Estimated 6 minute read

Following on from the piece on the recent ECB stress test analysis that rang the warning bell on the probable liquidity squeeze that is likely to come as a result of the upcoming changes in CCP clearing rules, this piece takes a deeper look at Denmark, and its pension funds’ possible liquidity issues.

In November 2019, the Danish central bank published an analysis of the current state of derivative use by the Danish pension fund market, as well as anticipating the upcoming changes in the derivative clearing rules. The conclusion was that the pension fund industry was a heavy user of derivatives, and that the changes would create a large liquidity risk that would be extremely challenging for the funds in the market to deal with unless they treated ‘margin led liquidity risk’ as a specific risk to be managed and mitigated. This analysis broadly agreed with the findings of the ECB stress test, published in the summer of 2020, but is interesting in its own right as it highlights how specific states within the EU have additional issues over and above the rule changes, due to their local characteristics.


Denmark has a traditional mix of EU pension fund types, meaning that it has a large guaranteed benefit sector, but also local characteristics…

Denmark has a significant proportion of ‘guaranteed benefit’ pension schemes, which mean that the final benefits paid by the scheme are sensitive to interest rate moves. This can be seen below in the chart taken from the report which illustrates the relationship between the present value (PV) of the liability under interest rate stress:

The present value of guaranteed benefits falls when interest rates rise

Source: Danmarks Nationalbank. Stylised example of how the present value of guaranteed benefits is affected by changes in interest rates.

The result is that Danish pension funds use derivatives, mainly interest rate derivatives, to hedge the interest rate risk that is built into the ‘guaranteed benefit’ heavy system. Interestingly, the Danish funds are among the front runners across the EU market to voluntarily move to central clearing, with 42% of derivative clearing already moving through Central Counterparty Clearing Houses, such as LCH or Eurex.

The majority of pension companies’ interest rate derivatives are bilateral contracts

Currently the funds choose whether they trade bilaterally or through CCPs, but soon changes will move through the industry, including a minimum threshold of notional derivative holdings ($8bn) and a requirement to pay part (the risk associated portion) of the margin (known as the Initial Margin or IM) in cash.

Here we see the added complexity for Danish funds. They must post margin mainly in Euros, rather than Danish Krona. This wrinkle means that these funds are dependent upon both the repo and the FX market, with their two day settlements, for their extended margin liquidity (short term or one day cash generation to pay unexpectedly high margin). As with virtually all pension funds globally, the sale of fund assets to raise cash to post as margin is seen as a worst-case scenario, as it reduces the funds ability to maintain its funding ratio between its assets and liabilities.

Source: Danmarks Nationalbank. Data based on Danish pension companies’ interest rate derivatives at end-September 2018.

With all of this in mind, the central bank ran tests that involved interest rate moves of 1% (medium to high volatility for the country) and found that under these circumstances, and the new rules, most funds would be unable to post the required collateral using available cash.

Companies’ bank deposits will not cover a 100 bps variation margin call

Source: Danmarks Nationalbank. Portfolio of assets for companies included in the analysis. 


The funds would usually rely on the banking system for emergency liquidity needs through short term borrowing…

The most obvious source of ‘plan B’ liquidity is the banks, but here there are factors related to COVID-19 to be taken into account. The particular issues facing banks and their balance sheets have been covered in a separate piece but the basic points are:

  • Asset values are down across the balance sheet due to the pandemic
  • New Accounting Measures (IFRS9) mean that credit risks have to be more rigorously represented in the RWAs that form the balance sheet
  • Post pandemic re-ratings will exacerbate the downgrading of ratings, further shrinking the balance sheets
  • Banks may become far more selective in how they lend or leverage their balance sheets

It is the case that the Danish economy fared relatively well, especially compared to its sister states in the EU, but still fell 7.4% in the second quarter of 2020. This means that the impacts above are highly relevant to the Danish market, as the funds will not be able to necessarily rely on banks for emergency repo financing. The potential weakness of ‘plan B’ shines a spotlight on liquidity management within pension funds, particularly liquidity risks associated with margin calls in the world of central clearing.

It is this finding, by the central bank that leads them to conclude that the pension fund market has a significant liquidity risk to deal with as the rule changes roll through by September 2021 (with a slim possibility of some kind of extension to a farthest out date of 2023).


Pension funds looking to manage this risk must act like bank treasuries…

The key to controlling this liquidity risk is active margin management, effectively treating the derivative process the same way that bank treasuries do, including:

  • Stress testing and forecasting margins
  • Intelligent pre-trade optimization
  • Regular, targeted, rebalancing of the trades across CCPs and FCMs (brokers)
  • Constant monitoring and management of the end to end derivatives process

As with the voluntary use of central clearing, the Danish pension fund industry is ahead of the game with two of its largest funds, PFA and ATP actively engaging OpenGamma to provide the tools to perform these vital processes.

Active derivative management not only provides the necessary tooling for 21st century risk management but provides enhanced processes and savings through the entire economic cycle, as Jan Ritter, senior vice president, Liability, Hedging & Treasury at ATP (in an interview with Total Derivatives) says, “I recommend the pension industry starts building up its treasury side and putting in place the right processes and structures to be ready for the future”


In summary, the Danish pension fund market is generally forward looking, in its use of derivatives, its use of central clearing and its active management of the derivatives clearing process. This forward looking attitude will be much needed as the EU recovers from COVID-19 at the same time as imposing new rules on banks and derivative clearing.


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