Pension funds, hedge funds and other non-bank market participants need to up their game when it comes to liquidity preparedness in times of marketwide stress, the Financial Stability Board said.

A consultation paper published on April 17 by the FSB, an international body that monitors the global financial system and makes recommendations, identified weaknesses in risk management and governance as key causes of inadequate liquidity preparedness by some market participants during recent periods of liquidity stress in markets.

The report highlighted recent market stresses — such as the September 2022 gilt market crisis that affected many liability-driven investment strategies and the pension funds that used them, turmoil in certain commodity markets in 2022, and the collapse of family office Archegos in 2021 — as underscoring “the importance of margin and collateral calls to financial stability.”

The FSB outlined eight policy recommendations for non-bank market participants that might face margin and collateral calls — including pension funds, hedge funds, insurance companies, other investment funds and family offices. It wants market participants to comment on its proposals by June 18.

Recommendations one to three cover liquidity risk management practices and governance, including requiring contingency funding plans to ensure liquidity needs can be met and regular reviews of liquidity risk frameworks.

Recommendations four and five cover liquidity stress testing and scenario design, calling for the identification of sources of liquidity strains and “stress tests to cover a range of extreme but plausible scenarios, including both backward-looking and hypothetical.”

The final three recommendations cover collateral management practices, setting out “the need for sufficient levels of cash and readily available and diverse liquid assets and collateral arrangements to meet margin and collateral calls.”

The proposals apply to margin and collateral calls in centrally and non-centrally cleared derivatives and securities markets, including securities financing such as repurchase agreements, know as repo. The proposals are high-level and cross-sector policy recommendations, building on and complementing existing rules and regulations, the FSB said.

“The overarching objective of the FSB’s work on liquidity preparedness for margin and collateral calls is to reduce excessive procyclical behavior of market participants in response to margin and collateral calls during times of marketwide stress, both by enhancing market participants’ liquidity preparedness and by strengthening the ability of authorities to monitor and manage associated financial stability risks,” the consultation paper said. “The recommendations in this report aim to strengthen the overall resilience of the financial system by enhancing the liquidity preparedness of non-bank market participants for margin and collateral calls and thereby reducing excessive procyclical behaviour.”

The FSB said other internal work to be carried out this year “will address the strengthening of authorities’ ability to monitor financial stability risks associated with inadequate liquidity preparedness for margin and collateral calls.”

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