How Derivative Margin Calls Could Trigger Fire Sales in NBFIs, Says ECB-SNS Study

A groundbreaking study from the European Central Bank (ECB) and Scuola Normale Superiore (SNS) delves into a critical blind spot in financial stability: the liquidity preparedness of non-bank financial institutions (NBFIs) when facing derivative margin calls. The research, published as ECB Working Paper No. 3074, introduces a new analytical framework to assess systemic risk emerging from liquidity shocks in the NBFI sector. These institutions, ranging from investment funds to insurance and pension firms, are increasingly prominent in financial markets but lack access to the liquidity backstops and regulatory buffers enjoyed by banks. As the paper highlights, when market volatility spikes and margin requirements surge, these NBFIs may be forced to sell assets rapidly or default on their obligations, potentially amplifying financial instability across the system.

A Novel Approach to Monitoring Margin-Induced Liquidity Stress

At the heart of the ECB-SNS study is a dual-indicator system that measures an NBFI’s exposure to liquidity pressure. The first indicator assesses net margin flows in relation to an entity’s stock of high-quality liquid assets (HQLA), while the second focuses on variation margins, a type of daily cash payment, against the fund’s cash reserves. These indicators are designed to flag institutions experiencing unusual or unexpectedly high margin outflows. When either ratio exceeds a pre-set statistical threshold, the institution is classified as “distressed.”

The authors go further, analyzing whether distressed institutions’ asset liquidation strategies differ from those of their non-distressed peers. They also introduce a network-based contagion model to identify which banks or financial actors may be vulnerable to liquidity stress spilling over from NBFIs. This comprehensive framework is then applied to two major episodes of financial turbulence: the COVID-19 market shock in early 2020 and the monetary tightening period between 2022 and 2023.

COVID-19: A Sudden Spike in Margin Pressure

During the Covid-19 market turmoil from February to March 2020, equity market volatility surged, prompting massive increases in derivative margin calls, especially variation margins, which must be paid in cash. The study finds that margin calls in some equity portfolios grew by as much as fourfold in mid-March. By March 17, nearly 40% of the analyzed funds showed signs of liquidity stress. These calls peaked just before the European Central Bank announced the €750 billion Pandemic Emergency Purchase Programme (PEPP), which stabilized markets shortly afterward.

The study reveals that distressed funds in this period primarily liquidated Level 2B HQLA, mainly equities with lower liquidity, regardless of whether these assets formed the bulk of their portfolios. This non-proportional selling behavior suggests a reactive, liquidity-driven strategy rather than a balanced portfolio adjustment. In contrast, non-distressed funds tended to sell assets more in line with their portfolio composition. Network analysis of EMIR data revealed that although most banks had limited exposure to stressed NBFIs, a few counterparties, particularly clearing members and bilateral OTC dealers, had significantly higher inflows from distressed entities, putting them at risk of absorbing systemic stress.

Monetary Tightening: Gradual Stress, Persistent Gaps

In the second case study, covering July 2022 to September 2023, the paper analyzes liquidity stress during the ECB’s cycle of interest rate hikes to combat inflation. Unlike the abrupt Covid shock, this period represented a more predictable yet persistent form of stress. Interest rate and currency derivatives exhibited the greatest margin volatility, especially variation margins.

Even with more gradual rate increases, distress signals appeared in similar patterns. Distressed NBFIs again showed less proportionality in asset liquidation, this time selling primarily Level 1 HQLA, typically government bonds. These funds faced liquidity strain not just during ECB rate announcement windows, but also in the periods between, highlighting ongoing sensitivity to market shifts. The authors find that, much like in 2020, a small number of counterparties, mostly banks, held elevated exposure to distressed funds, which could make them conduits for contagion during market stress.

Implications for Policy and Financial System Resilience

The study provides compelling evidence that while margin and collateral requirements serve to mitigate counterparty risk, they can also generate liquidity demands that exacerbate market instability if institutions are not adequately prepared. The authors argue that liquidity preparedness should become a core part of macroprudential supervision. Their indicators can serve as early-warning tools, offering regulators a clearer view of who may struggle to meet sudden cash calls in volatile conditions.

Importantly, the research also highlights the need for better data access. While EMIR provides detailed information on derivative transactions and margin activity, granular data on fund holdings and liquidity buffers, especially cash and HQLA, remains fragmented or limited to supervisors. Enhanced data-sharing mechanisms, possibly coordinated at the international level, would allow regulators to map out systemic vulnerabilities more effectively.

Strengthening NBFI Liquidity: A Policy Priority

The study serves as a wake-up call for policymakers and financial regulators. The growing role of NBFIs in capital markets necessitates new tools to measure and manage liquidity risks, particularly under conditions of sudden market stress. As financial stability becomes increasingly reliant on entities beyond the traditional banking system, ensuring that NBFIs can meet their margin obligations without triggering fire sales or contagion is essential.

The ECB and Scuola Normale Superiore researchers offer a robust, data-driven solution that aligns with recent calls from the Financial Stability Board and the Bank of England to improve NBFI resilience. By bridging the gap between macroprudential theory and operational monitoring, this framework stands to become a key element in safeguarding the financial system the next time the margins call.