Liability-driven investment strategies used by U.K. pension funds sold around £23 billion ($28.1 billion) of gilts during September and October's liquidity crunch, as they raced to meet collateral requirements.
Speaking at a House of Commons Treasury Committee hearing on Monday, Andrew Bailey, governor of the Bank of England, added that pooled LDI arrangements were forced sellers of assets over the liquidity crunch period, starting the last week of September through mid-October.
Following a Sept. 23 announcement of unfunded tax cuts by the then-chancellor of the exchequer — proposals that were later rescinded by a new government — U.K. gilt yields soared and prices plummeted. Some pension funds with leveraged LDI programs, used to hedge liabilities, faced huge and multiple collateral calls to keep their hedges in place and were forced to sell liquid assets in order to meet demands.
Mr. Bailey said it was an "85:15 situation…85% of these LDI funds were what is called segregated funds: a big pension fund has a single LDI fund dedicated to itself. And 15% were in so-called pooled funds, which were smaller pension funds coming together into a pooled LDI fund." He said there are about 175 pooled LDI funds representing about 1,800 underlying pension funds.
"It was the pooled funds that were the forced sellers, so it was the 15%," Mr. Bailey said.
One of the issues, he added, is that "the pooled funds have a limited liability structure. That is obviously essential in that structure because no one pension fund is going to take on the liabilities of every other pension fund that is in the pooled fund." Therefore, pooled LDI arrangements have triggers in place to sell assets and thereby became forced sellers, Mr. Bailey said. That 15% of the LDI market "remained relatively obscure, and the fact that this legal structure was sort of buried in there was also somewhat obscure."
Asked what lessons will be taken from the LDI-related liquidity crunch, Mr. Bailey said that none of the pooled funds are U.K.-domiciled, but rather located in parts of the European Union. "You have to further regulate. I mean, we are already doing that, by the way; I know the microregulators are, but you have another dimension to the regulatory situation," Mr. Bailey said.
Discussing regulatory measures put in place since the liquidity crunch, including by the U.K. Pensions Regulator, Sam Woods, deputy governor for prudential regulation at the BOE and CEO at the Prudential Regulation Authority, also speaking at the hearing, said: "We are in a sort of stopgap situation."
TPR in November reaffirmed the need for pension funds to hold higher buffers for LDI-related strategies, while European regulators had already highlighted increases in yield buffers to 300 to 400 basis points on average.
Regarding increased levels of collateral buffers, "we think that is okay for now. The recommendation we have made is that that needs to be maintained for the moment, but we need steady-state expectations as well. That is the next stage. Although it is great that we have the stopgap, I think the real test here will be whether those steady-state regulations do the job," Mr. Woods added.
