Key Takeaways

  • Interest rate swaps, commonly used to hedge interest rate risk, can expose pension funds to significant liquidity risk. Margin calls from these swaps, triggered by rising interest rates, can reach up to 15% of assets under management.
  • Contrary to conventional wisdom, pension funds can exacerbate movements in bond prices and interest rates during inflationary interest rate environments by selling government bonds to meet swap margin requirements.
  • Pension funds with tighter solvency regulatory constraints, such as those with large funding gaps, tend to use interest rate swaps more aggressively. Stricter solvency regulations can thus have the unintended consequence of increasing liquidity risk for pension funds.

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Summary

Motivation. With their long-term investment horizons and relatively locked-in capital, pension funds are thought to face limited liquidity risk and help stabilize financial markets. However, the growing use of interest rate swaps to hedge interest rate risk by pension funds challenges these assumptions. This paper shows that margin calls from interest rate swaps due to rising rates can result in substantial liquidity pressures for pension funds and exacerbate market movements.

Methodology. The authors focus their analysis on the Dutch pension system, which accounts for over half of all pension assets in the euro area. Dutch pension funds are subject to strict solvency regulatory requirements, which expose the funds to interest rate risks. Detailed position data from 2012 to 2022 is sourced from the Dutch Central Bank for 258 defined benefit pension funds. By 2022, nearly all sampled funds used interest rate swaps as their primary tool to hedge against interest rate risks. The authors examine 1) how regulatory requirements influence swap usage, 2) which assets pension funds sell when interest rates rise, and 3) whether these sales adversely impact asset prices.

Findings. 

  • Interest rate swaps are an appealing hedging tool because they require only a small initial investment and thus allow the funds to allocate more capital to high-return assets. 
  • Margin calls from interest rate swaps range from 4.5% to 15% of pension funds’ total assets under management. A one percentage point increase in interest rates results in a median margin call of 7.5% of AUM.
  • Margin calls triggered by a rise in interest rates are larger than the available cash balance for 74% of the sampled pension funds.
  • Pension funds sell safe, liquid assets in response to margin calls, and specifically shorter-term German and Dutch government bonds. 
  • Sales of government bonds due to margin calls negatively affect bond prices, with pension funds contributing to 4.5 basis points or 10% of the increase in the Dutch 5-year yield during the COVID-19 pandemic rate hikes.
  • Tighter capital requirements for pension funds combined with mandatory cash collateral for interest rate swaps contribute to increased liquidity risk for pension funds and greater market volatility.
  • The study’s findings can be applied more globally, with the 2022 UK pension crisis a prominent example of how margin calls from derivative positions can increase liquidity risk and destabilize markets.

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