If you are wondering what’s behind the sudden largesse of the European Central Bank (ECB) when it comes to purchases of bonds, you may find a recent speech by an ECB official at a conference about financial stability enlightening.
While regulators focused on making banks safer following the 2007-2009 financial crisis, the non-bank financial sector has been allowed to continue without the same stringent requirements for liquidity and leverage. This gap came into sharp focus during the crisis caused by the Covid-19 pandemic.
The non-bank financial sector consists of entities such as investment funds, hedge funds, insurance companies, peer-to-peer lenders – essentially, financial institutions other than banks.
It would be a mistake to say that these institutions are not regulated. However, the focus seems to be on how they present information about themselves and their products to customers, rather than on how they conduct themselves in the markets.
This oversight may have contributed to the market turmoil in March this year, and it is something that needs to be addressed, according to a recent speech by Isabel Schnabel, a member of the ECB’s Executive Board.
Since the financial crisis of 2007-2009, the share of nonbank credit in eurozone companies’ total external debt financing has doubled, to represent around a third currently; the share of marketable debt securities (essentially, bonds) in external financing has also doubled in the eurozone in the same period.
“These developments are to be welcomed,” Schnabel said, as it means the markets are deepening and the sources of finance for companies are diversifying. But, she added, “the macroprudential framework for the non-bank financial sector is still in its infancy.”
This is why the ECB was forced to take drastic measures during the panic that engulfed the markets in March.
Many funds were selling what they could, not necessarily what they wanted, to meet the redemption requests of their clients.
Because of this, bond spreads widened beyond the rise in perceived default risk, net asset value spreads for exchange-traded funds widened to record levels, and even yields on the safest global government bonds spiked — despite a flight to quality.
This latest phenomenon, in Schnabel’s opinion, suggested that “more was going on.” Demand for liquidity was unusually high.
The investment fund sector alone sold securities worth almost €300 billion in the first quarter of the year, or 3% of its assets under management. High yield corporate bond funds’ outflows were an eye-watering 10% of their assets under management.
Still, the redemptions don’t tell the full story. Schnabel said the evidence suggested the funds in the eurozone sold more securities than their clients redeemed.
Liquidity, leverage, margins
Three factors were behind this: a mismatch between the liquidity of the funds’ assets and their redemption policies, too much leverage, and margin calls.
For the first factor, funds with illiquid assets were lulled into a false sense of security by low volatility before the pandemic and had reduced their cash holdings. When the markets went down, they sought liquidity, but it was too late. This resulted in forced sales, amplifying the markets’ fall.
The second one, leverage, has to do with risk parity strategies — in which investors allocate risk, rather than capital. They use leverage to do this, and risk is conflated with volatility. The strategy works well when volatility is low, but when it spikes as it did in March, the pain is amplified by the investors’ leverage.
“As volatility spiked and diversification benefits from cross-asset exposures vanished, volatility-targeting investors were prompted to sell assets and reduce leverage,” Schnabel explained.
Finally, margin calls played an important role as well. Margin requirements – the amount of funds an investment entity must have available at all times in order to be able to trade – are used to reduce counterparty credit risk.
But, Schnabel said, during those high volatility days, some eurozone insurers and pension funds that use a lot of interest rate swaps and foreign exchange derivatives liquidated their shares in money market funds in order to meet margin calls.
ECB to the rescue
“There was a striking correlation between margin calls and money market funds outflows over the entire period of market stress,” she said.
To save the markets, the ECB launched the pandemic emergency purchase programme (PEPP), which “had a strong and immediate stabilising effect on financial markets” as “it instantly addressed the issue of illiquidity, instilled confidence and thereby reduced systemic stress and bond spreads,” Schnabel said.
Still, the ECB will not be able to keep pulling rabbits out of its hat forever.
If the saying “never waste a good crisis” will be followed this time, expect regulators to work on the three areas highlighted above. More stringent conditions could be imposed on the use of liquidity, leverage and margin trading for investment companies.
However, it remains to be seen if the new regulations, when they come, will try to make sure they do not hinder investment. This is crucial at a time when capital needs more than ever to flow freely where it is needed.