Robert Czech, Simon Jurkatis, Arjun Mahalingam, Laura Silvestri and Nick Vause
Financial markets reflect changes in the economy. But sometimes they amplify them too. Both of these roles were evident as the Covid-19 (Covid) pandemic materialised. As the economic outlook deteriorated, risky asset prices fell in reflection of that. And those falls were amplified as some investors reacted by liquidating assets. That also amplified increases in financing costs for companies issuing new debt or equity, which could have further damaged economic prospects. Various ‘procyclical’ mechanisms contributed to this macrofinancial feedback loop, as shown in Figure 1. This post reviews findings from research about these particular mechanisms, covering (i) how they work, (ii) how strong they are and (iii) how they might be mitigated. And, where there are gaps, it suggests new research.
Figure 1: Four key procyclicality mechanisms in the financial system
Mechanism 1 (of Figure 1): margin calls
Margin calls related to derivatives are a first source of procyclicality. To cover potential counterparty losses in the event of default, derivative users typically post collateral to their counterparties to cover both changes in their current exposure (variation margin (VM)) and potential future exposure (initial margin (IM)). During good times, when price volatility is low, IM requirements are low, and this can help market participants take larger positions. When the cycle turns, however, higher volatility can generate calls for additional IM, which – along with any VM calls – would then be relatively large since they would apply to larger positions. Large margin calls were widespread during the Covid crisis, including for derivatives cleared by central counterparties (CCPs). CCP disclosures and regulatory transactions data show that the total IM received by most CCPs increased significantly in 2020 Q1 compared with the previous quarter, doubling in some cases (Chart 1.A), while VM payments spiked in the middle of March (Chart 1.B).
Chart 1: Margin calls during the Covid crisis
(A) Change in IM held by CCPs in 2020 Q1(a)
Sources: CCP public quantitative disclosures and Bank calculations.
(a) Bubble sizes reflect total IM held in 2020 Q1. See Chart E3 in the August 2020 Financial Stability Report for further details.
(B) Estimated VM payments in March 2020(a)
Sources: Bloomberg Finance L.P., Derivative trade repositories and Bank calculations.
(a) Covers sterling interest rate swaps and forward rate agreements as well as GBPUSD, EURUSD, JPYUSD, USDGBP, USDEUR and USDJPY FX forwards for 400 UK institutions. See Chart E2 in the August 2020 Financial Stability Report for further details.
While VM calls are essentially determined by price moves, the procyclicality of IM requirements additionally depends on modelling choices. Some CCP models that were calibrated using data from less turbulent times generated particularly large IM calls during the Covid crisis. In other cases, margin calls were reduced by anti-procyclicality (APC) mechanisms, which boost IM requirements in good times so they don’t have to rise as sharply in bad times. To varying degrees different APC mechanisms trade-off lower IM calls in times of stress for higher IM requirements in normal times, although this can be an expensive trade-off given fat tails are often observed in derivative returns. However, it can have the benefit of reducing the likelihood of margin calls that would erode derivative users’ liquid asset buffers, which could lead to the liquidation of positions and a fire-sale externality. Such considerations lead to topical research questions such as: To what extent would higher IM requirements in normal times reduce leverage and the procyclicality of margin calls? Or is improving liquidity preparedness among market participants a better option?
Mechanism 2 (of Figure 1): fund redemptions
One of the most notable features of open-ended investment funds is liquidity transformation. Although funds may invest in illiquid assets such as small stocks and corporate bonds, fund shares are often liquid claims – investors can redeem their shares at the fund’s end-of-day net asset value (NAV) at any time. To meet large investor withdrawals, funds may have to sell illiquid holdings at discounted prices, and the liquidation cost would be borne by the remaining investors. Therefore, investors have an incentive to head to the exit before others. This first-mover advantage could lead to large redemptions from open-ended funds, particularly during market downturns. These redemptions may further aggravate the price drop of the illiquid asset being sold.
Due to the lower liquidity of their portfolios, corporate bond funds are typically more vulnerable to the procyclical first-mover advantage than equity funds. This risk recently crystallised in the Covid stress episode in which bond funds received large and sustained redemption requests. For example, net outflows reached more than 5% of assets under management (AUM) for corporate bond funds in March (Chart 2) – the highest outflows since the global financial crisis. Funds sold large quantities of corporate bonds to meet these redemptions, thereby contributing to the downward pressure on prices and liquidity in the secondary corporate bond market, which was exacerbated further by the impaired liquidity provision by dealers. Only the quick and large-scale responses by central banks around the globe helped to avoid a prolonged tightening of financial conditions, which could have led to greater damage to output and employment.
Chart 2: Open-ended fund flows and average returns in March 2020(a)
Sources: Morningstar and Bank calculations.
(a) For funds with at least 30% of their portfolios invested in the designated asset classes.
There is a lively debate among policymakers and academics on tools that could mitigate procyclicality in investment funds. Potential remedies include, for example, swing pricing and notice periods. This discussion provides important questions for further research: How can we evaluate these different policy options and their impact on the flightiness of fund investors, in particular during periods of stress? Moreover, how do changes in the incentive structures of portfolio managers or the risk-taking behaviour of funds (eg via derivatives) impact the procyclicality in the fund sector?
Mechanism 3 (of Figure 1): hedge fund deleveraging
Hedge funds invest across different markets and are often highly leveraged, relying on prime-brokerage and – to an increasing extent – the repo market for funding. This can be seen in Chart 3, which shows a notable increase in net repo borrowing by hedge funds in the year or so before the Covid pandemic. Leverage amplifies profits in good times but also losses in bad times. If losses significantly erode capital, hedge funds may feel unable to maintain their risk exposures and liquidate some of their positions. They could also be forced into such action by investors redeeming their shares, or – if volatility is rising at the same time – by increased margin requirements for their derivatives positions or repo funding. Asset liquidations can then exacerbate price moves, potentially generating a self-reinforcing spiral.
Chart 3: Prime brokers’ repo and reverse repo lending to hedge fund counterparties(a)
Sources: Bank of England Hedge Fund as Counterparty Survey and Bank calculations.
(a) See Bank Overground post for further details.
These risks crystallised in the US Treasury market in March 2020 as the economic implications of the Covid pandemic became apparent. Notably, hedge funds unwound US Treasury positions following severe portfolio losses and margin calls, contributing to a sharp rise in yields and market illiquidity. A significant part of these sales can be attributed to highly leveraged relative value strategies, which take advantage of price discrepancies between government bonds and the corresponding futures contracts. Only large-scale intervention by the Federal Reserve managed to restore market liquidity and break the self-reinforcing loss spiral.
These events highlight important questions for future research, such as: what is the role of highly leveraged funds in UK gilt markets (where hedge funds appear to engage in different strategies compared to the US Treasury market)? Also, to what extent do hedge funds behave in a procyclical manner during downturns and propagate stress across markets?
Mechanism 4 (of Figure 1): dealer intermediation
Dealers play a crucial role in providing liquidity in many markets, such as corporate and government bond markets. Dealers’ willingness and ability to intermediate between buyers and sellers determines the extent to which initial asset sales can lead to downward price spirals in such markets.
The state of market liquidity in dealer-intermediated markets since the global financial crisis is a widely discussed topic. Evidence gathered, for example, for the corporate bond and repo market, suggests that post-crisis regulatory reforms constrained dealers’ ability to make the market. At the same time, new forms of trading – commonly referred to as electronic trading – have grown in popularity, such as request-for-quote platforms. These platforms increase competition, risk-sharing possibilities and reduce search costs. So-called all-to-all platforms even provide the ability to circumvent dealer intermediation altogether. These alternative trading protocols have been found to positively affect market liquidity in good times. However, their resilience under severe stress has not been sufficiently studied yet (see O’Hara and Zhou (2020a) and (2020b) for first evidence). Chart 4 shows that although investors mostly (in terms of trading volume) resorted to over-the-counter trading in the Covid-related ‘dash-for-cash’ period, they increasingly used exchanges (in terms of trade count) to obtain liquidity.
Chart 4: UK corporate bond trading by venue(a)
(A) By trade volume
(B) By trade count
Sources: MiFID2 transaction reports and Bank calculations.
(a) MTF = Multilateral Trading Facility (eg RFQ platforms); OTF = Organised Trading facility (for third-party trading); SI/OTC = dealer trades, either on a dealer’s own platform (as a ‘Systematic internaliser’) or over-the-counter.
With the disruptions seen in dealer-intermediated markets during the Covid crisis, the question of how to make them more resilient is a critical and open one. For example, should inter-dealer markets be further consolidated via central clearing to free-up dealers’ balance sheet? Or, should the development of alternative trading platforms be encouraged to reduce the reliance on dealers in the first place?
This post has reviewed the existing evidence on selected procyclical mechanisms in financial markets. In doing so, it identifies key questions, emphasised by the Covid-related financial stress in early 2020, that warrant further investigation. The authors would welcome further engagement with the research community on these issues.
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