[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.

Initial and variation margins collected by four European central counterparties together increased by around € billion during the peak of the crisis (see left chart slide 9). Total variation margins posted by euro area investment funds rose more than fivefold over the same period and exceeded pre-pandemic cash positions for more than one-quarter of funds with derivative exposures. [12] To meet margin calls, some euro area insurers and pension funds that make extensive use of interest rate swaps and foreign exchange derivatives liquidated shares held in money market funds (MMFs). [13] There was a striking correlation between margin calls and MMF outflows over the entire period of market stress (see right chart slide 9). [14]  Systemic risks due to interdependencies Taken together, low liquidity buffers, pockets of leverage and rising margin calls gave rise to perilous price spirals and contagion that threatened to destabilise the entire financial sector through network effects. https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp201119_1~4a1ff0daf9.en.html  3/7  20/11/2020  COVID-19 and the liquidity crisis of non-banks: lessons for the future  Insurance corporations, for example, not only rely heavily on MMFs for their liquidity management, they also hold over 25% of their assets in investment fund shares. This meant that pressure on investment funds in March negatively affected insurers’ profitability. For the United States, Darrel Duffie and others have provided evidence that the dislocations in the US Treasury market can in part be accounted for by non-banks heavily relying on government bonds for their liquidity risk management.