Welcome to another issue of Net Interest, where I distil 25 years of experience analysing and investing in financial companies into a weekly email. This one’s a long one – to support work like this, become a paid subscriber by clicking here. Thank you.

It seems that these days, someone, somewhere is on the end of a major margin call. 

Last week, it was the turn of UK pension funds. After a sharp fall in the value of UK government bonds, pension funds bound to a particular investment strategy (known as Liability-Driven Investment or LDI) were hit with calls from banks to post more collateral against their borrowings. Initial reports were of margin calls of as much as £100 million each; later it transpired that one such fund – the Pension Protection Fund – was asked to put up £1.9 billion in additional cash. In the event, the Bank of England intervened to stabilise the situation and UK pension funds now have some breathing room.

But the collateral calls they experienced are just the latest in a long list of high-profile calls:

• Throughout the year, energy companies have been seeking help from governments to backstop their liquidity. Back in March, the European Federation of Energy Traders complained that “high and volatile wholesale energy prices are leading to intolerable cash liquidity pressure for energy market participants”. They pointed out that “initial margin (collateral) requirements have increased by circa 6 times within the last 4-6 months. Market volatility has led to the average amount of variation margin required increasing by 10 times from one business day to the other.” 

We’ll explain what all that means further down, but the upshot is that energy companies are facing margin calls. In August, Wien Energie, a municipal utility in Vienna, disclosed it faced a margin call of €1.75 billion in a single day. One by one, European governments have stepped in with support, including the UK government which offered a £40 billion credit line to British energy companies. This comes as one energy group – Norwegian company Equinor – warns that margin calls in the sector in Europe may exceed €1.5 trillion. 

• In March, the London Metal Exchange (LME) cancelled eight hours worth of trades after traders suffered debilitating margin calls in the wake of a gap-up in the price of nickel. The exchange said it issued more than $7 billion of margin calls the day before it suspended the market – nearly four times the previous daily record – although it hasn’t disclosed what the cash calls would have been if it hadn’t halted trading. The episode prompted the single biggest margin breach in the exchange’s history, of $2 billion, an order of magnitude higher than the previous peak breach of $51.7 million in the last quarter of 2021.

• Last year, we had the case of Archegos Capital Management. On the morning of March 25, 2021, Credit Suisse issued Archegos, a little-known family office, with a multi-billion dollar margin call after the value of some of its stock holdings plummeted. Archegos traded its stock positions via swap, which allowed it to gain exposure without putting up much capital. Two days earlier, the firm had over $600 million of excess margin at Credit Suisse, its broker, but within 24 hours, that excess was wiped out by market movements. The excess swung to a deficit, initially of $175 million and, one day later, to $2.7 billion. “Given the size of that call, the matter was escalated to the Co-Heads of Prime Services and the Head of Equities,” an official Credit Suisse inquiry recounts. They “scheduled a call with Archegos for that evening to inform it of the upcoming margin call. Archegos’s COO informed CS that Archegos no longer had the liquidity to meet either CS’s or any of its other prime brokers’ margin calls on the following day.” Credit Suisse was forced to wear the loss, thus beginning the unwind of its long-standing investment banking franchise. 

• And before that, in January 2021, there was the GameStop saga. An historic rally in the stock of GameStop Corp. sent its price from $19 at the beginning of the year to an intraday high of $483 on January 28, leading to losses for anyone who was short. Credit Suisse swerved that one. “You’ll recall they [Archegos] took an $800mm+ PnL hit in CS portfolio during ‘Gamestop short squeeze’ week,” a Credit Suisse executive wrote in an internal memo. “We were fortunate that we happened to be holding more than $900mm in margin excess on that day, so no resulting margin call.”

Robinhood was not so fortunate. For every trade Robinhood facilitates, it needs to have sufficient reserves, posted as collateral at the NSCC central clearing agency, for the two days it takes for trades to settle. In highly volatile trading, where share prices whipsaw by hundreds of dollars, the agency requires more margin to guard against an increased risk of defaults. On January 27, 2021, Robinhood Securities had $700 million on deposit with the agency. The next morning, at 5:11 am EST, it received a daily automated notice from the agency asking for a $3 billion top-up by 10 am. Receiving the notice, a clearing operations manager based in Orlando, Florida texted a former colleague: “Hypothetically what happens if a firm can’t meet their morning NSCC margin settlement?” The response: “...wake up your senior leaders. Time for a cash infusion.” ¹

The Same But Different

Not all of these cases are the same. They cover different asset classes, from interest rates to commodities to stocks, and they cover different types of margin. There are two types: initial margin and variation margin. Both are required to protect a party to a contract in the event of default by the other party. Initial margin is posted when a trade is executed to provide a buffer of insurance and is returnable to the investor when the trade expires. Variation margin is paid daily from one side of the trade to the other, to reflect the current market value of the trade. Margin is usually posted in cash or government bonds.

In the case of the UK pension funds, it was variation margin that swung against them. As at October/November 2019, a survey of around half of the UK’s pension funds by assets revealed that they were sitting on interest rate swaps with £216 billion of total notional principal. The swaps were there to provide increased exposure to long-term government bonds. To fully match the outgoing stream of pensions they have promised to pay in the future, pension funds need to accumulate assets with a similar profile. Long-dated government bonds do the job, but their returns can be lacking, so funds use the swaps to achieve leveraged exposure (4.2x being the average in the case of the sample) and then also invest in riskier and higher-yielding assets to generate the growth. In a stylised structure, a fund may own £25 of government bonds, of which £10 is used as collateral against the swaps, alongside £75 of growth assets. ² ³

But the sharp rise in yields put pressure on the structure. As collateral prices fell (higher yields = lower bond prices) and their derivative overlays lost value, pension funds were required to post more collateral. A number of funds even burned through their excess collateral and were close to negative net asset value, which put them at risk of having to wind up. In that event, any government bonds held as collateral by banks were likely to have been sold on the market, driving a potentially self-reinforcing spiral of lower collateral values and forced liquidation. After being briefed that pension funds may have had to dump £50 billion of long-term bonds – into a market that normally trades only £12 billion a day – the Bank of England intervened. ⁴

More Calls

Now, maybe it’s just recency bias, but it seems to me that the frequency of high profile margin calls is increasing. There have been plenty of derivatives-driven debacles in the past. I’m old enough to remember Metallgesellschaft, Orange County and Barings, all of them major corporate disasters of the 1990s fuelled by derivatives. But in the grand sweep of history, derivatives were still relatively young in those days; the first formal swap agreement was entered into only in 1981. These episodes reflect a combination of misunderstanding, abuse and poor risk management, as well as a mismatch between people in those organisations who properly understood derivatives and those who didn’t. 

Since then, derivatives have become a lot more widespread. The total notional amount of over-the-counter derivatives outstanding is currently $598 trillion, up from $72 trillion in the late 1990s.

Importantly, though, the nature of the market changed, with collateral taking more of a central role. When the derivatives market first emerged, dealers were perceived to present a low degree of credit risk, but as the market expanded, a greater number of organisations began to participate, many of which had low credit ratings. To compete, lower rated banks started offering to back their derivatives with collateral, either in the form of cash or government bonds. Initially, there was a lot of dispersion in the way collateral was processed. Over time, the industry converged on specific agreements (CSAs) but negotiating them and managing the associated collateral was typically taken care of in banks’ back offices; they had little bearing on derivatives pricing. That changed during the global financial crisis. In 2005, Goldman Sachs had already started an internal project to rebuild its valuation infrastructure to account for the effect of collateral. Its success during the crisis led to its broad adoption across the industry.

This focus on collateral fed into a wider shift towards a less intermediary-focused financial system and a more markets-focused one, where the source of liquidity is collateralized funding rather than bank deposits. Post-crisis regulatory reforms helped it on its way. In the seven years following the crisis, trading activity on Europe’s collateralized money markets increased by 25%, while activity on the unsecured market fell by 80%. By improving borrower incentives and signalling creditworthiness, collateral can increase efficiency in the system, particularly if it is represented by safe and liquid assets like cash or government bonds. 

It also allows non-banks to participate in the system, as they have at an increasing rate. Twenty years ago, non-banks held $51 trillion of financial assets, compared with banks’ $58 trillion; on the latest data, non-banks have grown to $227 trillion in scale, outstripping banks at $180 trillion. Among them are asset management firms, pension funds and insurance companies. Indeed, investment funds and other asset managers have become more and more important as sources of demand for derivatives, their gross derivatives positions increasing faster than those of dealers. 

The drawback of a heavily collateralized market, though, is its tendency to inject procyclicality into the system. Periods of market turbulence can drive sharply higher collateral requirements, which can prompt more turbulence if that leads to forced selling – such as we saw in the UK last week. 

This became evident during the Covid-19 market turmoil of March 2020, when collapsing asset values coupled with a surge in the demand for liquidity prompted the mother of all margin calls. According to a recent review led by three of the world’s leading regulators, daily variation margin calls from central clearinghouses (CCPs) increased from around $25 billion to a peak of $400 billion. Meanwhile, the total initial margin requirement across central clearinghouses increased by $300 billion over the month, with a further increase in excess collateral of $115 billion, for a total of $415 billion – 40% up on the average for February. 

In the event, fire selling of assets by clients was generally avoided, largely due to central bank intervention to support funding markets, but also due to discretion on the part of clearinghouses. At a clearinghouse roundtable in May, an executive from ICE Clear (part of the Intercontinental Exchange) reflected on the events of March 2020. “I had the keys to the castle at that point in time,” he said. “And it would’ve been a very bad day [if ICE had declared a client in default] … It would’ve been cataclysmic at that moment in time … We chose to give the appropriate amount of time not to dislocate the market and create a bigger stress.” According to the FT, the client was Citigroup – a technology glitch meant it was late to meet a margin call. 

The prevailing view was that the pandemic was a one-in-a-thousand year event that nobody could have predicted. Yet while that may be true in terms of the direct cause, markets do have a tendency to make outsized moves more frequently than observers suppose. It’s a feature we discussed here, in How Markets Work, a few months ago. 

A corollary is that such moves are unlikely to be factored into investor models. The regulators’ Covid-19 review highlighted how “clients…varied in their level of preparedness for margin calls”. In the case of the UK, pension funds calculated “basis points to exhaustion” to estimate potential collateral needs under market stress, the average being 291 basis points in October/November 2019. But when the stress came, it was more intense. On Wednesday 28 September, the yield on 30 year UK government bonds moved more intraday than it had moved all year in all but four of the past 27 years. 

Such extreme moves are a feature of most of the margin calls we’ve highlighted. Neither the rise in the price of nickel nor the rise in the price of GameStop were factored into models employed by participants in those markets. ⁵

The problem is that a more collateralised market makes moves like this more likely. There are three reasons.

First, banks are now much smaller relative to the scale of markets, so are unable to act as loss absorbers. This is increasingly apparent in the US Treasuries market, which has outgrown the capacity of dealers to safely intermediate it on their own balance sheets: Since 2008, total assets of large banks have barely risen, while the stock of US Treasuries outstanding has grown over 2.5x.

Second, since the financial crisis, regulators have encouraged more derivatives to be cleared via central clearinghouses. Today, close to 75% of interest-rate derivatives and 85% of credit-default swaps are cleared via central clearinghouses. But although they function as public utilities, central clearinghouses are profit maximising – many of the largest are owned by publicly-traded exchange groups. As such they have an incentive to encourage trading, and one of the ways they have done that is by lowering the capital charge for members. 

Third, technological improvements have facilitated high-speed trading on automated platforms. Another feature of many of the margin calls highlighted is that markets move faster than men. The Robinhood clearing operations manager was told to “wake up” his senior leaders. The Bank of England reported that for some pension funds, “the speed and scale of the moves in yield and consequent decline in net asset value far outpaced the ability of the DB [Defined Benefit] pension fund investors to provide new capital in the time available.”

All this leads to more frequent and widespread episodes of market stress. Regulators can see it: At a speech in London in January 2021, the Bank of England’s executive director for markets, Andrew Hauser, acknowledged that “there is every reason to believe that, absent further action, we will see more frequent periods of dysfunction in the very markets increasingly relied on by households and firms.” Investors can see it – they only need to look at the MOVE index of Treasury market volatility or the implied volatility of the dollar index. Even people removed from markets can see it – things just feel a little bit more uncertain since 2020, don’t they?

The impact is already showing up in margin breaches. A margin breach occurs when the collateral in a clearing member’s account falls short of the amount needed to cover its marked-to-market exposure. Recent data from LCH Ltd, one of the largest clearinghouses in the world, shows a spike in breaches this year.

After the fact, more margin calls are likely to lead to a deleveraging among market participants. Collateral and margin requirements determine the extent to which investors and traders can lever up their own capital. In good times, low collateral and margin requirements allow for higher leverage. When shocks hit, higher requirements can increase abruptly and create deleveraging pressures. Already, initial margin requirements on UK interest rate swaps have increased by 65% since the mini-Budget that triggered the crisis. 

A new financial system is confronting its first major challenge. Along the way, brace for plenty more margin calls.