LDI: all in it together, but some responsibilities are regulators’ alone

The overview helpfully reminded trustees that they “are ultimately responsible for how the assets in your scheme are invested”, and that “investments must be appropriate for your scheme”. 

The purpose of the guidance is to raise awareness of the additional risks faced in using leveraged LDI. These include the liquidity risks and requirements for collateral, since demands can change over short periods as interest rates change.

The updated position follows the Bank of England’s recommendation that pensions regulators impose a minimum collateral buffer of 250 basis points on LDI positions to avoid the liquidity event prompted by then-chancellor, Kwasi Kwarteng’s “mini” Budget in September 2022. 

Do you remember, the 23rd night of September?

The Financial Conduct Authority also published guidance on April 24, advising asset managersof the need to ensure their LDI portfolios are resilient to future market volatility.

FCA executive director for markets Sarah Pritchard said: “Since September last year, we have been closely monitoring asset managers using LDI strategies as they make improvements and the sector is now much more resilient to potential risks, but there is more to be done.

“This guidance sets out what we expect in terms of risk management, stress-testing and client communication, so that the necessary lessons are learned from last September’s extreme events. Many of these lessons will be relevant to firms beyond the LDI sector.”

A higher bar is being set. It’s clear that a siloed approach from investment manager or investment adviser, narrowly focused on their own role alone, is insufficient to meet expectations.

Simeon Willis, XPS

Guidance welcome, but light on detail

Isio investment advisory partner Tim Barlow welcomed both publications, and was particularly pleased to see the FCA encouraging asset managers to better understand their clients’ liquidity waterfalls, and ensure that clients are able to deliver collateral to their LDI vehicles within five days or sooner. 

“This is likely to lead to more schemes consolidating their LDI and collateral assets with a single manager, which in our view is ultimately a simpler, better and more cost-effective solution than many schemes currently have,” he said.

“We are also pleased to see that the FCA expects managers to have established a crisis response protocol which explicitly covers resourcing. The resourcing issues many LDI managers experienced during the crisis exacerbated the problem as it meant schemes were often required to make decisions with little or no information.

“Improvements here are critical to help schemes navigate the next crisis, whatever that may be.”

Barlow also welcomed the TPR guidance as likely to improve resilience, building on the Bank of England’s statement, though it will have little practical effect on most schemes.

The devil is often in the detail and this is where TPR could have spent more time, said Barlow. “The regulator should provide more guidance on what constitutes ‘periods of stress’, where schemes can operate LDI hedges below the minimum resilience level of 250bp,” he added. 

“This would help trustees plan better and avoid reckless prudence in the amount of collateral set aside to support LDI hedges.”  

XPS Pension Group chief investment officer Simeon Willis identified in the FCA announcement a theme that all participants share greater responsibility for LDI arrangements being appropriate to achieve the end investor’s intended outcome. 

“A higher bar is being set. It’s clear that a siloed approach from investment manager or investment adviser, narrowly focused on their own role alone, is insufficient to meet expectations,” he said.

This will mean that all involved in the decision chain must demonstrate they are considering the suitability of the investment for the end investor and the resilience of that investor’s overall arrangements, Willis said. LDI managers must ask questions about a client’s objectives from investing in an LDI fund, so it can be sure the fund is the best approach.

“These more outcome-focused developments mirror the messages that have emanated from discussions around the responsibilities of regulators themselves – for example, the Bank of England’s recommendation last month that TPR is set an additional objective around financial stability,” he added.

“This overlapping approach has been proposed as a means to ensure key matters of systemic importance don’t slip through the cracks, which is surely no bad thing.”

Regulator, heal thyself…

LCP investment partner Steve Hodder echoed the view that little will change at most schemes, as the minimum collateral holdings exceed those recommended by the Bank of England. However, he welcomed the need for all managers to move toward best practice.

We believe that systemic risk within a market is something for the relevant regulators to address on behalf of market participants.

Steve Hodder, LCP

“We welcome the clarity that LDI collateral buffers are able to be drawn upon in periods of market stress,” he said. “We had seen some interpretations that buffers need to be maintained at all times, which would have simply moved the problem of potential for forced selling, rather than fix it.  

“This guidance may also increase the confidence of LDI managers to return excess capital to pension schemes when buffers exceed regulatory levels, which should help to improve the efficiency of scheme strategies.”

Hodder said the FCA’s guidance was “largely sensible”, addressing “the right points”. But he took issue with two statements, the first being: “In general terms, systems were not set up to allow them to react with the speed that was needed.  

“From our experience, the majority of pension schemes were able to act with the speed that was needed, supported by their LDI managers,” he continued, suggesting that the regulator would do well to not attempt to generalise, given the very varied practices within a LDI marketplace that is far from homogeneous.

Hodder also rejected the call by the FCA for managers and trustees to consider the impact of “circumstances where adverse market factors are amplified by the actions or responses of other market participants”, and said this was the job of the regulator.  

“We believe that systemic risk within a market is something for the relevant regulators to address on behalf of market participants, and are wary of regulators seeking to push this responsibility down to the level of investment managers and individual trustees,” he said.