(March 6, 2012) — The United Kingdom Government could cause a ‘flash crash’ in June, should it liquidate a certain section of the Royal Mail Pension Fund portfolio it is set to take over later this month.
The pension fund portfolio contains £2.7 billion in UK equity futures, classed as a ‘return-seeking overlay’, according to its latest annual report. These futures are due to either roll over in June, as has been the case for the past couple of years, or be liquidated.
The £2.7 billion figure is equivalent to around 7.5% of the UK FTSE futures market, according to data from Bloomberg this morning.
Market analysts said this figure would be equal to around 80% of an average day’s trading volume on the FTSE100 and could have a dramatic impact on the market if liquidated.
An investment banking analyst said: “Using our Market Impact model and simulating the sell of the underlying cash we would expect an impact cost of around 2%. This trade as a percentage of the average daily volume (ADV) of each stock represent 80% of the ADV so a careful execution of that trade would be needed to minimise its impact.”
According to Bloomberg, the market capitalisation of the entire FTSE index was around £1.65 trillion this morning. Using these calculations, unwinding these positions in June could have a £16.5 billion impact on the UK equity market.
The government is set to take control of the pension fund’s assets, which belong to the legacy public sector company, this month once a hurdle set by the European Union has cleared the path for transferral. The Government will then be responsible for paying the members’ pensions.
In autumn last year, the Office for Budget Responsibility commented on the £25 billion in potentially transferred assets: “There is significant uncertainty over the timing, nature and size of the corresponding transactions, with the proposal still subject to state aid discussions. However, there are potentially very large fiscal implications, for example public sector net borrowing (PSNB) may be reduced by around £25 billion in the year the transaction takes place.”
If the Treasury is to take over the portfolioit will have to decide what to do with the futures contracts. If it rolls them over for another year, it risks political backlash should the UK equity markets fall and result in a derivatives loss; but if it unwinds the positions, there is a risk of a ‘flash crash’ as the UK stock markets would be flooded with unwanted futures positions.
Since June 2011, these futures would have so far produced a 1.6% return, according to Bloomberg.
A panel of transition managers has been appointed, but not yet named, by specialist firm Inalytics to transfer the assets of the pension fund into government accounts. No detail has been given on the terms of their mandate.
In this month’s magazine, aiCIO revealed the Royal Mail Pension Fund had been overcharged by State Street for its transition management work last year, which led to a refund by the bank and the dismissal of two of the department chiefs.
There is precedent by the UK government to sell down pensions assets it has taken on. In 2004, the Treasury assumed the liabilities for the nuclear industry, and with it took over the £4 billion Nuclear Liabilities Investment Portfolio (NLIP) from British Nuclear Fuels (BNFL).
Following this move the treasury liquidated the portfolio of managed funds and index-linked gilts in two stages, according to the Government’s Debt Management Office (DMO). The first part was to liquidate managed investment funds, and redeem one of its index-linked gilts in December 2006. The remaining £1.8 billion of index-linked gilts were sold in May and June of 2007.
A Department for Business, Innovation and Skills spokesperson said: “At this stage we are not able to comment on the level of assets transferring to Government. However we will look to realise all assets in a measured fashion whilst seeking to avoid any market distortion.”
The Royal Mail Pension Fund declined to comment.