Firms must improve liquidity safeguards – BoE’s Cunliffe

Firms must take more responsibility for their own liquidity management, says the Bank of England’s Jon Cunliffe, rather than relying on central banks during crises.

“The March 2020 ‘dash for cash’ has given us a valuable lesson,” the BoE deputy governor said on February 9. “We should not waste it.”

Margining is one area that needs improvement, out of many that the Financial Stability Board is examining, he said. Cunliffe co-chairs an FSB group investigating the use of margin as a factor in the market stress of March 2020, at the onset of the Covid-19 pandemic.

From around March 9 to 18 that year, fear of spreading illiquidity caused investors to dump assets in search of cash. Cunliffe said the dash for cash “turned into a stampede”, as falling asset values worsened the illiquidity investors were trying to flee. “This self-reinforcing dynamic was broken by massive central bank intervention,” the BoE deputy told a derivatives market conference.

The Federal Reserve led the response, launching a $500 billion asset purchase programme, quintupling its repo operations and creating the ‘Fima’ repo facility for foreign central banks.

The market panic quickly subsided in the following days. But Cunliffe said it was wrong to draw the conclusion either that the episode was just a temporary period of stress, or that central banks would always be ready to “underpin market liquidity”.

Moral hazard can emerge if market participants believe the central bank will bear the cost of insuring against liquidity shocks, Cunliffe warned.

An additional problem is that central banks may not always be able to step in. “At a time of rising, externally generated price pressures or when demand is stronger than supply, inflation-targeting central banks may not find it so easy to provide massive injections of liquidity,” Cunliffe said.

Better margining

In a bid to boost firms’ resilience to liquidity shocks, the FSB is working on a series of reforms. These include measures aimed at money market funds, bond market structure, cross-border US dollar funding, and margining, among other areas.

The FSB group on margin carried out a survey that showed initial margin demanded by central counterparties (CCPs) rose 70% from the start of the Covid crisis to its peak in mid-March 2020. Daily variation margin calls rose substantially more, by more than 500%.

Cunliffe stressed that this was largely a sign the system was working as intended. Margin calls protect the value of collateral held against leveraged positions, cutting credit risk. Margin is designed to be procyclical to increase buffers during periods of stress.

“But it is right to try to dampen this dynamic to the extent practicable and to avoid unwarranted procyclicality,” Cunliffe added.

The FSB group found the model parameters used by CCPs to calculate margin tend to be opaque, and differences in parameters can lead to big differences in margins. Firms said it was often unclear how much additional margin they would have to provide during stress. CCPs did not necessarily have good data on whether firms could meet the margin calls.

Cunliffe said regulators are now looking at several areas of reform. Variation margin could be collected and distributed more efficiently, while more work is needed on whether initial margin strikes a good balance between “business as usual” and guarding against stress, he said.

Additionally, “participants need to have sufficient information, data, and tools to be able to plan ahead,” Cunliffe said. Regulators could look at requiring better simulations of possible margin calls and greater model transparency.

Lastly, clearing members and clients need to improve their own liquidity management, the BoE deputy said. He suggested liquidity measures for non-banks and steps to encourage intermediaries to pass on liquidity to clients could help.