Ask about liability-driven investment and it is striking how little people otherwise expert in financial matters know. Hey, we’ve all been on a crash course in recent days — not least sterling, the gilts market and the Chancellor of the Exchequer.
Still, even those immersed in this corner of the pensions world have precious few hard answers. How big is the market? How fast has it been growing? What is the derivative exposure within it? How has leverage risen?
“In terms of who is doing what business and at what leverage, I don’t think anyone in the market has a particularly good picture”, said Simeon Willis, at consultancy XPS Pensions.
Take a step back from this week’s crisis intervention by the Bank of England to calm the gilts market. LDI is a perfectly sensible thing for a pension fund to do. At its most basic, it involves buying assets, often government bonds, to match future liabilities. Perhaps £1.5tn in liabilities, though no one seems quite sure, is hedged using LDI.
Some of that money will use leveraged derivatives, like interest rate swaps or gilt repos, to match liabilities and protect from market moves. Defined benefit pension funds have been herded in this direction by none other than the government. “Government pressure for schemes to de-risk has encouraged financial engineering to get the most out of assets,” says Patrick Bloomfield, a partner at consultant Hymans Robertson.
To take a simplified example, a pension fund buys £100 of gilts and then sells to a bank with an agreement to buy them back in a year at a specified price. (Collateral is due on the trade depending on whether gilts rise or fall.) The fund takes the £100 it got for its gilts and does it again: another £100 of gilts, another repo transaction. And again. And again.
The result is that when gilts fall the fund is on the hook for margin calls on several hundred pounds worth of contracts compared with its original £100 of gilts. A sharp fall prompts a scramble for collateral, sparking more selling and downwards price pressure. On Tuesday, before the BoE stepped in, there was a liquidity squeeze: some funds couldn’t get cash fast enough to meet the increasingly urgent collateral demands.
Regulators were aware of rising use of these derivatives, dubbed a time bomb this week by the head of Next. A 2019 survey for The Pensions Regulator and the BoE found that nearly half the schemes surveyed had increased their use of leverage. Pension funds can strike their own deals but many invest via pooled vehicles, managed mainly by Legal & General, BlackRock or Insight. The permitted leverage ranged, at that point, from 1 to an alarming 7 times.
That work bizarrely hasn’t been updated. The pensions watchdog said funds don’t provide the information, even around leverage, as part of their annual returns (and no one apparently thought to ask).
The BoE, which monitors system-wide risk, did a one-off stress test in 2018 and concluded that there appeared to be “no major systemic vulnerability”. But it added that “more complete and consistent monitoring is . . . required” and that “data currently reported to the supervisors of non-banks are not sufficient to measure the risks from leverage.”
There is a definite whiff here of a market that fell between different watchdogs, with each trained on its own issue. The LDI funds are generally offshore. Regulation of the asset management companies is done by the Financial Conduct Authority, which has been talking to them since July. The BoE, which oversees bank counterparties in the trades, clearly knew this market could cause problems despite the 2018 all clear: a 2021 paper on the “dash for cash” at the beginning of the pandemic mentions the role of “LDI investors facing margin calls”. At the very least, the regulators collectively identified a vulnerability but didn’t entirely address it.
It would be too convenient just to blame the watchdogs. Let’s be clear: if the government puts a bomb under the gilts market, then someone somewhere is going to blow up. The sell-off since the “mini” Budget last Friday was 2.5 times that seen in the 2020 dash for cash, far exceeding what was considered an extreme stress test in 2018.
Regulators perhaps appear uncoordinated or slow to focus on the potential implosion of this murky corner of the pensions world. But it was the government, ultimately, that lit the fuse.