LDI liquidity crisis – policy and regulatory responses

The immediate panic caused by the liquidity crisis that affected a large number of defined benefit (DB) pension schemes invested in liability driven investment (LDI) funds in September and October 2022 has now passed. However, a great deal of attention continues to be focused on understanding the causes of the crisis, ensuring steps are taken to maintain the resilience of LDI funds and identifying the lessons that can be learnt and the actions needed to prevent a repeat. Indeed, the House of Lord's Industry and Regulator's committee has today written to the City and Pensions Ministers outlining several recommendations for reform.

Other parliamentary committees have also been scrutinising the use of LDI by UK pension funds and the impact this had on fiscal events in Autumn 2022. The committee hearings and written evidence provided to them (together with today's letter) give some indication of the steps that pension schemes, asset managers and investment advisers might expect to be taken by policymakers and regulators to reduce the risk of the LDI liquidity crisis (or similar events) being repeated.

These include:

• new regulatory guidance and potential restrictions on the use of LDI and leverage by UK pension schemes (including the operational and governance processes schemes should have in place to manage liquidity);
• new requirements for UK pension schemes, asset managers and funds to provide more data to UK and overseas regulators on underlying scheme investments (including LDI exposures and the associated leverage);
• extending the pensions notifiable events framework to cover LDI; and
• individual pension scheme investment consultants being brought within the FCA's regulatory perimeter.

Some of these actions are already underway with the Pensions Regulator issuing guidance on 12 October 2022 and 30 November 2022 regarding the level of resilience that should be held and maintained in leveraged LDI funds used by occupational pension schemes. Further guidance is due to be published by the Financial Conduct Authority (FCA) and the Pensions Regulator in March and April 2023 respectively.

Parliamentary scrutiny

Several hearings on the LDI liquidity crisis and the fiscal events of Autumn 2022 have been held by various parliamentary committees. Witnesses have included senior figures from the Bank of England, the FCA, the Pensions Regulator, the Pension and Lifetime Savings Association as well as pension scheme actuaries and investment consultants and LDI fund managers.

Scrutiny from the committees has focused on a range of issues including the use of leverage in LDI structures, regulatory oversight of LDI funds, regulation of investment consultants, operational issues and trustee understanding.

Contributing factors

Although many of the witnesses have stressed the exceptional nature of the events following the mini budget at the end of September 2022, leveraged LDI funds have been identified as having been a primary cause of the turbulence in the gilt markets. In its letter to the City and Pensions Ministers published today, the House of Lord's Industry and Regulators Committee, makes clear its view that "While the fiscal statement was the trigger for changes in gilt markets, we believe that the downward spiral was caused by the presence of leverage in LDI funds and subsequent collateral demands from lenders against a backdrop of rising inflation and interest rates". It goes on to say that "If it were not for the use of leveraged LDI, then it is likely there would only have been some volatility and a market correction". Consequently, it concludes that "the use of LDI strategies caused the Bank of England intervention".

A range of factors associated with the operation of leveraged LDI funds have been identified as having contributed to this. These include:

• operational issues, including concerns about the speed with which some schemes were able to respond to the crisis, difficulties obtaining scheme-specific information from asset managers and delays caused by the operational processes around LDI products, such as the frequency of dealing and the ability of fund managers to access cash in other parts of their organisation in a timely manner to meet collateral calls;
• the fact the urgent calls for collateral affected so many schemes at the same time which created operational challenges for advisers and asset managers (such as notifying affected schemes and providing information in a timely manner) and created bottlenecks (for example, in processing trades to liquidate assets);
• stress tests (by regulators, asset managers and trustees) and liquidity buffers not anticipating such a sharp and rapid rise in gilt yields;
• the lack of data available to UK regulators to enable them to identify the risks posed by schemes' LDI strategies;
• the fact most of the LDI funds in question were located outside of the UK (principally in Ireland and Luxembourg) which meant UK regulators were reliant on their overseas counterparts for oversight and information gathering;
• the procyclical nature of margin requirements which meant schemes and asset managers were being forced to sell gilts to meet margin calls, compounding the problems in the market; and
• how illiquid and dysfunctional the gilt market became, especially the index-linked market, with even small trades moving prices significantly.

Alongside this, the Industry and Regulator's committee also points the finger at accounting standards which it says is "the fundamental issue identified by the Committee" on the basis that "leveraged LDI has been created as a solution to an artificial problem created by accounting standards, but in the real world its application creates downside risks". In its view, "[t]he approaches of accounting standards, the regulator, and the widespread adoption of leveraged LDI has transformed pension schemes from being long-term institutions into ones focused mainly on short-term volatility in prices and interest rates."

More broadly, concerns have also been expressed about the resilience of the non-banking system more generally and the lack of regulatory oversight of this sector.

Pooled v segregated funds

In general, the liquidity problems appear to have been more severe for pooled LDI funds as opposed to those with segregated accounts. Although pooled funds represent only 15% of the LDI market, in her evidence to the Work and Pension Select Committee on 1 February 2023, Sarah Breeden, Executive Director for Financial Stability, Strategy and Risk at the Bank of England, identified the problems experienced by pooled LDI funds as one of three key factors which caused the stress in the LDI market.

Segregated LDI funds have a single fund dedicated to each pension scheme. The fund manager will often also have access to other assets held by the relevant pension schemes which can be used to meet a liquidity call.

In contrast, there are around 175 pooled LDI funds, with 1,800 individual schemes participating in them. Therefore, operationally it takes time to recapitalise a pooled fund, with such processes typically taking a couple of weeks. Given the speed and scale of the rise in gilt yields seen last Autumn, in several instances pooled funds could not recapitalise quickly enough, which meant they were forced to sell assets. As a result of the challenges faced by pooled LDI funds, some pension investment consultants have downgraded them.

Policy and regulatory response

It seems inevitable that action will be taken by policymakers and regulators in light of the LDI liquidity crisis. Indeed, steps have already been taken to mitigate the risk of a repeat. For example, co-ordinated statements were issued by the Central Bank of Ireland, the Commission de Surveillance du Secteur Financier, the UK Pensions Regulator and the FCA on 30 November 2022 setting out the levels of resilience that should be maintained in LDI funds.

While it is not possible to be certain what further steps will be taken, based on the issues and concerns identified in the parliamentary hearings to date and the written evidence that has been submitted, it appears this may include some or all of the following:

• new regulatory guidance and potential restrictions on the use of LDI and leverage by pension schemes;
• new requirements for UK pension schemes, asset managers and funds to provide more data to UK and overseas regulators on underlying scheme investments (including LDI exposures and associated leverage and liquidity buffer);
• the extension of the pensions notifiable events framework to cover LDI;
• pension scheme investment consultants being brought within the FCA's regulatory perimeter;
• new requirements for market and pension scheme stress testing to assess the impact of more severe market events; and
• new requirements for trustees to ensure they have adequate operational and governance arrangements to manage liquidity in stressed scenarios.

It has also been suggested that:

• there should be greater flexibility around the type of assets that can be posted as collateral by pension schemes; and
• improvements should be made to the operation of pooled funds, including increasing the frequency of dealings, pooled LDI fund managers having greater visibility over where clients have access to additional collateral and improving the communication between pooled fund managers and end investors, particularly in a stressed scenario.

Addressing this latter point, the FCA has called on LDI fund managers to address the operational issues they encountered last Autumn including:

• the speed at which they are able to rebuild liquidity buffers or rebalance funds;
• their ability to communicate critical information to individual clients, often in large quantities, in a timely manner; and
• ensuring they or their key stakeholders (such as bank counterparties) have arrangements, including the operational capacity and contractual authority, in place to carry out required actions such that sufficient liquidity in LDI funds can be realised in times of stress.

Industry and Regulators Committee recommendations

Picking up on the need for reform in its letter to Ministers, the House of Lord's Industry and Regulators committee recommends that:

• The Government and the UK Endorsement Board should review the system of pensions accounting to see whether a less volatile, longer-term asset-led approach would be more appropriate for schemes that still have some time left to run. In particular, it says that the solution would be "to adopt accounting standards for parent companies and pension funds which reflect the expected long-run return on the actual asset portfolio, enabling pension funds to invest an appropriate share of their portfolio in equities and other real assets without increased volatility in the reported fund deficit, and avoiding the need for leveraged LDI strategies to boost their returns".
• The Government should review whether the use of leverage and derivatives by pension schemes should be more tightly controlled in the future. If schemes are to continue to use leveraged LDI, it calls for far stricter limits and reporting on the amount of leverage allowed in LDI funds and greater liquidity buffers introduced for leveraged exposures.
• The Government should ensure that investment consultants are brought within the regulatory perimeter as a matter of urgency.
• Regulators should ensure they have more information on the leverage present within pension scheme finances and that stress tests are conducted. The more bank-like strategies and instruments that are used by pension schemes, the more bank-like its supervision should be, and the Government should consider giving the Prudential Regulation Authority a role in overseeing pension schemes.
• The Pensions Regulator should be given a statutory duty or ministerial direction to consider the impacts of the pensions sector on the wider financial system. The Financial Policy Committee should continue to take the lead on systemic risks to financial stability and should be given the power to direct action by regulators in the pensions sector if they fail to take sufficient action to address risks.

Next steps

The enquiries being conducted by the various parliamentary committees are ongoing. As we have seen today, the committees will not hold back in making recommendations for how the LDI market and the use of leveraged LDI by DB schemes should be regulated and reformed to prevent a repeat of the events that unfolded towards the end of last year and to address the systemic risks posed by such funds.

All eyes will be on how policymakers and regulators respond. We may gain some further insights into this in the coming months with:

• the FCA due to publish a further statement on good practice for LDI managers in March 2023; and
• the Pensions Regulator due to include further guidance on minimum levels of resilience in LDI funds and on scheme's operational and governance processes in its Annual Funding Statement 2023 (due to be published in April).

The FCA is also working with the Bank of England and the Pensions Regulator to develop a longer-term resilience standard for LDI funds. This will be considered by the Financial Policy Committee of the Bank of England during the first half of 2023.

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