[9] Tentative evidence of the sharp sell-off in March corroborates the view that leverage has probably also been a source of procyclicality during the pandemic. Investment strategies reliant on low market volatility have possibly played a significant role in this. [10] These strategies have grown rapidly in recent years. Globally, there may be funds with assets under management worth around $ billion invested in some 100 risk parity funds, a well-known hedge fund strategy for multi-asset funds. These volatility-targeting funds typically use leverage when market volatility is below target, as it was before the pandemic, and they have to liquidate leveraged positions when market volatility surges. This probably amplified selling pressures in March. ECB simulations demonstrate that a strict risk parity rule would have called for a large unwinding of leveraged investments when cross-asset correlations surged earlier this year (see left chart slide 8). As volatility spiked and diversification benefits from cross-asset exposures vanished, volatility-targeting investors were prompted to sell assets and reduce leverage (see right chart slide 8). [11] The new portfolio would have had a cash share of nearly 25% as a result. Notably, asset sales would have extended to all asset classes in the portfolio, including the supposedly safer ones, in line with what we observed in the spring. Margin calls and demand for liquidity The third factor relates to margin calls. Margining requirements are an important safeguard to reduce counterparty credit risk. But they also increase liquidity risk, particularly when liquid asset holdings are inadequate.

Although we are providing clarity around how the central bank would react in the event of market-wide or large idiosyncratic stress, it is important that some of our facilities retain elements of discretion. For example, the benefits of Discount Window Facility and Emergency Liquidity Assistance could be undermined by immediate disclosure, if speculation about individual firms were to threaten financial stability. In this respect, both the Winters and the Plenderleith reports recognised that a lag between usage and public disclosure can provide a good balance between our financial stability objectives and our duty to be accountable to the public. 5. Co-ordinating liquidity support with micro-prudential policy  Historically, one of the arguments for having ambiguity over the Bank’s provision of liquidity insurance, particularly against a wide range of collateral, was that clarity would induce moral hazard. The more certain banks could be of the availability of liquidity insurance, the less incentive they would have to manage their own liquidity prudently through private markets. Acting as a mitigant against this, the expansion of the Bank’s liquidity provision capabilities has gone hand in hand with two other key developments: the introduction of stronger liquidity regulation requiring banks to hold more liquid assets (Figure 3), 8 and the creation of a resolution regime which makes it more credible that firms will be allowed to fail in an orderly manner. Taken together, liquidity insurance, the resolution regime and microprudential supervision provide a framework of incentives for banks to manage their liquidity.