension sector's combined investment portfolios (around €1,500 billion), their transactions have a potential impact on financial markets. If several large pension funds were forced to sell off assets at the same time, this could put pressure on prices in financial markets. This happened in the United Kingdom in autumn 2022, following turmoil over the national budget which caused great volatility. Calm only returned after the Bank of England had intervened to stabilize the bond market.

Against this backdrop, DNB and the AFM asked a group of pension funds and relevant pension administration organizations to calculate various stress scenarios. In these scenarios, sharp interest rate and currency shocks occur and the accessibility of money markets - such as the repo market - is under pressure. DNB and the AFM conducted this study at the request of the Financial Stability Committee, in which the Ministry of Finance, the AFM and DNB discuss financial stability in the Netherlands on a regular basis.

Pension funds use various sources to meet margin calls

The study shows that pension funds are able to meet margin calls under derivatives contracts in the different stress scenarios without resorting to an extensive sell-off of assets. Pension funds use several sources to obtain liquidity. Initially, they mostly tap into sources that are readily available, such as cash and deposits. In addition, they use other liquidity sources such as repo market transactions, redemptions from money market funds, and high-quality debt securities as collateral.

It is crucial that money markets continue to function smoothly

The scenario results show that pension funds depend on the smooth functioning of money markets for their liquidity management. They can raise cash for short periods of time in these markets. For instance, the stress scenarios show that pension funds can raise large amounts of money through repo transactions – despite repo market restrictions in the scenarios – and redemptions from money market funds. This may prove impossible, however, in times of wider stress, when many market participants need cash. For example, when the COVID-19 crisis broke out (March 2020), money market funds struggled to meet investor redemption requests. They eventually managed to create sufficient liquidity by selling assets, but these sell-offs contributed to the self-reinforcing dynamics in financial markets. Liquidity in the repo market can also come under pressure when conditions are stressed, for example when banks prefer to hold more reserves in volatile market conditions and are less willing to lend cash.

In extreme stress scenarios, financial stability may be at stake

Due to their dependence on smoothly functioning money markets, extreme scenarios are conceivable in which pension funds still have to sell off assets. For example, when they are unable to raise liquidity in the repo market or when money market funds can no longer meet redemption requests. This may amplify turmoil on the financial markets. To safeguard financial stability, it is therefore important to further reduce the likelihood of such risks to the financial system materializing. For example, a more robust framework encompassing buffer requirements on money market funds (and other non-bank financial institutions) could make this sector more resilient in times of stress. This could improve access to liquidity for investors, including Dutch pension funds.

Lastly, newly introduced legislation will further increase pension funds’ need for liquidity in the coming years. The exemption for mandatory central clearing of derivatives ended in 2023. In the case of centrally cleared contracts, margin calls must always be met in cash. Since the clearing obligation applies solely to new transactions, the proportion of centrally cleared derivatives, and hence the need for liquidity, will gradually increase. Conversely, the new pension contract may have a downward effect on the need for liquidity, as interest rate risk hedging will shift from long to shorter maturities. It is therefore important to repeat this analysis in a few years and continue to monitor liquidity risks closely as it is uncertain how liquidity needs will evolve going forward.