Derivatives have become a critical tool for Australia’s massive superannuation sector, as funds look to manage the risks associated with their expanding offshore investments. The use of derivatives brings real risk management benefits, but it also means funds need to closely monitor their liquidity needs – and recognize that demands for cash and other high-quality liquid assets can suddenly spike during periods of stress. We believe use of a risk-sensitive margin methodology like the ISDA Standard Initial Margin Model (ISDA SIMM) can play an important part in responding to these dynamics, and we’re helping to support implementation within the sector.

The Australian superannuation industry has grown rapidly to become the fourth largest globally, with assets equivalent to roughly 160% of GDP. Around half of those assets are invested offshore and that proportion is predicted to rise further. The Reserve Bank of Australia (RBA) expects the system to grow to about 180% of GDP within a decade, with overseas investments approaching 75%. To manage the risks associated with that global exposure, Australian superannuation funds have been increasing their use of derivatives – FX hedges alone are estimated to total A$500 billion ($357 billion), and the RBA estimates this could double in 10 years.

That expanding use of derivatives means superannuation funds need to closely monitor and manage the liquidity implications. For funds subject to regulatory margin requirements on non-cleared derivatives, both initial and variation margin can create significant and sometimes sudden calls on liquid resources, especially during periods of stress. While FX swaps and forwards – widely used by superannuation funds – are exempt from regulatory margin requirements, banks may start to require their superannuation fund counterparties to provide margin on a discretionary basis to reduce credit and capital charges as FX hedge books grow. Even if FX swaps and forwards remain unmargined, these short-dated instruments require regular rollover and settlement, concentrating liquidity needs at specific points in time.

The result is a more complex and dynamic liquidity profile – one that requires robust planning, governance and risk management. ISDA published a paper earlier this year that explores these dynamics and recommends a series of actions that funds could take in response, including establishing repo and other contingent liquidity facilities, broadening eligible collateral for non-cleared derivatives where possible and strengthening stress testing, early warning indicators and contingency planning.

A key part of the solution is ensuring margin requirements accurately reflect risk – which is where the ISDA SIMM has a vital role to play. As a risk-sensitive model, the calculated margin amounts better reflect the actual risk of a portfolio than the standard regulatory schedule, helping to avoid over-margining and reducing avoidable liquidity drains. There are important risk management benefits too. A common, transparent model reduces the scope for disputes and allows margin to be agreed and exchanged more quickly – a critical advantage in volatile conditions.

It’s clear there is strong interest from the superannuation community to use the ISDA SIMM. We were in Sydney last week and ran training on the model, which was very well attended by the superannuation sector – a program we intend to repeat later in the year. To use the ISDA SIMM, however, superannuation funds must get authorization from the Australian Prudential Regulation Authority (APRA), and there is some trepidation over what the application process involves and a lack of clarity on what exactly is needed to obtain approval. This is different to the experience of buy-side firms in other jurisdictions, which can use the ISDA SIMM with limited impediments.

In our view, there are clear benefits to using the ISDA SIMM – the model is widely used, rigorously tested and governed, and subject to ongoing regulatory review. It is also now calibrated on a semiannual basis, ensuring the model is updated in a predictable and efficient manner. In contrast, the standard regulatory schedule is a blunt and static tool that does not evolve with market conditions.

There is a shared objective here: resilient, well-managed funds and stable, efficient markets. In our view, use of the ISDA SIMM supports both. We will continue to work with the industry – through training, advocacy and engagement with APRA – to help provide greater clarity and facilitate adoption.