Viewpoints

Q: How is PIMCO's risk management process approaching events in the eurozone?
De Leon: Our risk management practice goes beyond direct portfolio risk implications and includes legal, compliance and operational preparations. We conduct ongoing due diligence around processes and procedures that may need to be modified or adapted for potential scenarios in Europe. In addition, we enhanced our analytics and monitoring systems to accommodate a variety of potential scenarios. Although events in Europe are different in many ways than what we saw in the immediate fallout of the financial crisis, we put similar processes in place in the wake of 2008 and have continued to build on them, an approach we think helps us navigate risks, both known and unknown, on behalf of our clients.

Because a triggering event in the eurozone may come in many forms, PIMCO’s risk management process is dynamic and flexible, allowing us to evolve to understand, quantify and manage risks in broad scope and at the portfolio level. 

That said, we are particularly focused on preparation for multiple potential scenarios. We do not mean to suggest that any of these have more or less of a likelihood of playing out; rather, we view such preparation as part and parcel of our commitment to our clients. These scenarios range from a one-country redenomination with a bank holiday and capital controls put in place to a full break-up into 17 separate currencies, with bank holidays and capital controls in all countries.

I need to stress from the outset here that, as part of our ongoing monitoring of events in the eurozone, where guidelines permit we have limited exposure to many of the countries that we believe may be at most risk, and we also continue to actively manage exposures to all securities that may be affected by events in Europe.

Q: Without discussing specific clients or portfolios, what are the immediate effects a currency "exit" or redenomination might have on securities and other positions, including derivatives and swaps, and how is PIMCO positioned for such outcomes?
De Leon: PIMCO is preparing for these potential scenarios and has undertaken extensive legal and analytic review of the potential outcomes. These scenarios could play out through orderly processes in coordination with the European Union (EU) or by unilateral actions of individual countries. Most scenarios likely would entail bank holidays in order to allow time to implement any new currency regimes.

As long as the euro is not dissolved, we do not expect PIMCO’s over-the-counter derivative contracts to be redenominated, as they are typically governed by U.K. or New York law or, in some cases, German law. Forward-settling contracts most likely will be affected if they are in the country for which there is a redenomination. Capital controls initiated during any exit could lead to settlement and counterparty management issues, a potential outcome for which we are preparing.

PIMCO continues to conduct research with different industry groups on how euro-denominated derivatives would be treated in the event of a break-up.

Q: As events in Europe continue to unfold, liquidity is a paramount concern. How is the firm addressing liquidity for clients in this environment?
De Leon: In order to help ensure that we will be able to meet both potential redemptions and margin and collateral requirements with liquid assets, PIMCO has established recommended minimum cash and highly liquid short-term position requirements for portfolios. The minimum degree of liquidity in a portfolio is determined by risk parameters set by PIMCO's Investment Committee and Portfolio Risk Management team within portfolio guidelines. Those parameters take into account historical studies of withdrawals from accounts as well as a series of hypothetical stress tests and historical value-at-risk analysis.

Q: You mentioned counterparty risk; how does PIMCO manage it?
De Leon: PIMCO has an extensive process in place to effectively manage counterparty risk. The firm’s Counterparty Risk Committee oversees counterparty risk on a firm-wide basis, sets policy and standards, regularly reviews counterparties and evaluates exposures to existing counterparties.

In assessing counterparty risk, we do not rely on ratings agencies alone; our team of experienced credit analysts evaluates individual counterparties and clearing brokers using rigorous methods, including company visits, reports, earnings updates and constant dialogue. We then take into account other factors, including the counterparty’s systemic importance; the past experience of PIMCO and its affiliates with the entity; market levels for its debt, credit default swaps and equity; the quality of liquidity provided and the counterparty’s share of market participation.

As you may know, industry standardized contracts, generally known as “master agreements” or “netting agreements,” provide parties to a transaction with the ability to close out and net total exposure to a counterparty in the event of a default. PIMCO attempts to put master agreements in place on behalf of each account it manages and each separate counterparty legal entity with which we transact. PIMCO monitors exposures at the account and legal entity level, which we collateralize on a daily basis, based on a minimum transfer amount.

PIMCO has begun migrating positions to central clearing to remove the bilateral nature of OTC contracts and further help reduce counterparty exposure. To date, we have moved eligible interest rate swaps for a handful of currencies; credit default swaps on investment grade and high yield indexes; and, to a lesser degree, non-deliverable currency forwards and commodity swaps.

We are making substantial ongoing investments in technology and other resources to facilitate centrally cleared transactions.

Q: What other steps is PIMCO taking to help protect client portfolios?
De Leon: Our efforts include operational readiness and the development of detailed plans for potential eurozone events, as well as protocols to be implemented by various groups across the firm. For instance, we have conducted multi-departmental tests of our preparedness plan, involving all regions around the world, and we will continue to refine these plans and preparedness.

Elsewhere, PIMCO has actively engaged regulators and other industry stakeholders in discussions to enhance the collective understanding of the potential effects of regulatory requirements. For example, we are an active participant in industry groups, including the International Swaps and Derivatives Association (ISDA), the Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI).

Of course, communication to clients is equally important. Remember that while this is a period of significant uncertainty and volatility requiring rigorous risk management, this environment can also create needs – and opportunities – and we want to have an ongoing dialogue with our clients about them.