Regulators and policymakers are calling for action to address the risks associated with the use of derivatives by pension funds, after major watchdogs admitted last week that they were unprepared to the crisis that hit the sector in September.
The collapse, which is now the subject of four separate parliamentary inquiries, revealed that regulators did not have a reliable picture of the extent of hidden leverage in liability-driven investment strategies ( LDI), which cover around £1.4bn of future pledges made by the UK. pension plan benefits.
The crisis exposed a risk that regulators had not anticipated: derivatives commonly used by pension funds had built up such leverage that they posed a threat to the entire UK gilt market.
Last week, the heads of the Financial Conduct Authority and the Pensions Regulator admitted to a House of Lords committee that they had paid insufficient attention to the use of LDI by pension funds. A succession of experienced regulators told the Financial Times that action needed to be taken.
Sarah Breeden, executive director for financial stability at the Bank of England, called on regulators, banks and investment managers to ensure the risks inherent in derivatives are managed more safely.
“The root cause is simple,” she said. “Mismanaged Leverage.”
“There needs to be more focus on areas where there is less transparency so that authorities can understand the exposure of financial market participants to these risks,” said Dietrich Domanski, secretary general of the Financial Stability Board, a committee world of regulators and central bankers.
Sudden and large margin calls related to derivative positions remain a potential source of volatility that could lead to asset fire sales, the FSB said.
Anil Kashyap, a professor of finance at the University of Chicago Booth School of Business and an external member of the BoE’s financial stability committee, said it was “deeply frustrating for regulators” that the amount of the effect of leverage in the financial sector is difficult to measure.
“Imposing stricter reporting requirements on non-banks would be helpful as it would allow leverage data to be aggregated,” he said.
Effective oversight of the LTD industry is complicated by the lack of a single, overarching regulator. The BoE is responsible for the proper functioning of the gilt market, while the TPR oversees scheme administrators and the FCA regulates asset managers. LDI funds, however, may be domiciled in Ireland and Luxembourg and are the responsibility of the regulators in those countries.
Former FCA board member Mick McAteer said coordination between regulators “went wrong”, leading to a failure to recognize risks in the web of relationships between pension schemes, consultants, asset managers, LDI funds and banks.
The Prudential Regulatory Authority should be given a greater role in supervising pension schemes and all relevant regulators should make improvements to data sharing, he suggested.
“All regulators need to review their working relationships, including any [memoranda of understanding] there is therefore a better understanding of their respective responsibilities and a clear “ownership” in the event of a new crisis,” he said.
Asset managers running LDI strategies – which include BlackRock, Legal & General Investment Management, Insight Investment and Schroders – invest in long-term government bonds to provide a reliable income stream for retirees. They also use derivatives to make leveraged bets on gilts, stocks, and inflation rates, with investment banks taking the other side of these trades.
When long-term bond yields rise or fall, leveraged gilt trades require cash to be posted as collateral. It put them at the center of a liquidity crunch for thousands of UK pension funds, which had to sell assets quickly to meet collateral calls when yields soared following the ‘mini’ budget.
No detailed information about these derivative transactions is made public, creating a blind spot for regulators, who have expressed frustration at the leverage risks effectively hidden in LDI strategies.
If the BoE hadn’t stepped in, if the BoE hadn’t stepped in, if the BoE hadn’t stepped in, the three times more indebted LDI funds would have lost all their collateral following the extreme rises in gilt yields, leaving pension schemes facing market losses of up to £150bn, according to Investec.
Some LDI funds allowed pension schemes to buy exposure worth up to £7 in gilts for every pound invested in a derivative contract, such as a swap with an investment bank, multiplying the losses suffered by the regimes when gilt prices fell sharply.
“It feels like gambling rather than hedging against interest rate or inflation risk,” said David Blake, professor of pensions at Bayes Business School in London.
Stronger safeguards – including leverage caps and higher capital buffers on LDI strategies – are now being considered, the FCA said.
Charles Counsell, chief executive of TPR, told MPs last week that the regulator had not historically collected in-depth data on LDI strategies – even though around 60% of the UK’s 5,200 defined-benefit pension schemes are using them – and would now make it a “true focus”.
Dan Mikulskis, partner at consultant LCP, said LDI funds and mandates had been made more secure.
“We advise lower debt levels, larger safety buffers and plans to realize more collateral quickly. Some plans will choose to hedge a little less while others will move more assets into the LDI portfolio and away from growth assets,” he said.
But some have warned that improved safeguards may not fully mitigate the risks of using LDI strategies.
“Asset managers should also be required to perform more rigorous stress testing and reverse stress testing to identify scenarios in which LDI funds could boom again,” Kashyap said.