Non-banking stress tests, the regulation of investment consultants and the governance of pension funds — in particular those using pooled liability-driven investment strategies — are on the minds of regulators in the wake of the U.K. liquidity crisis.
The issues were outlined Tuesday by Nikhil Rathi, CEO of the Financial Conduct Authority, as he answered questions from the U.K. Industry and Regulators Committee on the use of LDI by pension funds.
Mr. Rathi said that how a failure of a non-bank entity would be handled needs to be considered. That question of coping with failures across the financial system is in the context of much less liquid global government bond markets, particularly at the long end of the curve, Mr. Rathi said. "So assumptions around the ability to sell collateral at scale — whether that's gilts or U.S. Treasuries — that may have existed 15 years ago, those assumptions don't necessarily hold in the same way today," and all the while as monetary policy is unwinding, he added.
Mr. Rathi was among other regulators answering questions related to the use of LDI by U.K. pension funds and the September situation that saw huge collateral calls for some funds on the derivatives used within their hedging portfolios. The increased calls were triggered by rising gilt yields — and therefore plummeting prices — in reaction to the minibudget announced Sept. 23, which included a set of unfunded tax cuts. The proposals have since been reversed.
Some pension funds were forced to sell out of liquid assets — including gilts, which caused a vicious circle in terms of price drops and collateral calls — to meet their LDI managers' demands. The Bank of England intervened in the markets on Sept. 28, pledging to buy billions of pounds in long-dated gilts and effectively providing a backstop in the market.
"Not all parts of the system performed as we would have wanted them to. There were clearly gaps in capability and competence in some of the investors," Mr. Rathi said. "There were clearly gaps in the investment consultants — we do believe they should be regulated, which they are not at the moment. He said some custodian banks were "struggling through manual processing" due to the volume of transactions they were having to deal with. "So all of these, I think, are things that we will want to take forward for the future — recognizing that what happened in terms of the scale and the speed was extraordinary," Mr. Rathi said.
The structure of some funds also needs to be looked at going forward, such as pooled funds, which Mr. Rathi said are typically used by smaller pension funds.
"A lot of these perhaps don't have the financial acumen to really understand what is happening here. Also, when it's overlaid with derivatives, if you're buying a product like that, you need to have the governance decision-making in place to move very quickly when markets move incredibly fast," Mr. Rathi added. Some of these funds, he said, had terms in place that allowed for cash to be called in 10 days — which doesn't work in an environment such as Sept. 28, when there was an intraday movement in gilt yields of 127 basis points.
Mr. Rathi also said some money managers are "doing some soul-searching now as to whether that is a product that they think is going to be available in the way it has been historically, going into the future."
Questioned on the extent to which the FCA oversees investment strategies used by money managers, Mr. Rathi said that, while the FCA generally will not micromanage investment strategies, an important point around the level of protection provided to different investors is relevant.
He explained that, typically, pension funds, as institutional investors, are treated as professionals — so they have access to advice and resources to make investment decisions — and the FCA has not put in place retail-style investor protection measures.
"Saying that, what we have seen … from this experience is that where a number of investment managers are offering a particular investment strategy, they need to make sure they have understanding of the operational issues that may arise both in terms of their intermediates they're using and indeed their customers," Mr. Rathi said.
Expanding on his comment about "soul-searching" on the part of some investment managers, Mr. Rathi said, "notwithstanding that these may have been professional investors, it's not obvious that they had the financial acumen to manage some of the products that were ultimately sold to them." While strategy documents all said investors could lose 100% of their money, "the question is, did they understand what would actually happen? And I think that's something that we are all reflecting on," he added.
Speaking at the same session, Charles Counsell, CEO of The Pensions Regulator, said about 60% of defined benefit plans have invested in LDI in some way. He stressed that the strategy has led to an improvement in funding levels and that LDI helped pension funds to get through the global financial crisis and the COVID-19 pandemic.
