The size and composition of variation margin calls on funds’ derivative portfolios during the coronavirus market turmoil. This result relates to the sizeable margin calls on equity derivatives simulated in this scenario (68% of the overall call) and the relatively low holdings of high-rated government bonds by equity funds. For centrally cleared contracts, the exchange of both initial and variation margin is required. The two stress scenarios chosen are stylised and motivated by the market moves during the 2008 financial crisis and the recent coronavirus stress (see Table B.2). The highest increase – by around 6.5 times – was reported on portfolios composed of equity derivatives, followed by interest rate (fivefold increase) and currency (fourfold increase) portfolios. The available data indicate that a substantial share of euro area funds with derivative exposures faced a liquidity squeeze from the high margin calls. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Stock market declines refer to the percentage change in the EURO STOXX 600 and S&P 500 indices. jeopardise protection against counterparty credit risk. The Amihud liquidity ratio and bid-ask spreads are utilized to assess the existence of liquidity premia.  For the extreme one-day market move, it is also assumed that the timing when margin is posted and received can differ across portfolios of a fund and thus the payments cannot be netted. OTC derivatives market to mitigate market risk. Get an overview of what the European Central Bank does and how it operates. The announcement of the pandemic emergency purchase programme (PEPP) on 18 March 2020 helped reduce market volatility (e.g. Think of commodity markets as a pyramid. The management of the market price risks of currencies, interest rates and commodities with derivative financial instruments, inevitably also entails counterparty and liquidity risks. For non-centrally cleared contracts, the requirement to exchange variation margin was phased in in two steps and applies to all European counterparties on contracts originated after 1 March 2017. using repo markets) and thus a broader liquidity buffer seems relevant. The most familiar way of trading derivatives is through a futures exchange. Further, in stressed market conditions, the liquidity in the derivative may be positively convex in that it improves as a result of increased demand for liquid hedges. Sources: EMIR data, sector classification from Lenoci and Letizia (2020), Bloomberg and authors’ calculations.Notes: Left panel: calculated as the sum of all positive margin calls on euro area investment funds, where a positive margin call occurs if either variation margin posted increases or variation margin received decreases from one day to another. Sources: EMIR data, sector classification from Lenoci and Letizia (2020), Refinitiv and authors’ calculations.Notes: The two maximum calls refer to the maximum daily variation margin call and the maximum cumulative variation margin call over a two-week period between 4 February and 17 April 2020. The rationale for the two concepts is that cash is the preferred asset class to meet an overnight or intraday call as it can be transferred between counterparties very quickly. money market fund shares) or drawing on credit lines. The primary reason behind this exemption is that without it, pension funds could face an increase in liquidity risk as they would be required to adhere to risk management of central counterparties (CCPs), including the daily exchange of variation margin (VM) in cash, which they may not currently hold in sufficient amounts. Specifically, they expose users to market risk, liquidity risk, and counterparty credit risk. The pricing functions exploit reported contract characteristics and external data sources, and are calibrated using EMIR data.. It is though also beneficial, from a financial stability perspective, to ensure At the same time, the simulation results rely on several assumptions and, as such, have to be interpreted with caution. Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Initial margin is an additional collateral buffer that protects a counterparty against a potential future decline in the market value of a portfolio over a short period, should the other counterparty default. Its price is determined by fluctuations in that asset, which can be stocks, bonds, currencies, commodities, or market indexes. Derivatives, and the investment strategies that use them, can potentially magnify investment risks if not appropriately risk-managed. It first considers the evidence on margin calls and fund liquidity drains during the recent market sell-offs in March. For daily margin calls, margin posted and received (obtained as the difference between the stock values reported in EMIR data) are not netted as the timing of payment outflows and inflows may differ. Under the prolonged turmoil scenario, 13% of funds with derivative exposures do not have sufficient liquidity buffers to fully absorb the simulated margin call. The European Banking Authority has proposed an intersection methodology to calculate a proxy CDS or Bond spread. The exchange of margin in the form of high-quality collateral reduces counterparty credit risk. Such netting, however, masks the individual positioning within the sector, where each fund needs to have sufficient liquidity to meet its own margin calls. Sources: EMIR data, sector classification from Lenoci and Letizia (2020) and authors’ calculations.Notes: Left panel: data refer to 30 March 2020. Sources: EMIR data, sector classification from Lenoci and Letizia (2020), Refinitiv and authors’ calculations.Notes: Based on end-2018 data. The cash shortfalls would be concentrated within a small number of pension funds with relatively low VM payments (see Chart A, right panel). We nd that distress due to margin procyclicality in the derivatives market can spillover to the interbank market leading to systemic liquidity risk. The full sample includes 13,969 funds, for which EMIR data indicate a holding of a derivative portfolio and variation margin can be calculated. For cumulative margin calls, the exact timing is assumed to be less critical and thus the margin payments are netted. Such tools should focus on containing the build-up of vulnerabilities before risks materialise.  In addition, the analysis is targeted at interest rate swaps, which are mandated for central clearing and where the share of Dutch pension funds is even higher, standing at 89%..  To simulate the impact, the analysis uses fund-by-fund supervisory data from De Nederlandsche Bank (DNB) on liquidity buffers and derivative exposures, complemented by EMIR data. Particularly affected are equity funds, where the share of funds with an insufficient buffer reaches 25%. The data provide detailed information on both the counterparties and the characteristics of the contract, including information about (the stock of) margin posted and received. At a high level, the elements will be familiar to anyone who helped implement ICA liquidity risk management programs over the past three years. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade. The results call for the development of macroprudential tools to address the liquidity risk in the fund sector as this risk can have wider systemic implications. An exchange operator defines standard terms of risk and liquidation. Taking positions in different markets might enable investors to diversify liquidity risk. Going forward, banks will have to closely monitor the liquidity requirements from their derivatives businesses, and can leverage their existing CCR frameworks to consistently manage liquidity risk. Contrary to general belief, future contracts enhance liquidity and information dissemination leading to higher trading volumes and lower volatility. In reality, an important part of investment analysis is determining the probability of an investment being profitable and assessing the risk/reward ratio of potential losses against potential gains. Using transaction-by-transaction derivatives data, this special feature assesses whether the current levels of funds’ holdings of cash and other highly liquid assets would be adequate to meet funds’ liquidity needs to cover variation margin calls on derivatives during stressed market periods, once the derivative portfolios become fully collateralised. Estimates accounting for such a gap suggest that the daily variation margin calls on euro area funds’ portfolios could have reached a daily peak of almost €40 billion on 16 March 2020 (see Chart B.2, right panel). Results of a stress scenario of a +100 basis point parallel shift in the yield curve. In other words, derivative listing improved the liquidity of illiquid stocks significantly and served one of the basic objectives of risk management. The broad liquidity buffer includes cash and holdings of high-quality government bonds, i.e.  While the size of the shock may be extreme, it is commonly used as a baseline stress scenario by the industry. The analysis shows a potential €15 billion cash shortfall and 96% of Dutch pension funds are found to have a sufficient amount of high-rated government bonds that could be used for collateral transformation. Regulatory requirements aimed at strengthening funds’ ability under stress to meet potential funding needs, including variation margin calls, could be effective in this respect. Such tools would make the sector more resilient to future financial turbulence and decrease the need for ex-post interventions (see Chapter 5). Moreover, in the high-volatility environment and taking into account the diverse positioning of funds, around half of these funds were likely to have received large liquidity inflows from variation margin calls shortly before the market turned against them. The initial margin requirements for non-centrally cleared contracts are less widespread as they continue to be phased in until September 2022. Moreover, in times of severe market stress, variation margin tend to be more procyclical and volatile than initial margin. call/put European/American options, futures and contracts-for-difference) and FX derivatives (e.g. For both approaches, two concepts of liquidity risk are considered: sudden demand for cash in one day and demand for high-quality liquid collateral spread over several days. 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