Our guidance and recommendations for Liability Driven Investment (LDI) managers.
The FCA has been collaborating with UK and international regulators to enhance the resilience of the Liability Driven Investment (LDI) sector. As part of this work, we have also engaged with asset management firms as they enhance their resilience and review the vulnerabilities they experienced; and how they manage the risks and liquidity in their funds. The primary purpose of this publication is to share our guidance and recommendations for LDI managers. As the vulnerabilities which existed in LDI may arise in other firms and sectors, we expect firms which may face similar types of risk to also consider the recommendations that we set out.
2. Background and why this matters
In late September 2022, UK financial assets saw severe repricing, particularly affecting long-dated UK government debt. While the volatility in gilt markets had external causes and affected various sectors, this publication focusses primarily on the impact on firms operating Liability Driven Investment (LDI) strategies.
For LDI strategies the spike in yields triggered a spiral of collateral calls and forced gilt sales that led to market dysfunction. There was a material risk to all LDI strategies but most immediately to pooled LDI funds. These events raised risks to LDI schemes’ pension fund clients (and sponsors); to counterparty banks; and, more generally to the UK’s financial stability and market integrity.
The combined scale and speed of the repricing in long-dated gilts far exceeded historical behaviour. The 30-year nominal gilt yield rose by 160 basis points in just four days, having had a yield of around 120 basis points at the start of the year. LDI funds maintain liquidity buffers that can be used to meet collateral and margin requirements. LDI managers ask their investors to recapitalise funds when key thresholds are reached to replenish liquidity buffers. While they held an adequate level of buffer to cope with historical movements, it proved entirely insufficient for September’s conditions.
Alongside the speed of repricing in gilts in September, earlier recapitalisation calls over the course of 2022 had caused a reduction in holdings of more liquid assets by investors. This meant it was more challenging for LDI managers to quickly recapitalise LDI funds.
The interventions by the Bank of England, for a temporary and targeted programme of purchases of long-dated UK government bonds until 14 October 2022, helped improve market conditions. This provided an effective solution to the immediate challenges that funds faced. It enabled fund liquidity to be improved, leverage to be reduced, and prevented outcomes that could have created further losses to these funds (and their underlying pension scheme clients). They also avoided the situation where bank counterparties to LDI funds would have been left holding large volumes of gilt collateral which they may have been forced to sell into an already strained market.
The structure of the LDI market is such that there are differences in regulatory oversight for the various participants: pension schemes, product managers (such as managers of alternative investment funds), investment consultants, investment banks and portfolio managers. The FCA supervises some, but not all, of the market participants directly. The FCA-authorised entities are typically responsible for the execution of investment strategies in respect of the assets which have been delegated to them by the product manufacturer, typically the non-UK domiciled alternative investment fund manager (AIFM).
In November 2022, regulatory authorities including the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier, as the main regulators of the funds in question, and the Pensions Regulator set out their expectations as to how LDI resilience should be maintained in the short-term. In March 2023, the Bank of England’s Financial Policy Committee (FPC) set out how resilience of LDI funds should be addressed on a more durable basis. The FPC’s proposals included consideration of the types of shocks for which funds should maintain resilience and operational arrangements that should be put in place.
This publication sets out our further recommendations to address specific vulnerabilities that arose within LDI managers. These recommendations are based on our oversight of markets and firms during and after September 2022’s volatility. They also reflect intelligence from other market participants and other regulatory authorities in the UK and internationally.
Some of the weaknesses these events highlighted are unlikely to be unique to the LDI sector. The more broadly applicable lessons learned include those about firms’ risk management arrangements; assessment of the severity and speed with which stress scenarios may arise; the feasibility of preferred actions when faced with systemic or widespread events; and the assumptions made regarding the resilience of operational (including outsourced) arrangements during extreme events.
3. Our observations and expectations
The issues experienced varied between firms and over time. However, across the sector we saw significant deficiencies in the management of risk including stress testing and scenario planning; communications and client servicing; and operational arrangements. Cumulatively, these contributed to the market dysfunction and the consequent threat to financial stability. Below, we set out our recommendations on how firms can increase their resilience to future market volatility.
We expect firms in all sectors to manage their products and services in a way that will enable these to perform in line with their stated objectives. They should also do so in a way that does not create risks to either the orderly functioning or the stability of UK financial markets. Especially where leverage is a feature, we expect firms to consider whether there are circumstances in which the product or service they offer may present such a threat.
Special consideration should be given to operational arrangements (including any third-parties that are critical to the product or service); liquidity risks; the profile and capability of the investor; the practical access to additional liquidity required in different conditions, including those that are more severe than previous events (i.e. stress testing); and other systemic factors that may heighten risk or constrain responses.
The observations in this statement apply principally to FCA-authorised firms providing services in relation to LDI strategies. This includes the management of mandates from pension schemes and pooled or single-client LDI funds, and encompasses firms appointed by a non-UK Alternative Investment Fund Manager (AIFM). In the following sections, we refer to the delegated portfolio managers as ‘Managers’.
3.1. Risk management and stress testing recommendations
Firms are responsible for developing their own scenarios to test resilience for their business and their specific sources of risk. Firms should also consider risks that emerge in the broader value chain within which their firm operates. This includes where they delegate activities (or have activities delegated to them) by other entities, and whether these other entities or stakeholders are in the same or in a different jurisdiction. Robust stress testing allows firms to better prevent and manage the adverse outcomes arising from a wide range of risks, including those in the broader value chain.
Liquidity management measures such as fund liquidity buffers and changes to clients’ liquidity waterfalls are a necessary but only partial solution to address vulnerabilities. There can always be events or conditions that exceed these liquidity provisions. Strengthening the resilience of LDI strategies requires realistic contingency planning and the application of appropriately designed stress tests.
Liquidity buffers should be set for each sub-fund at a level that allows them to: withstand severe but plausible stresses in the gilt market; meet margin and collateral calls without adding to market stress; and withstand the foreseeable demands that may be made. The FPC and Bank of England publications set out how buffer levels might be constructed to deal with systemic and idiosyncratic shocks. Buffers should also reflect the composition of the client base of that fund or sub-fund. The client characteristics relevant to the consideration of appropriate buffer levels would include the extent of liquidity and practical availability of these clients’ assets outside the fund; and the timescales within which clients could provide additional resources to recapitalise their positions.
Stress tests, and the contingency plans created to deal with stress events, should also consider multiple and simultaneous scenarios. Combined scenarios could involve both external and operational events. External events might include a change to prices or liquidity for the relevant asset types. Consideration might also be given to circumstances where adverse market factors are amplified by the actions or responses of other market participants. Operational events that might be included in combined scenarios could include incidents such as a critical system or supplier failing or a cyber-attack. Stress testing should also consider potential sequences of events: for example, how market, operational or client challenges may arise at different points during a stress scenario.
Stress tests and contingency plans for dealing with such scenarios should be reviewed regularly and particularly when circumstances alter. This includes when there are material changes to the product design, client base or the markets to which strategies are exposed. Examples of these developments might include where there has been a significant change, increase or decrease, to the volume, spreads and volatility of assets managed in relevant products; or where the liquidity conditions in markets relevant to these products has significantly deteriorated.
Effective risk management considerations
Managers should clearly understand the risk factors relevant to their portfolios. Effective risk management includes the following considerations:
- Asset and exposure concentrations, such as an exposure to a particular duration or asset type or counterparty; and how the markets in which these assets are traded may change under different conditions.
- The composition of clients’ liquidity waterfalls and how the elements within these (asset classes and instruments) might perform from a valuation and a liquidity perspective in the stress scenarios that may arise.
- The extent of leverage at the relevant categories (fund, mandate, client, or firm-level) and how these might change in different market conditions.
- Strategy concentration, where there is a large volume of assets in similar strategies which may encounter challenges at the same time.
- Client concentration whereby many investors may seek to deploy similar responses with operational and / or market challenges as a result.
- Sensitivity to developments in the macroeconomic environment, including changes in interest rates and inflation expectations, and both the speed and extent of any such alterations.
- The risk profile and systemic dynamics of events that could conceptually occur beyond the scenarios that are being modelled and the implications of such events.
- The availability and liquidity of assets in any portfolio their clients may need to draw on, particularly where these assets are outside their control.
- The speed at which additional liquidity can, in practice, be accessed, taking into consideration any potential operational impediments including legal rights of control over assets and settlement.
- The regulatory or legal implications of different actions or responses they may deploy.
3.2. Operational arrangements, communications and clients recommendations
In general firms’ systems were not set up to allow them to react with the speed that was needed. As part of their contingency planning, risk management and client obligations, we expect Managers to:
- Review the design of product operations, including features such as recapitalisation processes and buffer triggers to enhance their effectiveness even in stress scenarios.
- Make any necessary changes to their operations to enable clients to be able to deliver collateral to their LDI vehicles within five days or sooner. Where this isn’t possible, we would expect other liquidity measures in place on these funds, such as buffers, to be increased to reduce the additional risk.
- Inform clients clearly both what they will need to do if the identified circumstances arise and the consequences if clients are unable or unwilling to take these actions.
- Verify that they and their key stakeholders (such as bank counterparties) have operational and contractual arrangements in place to carry out any required action which the fund is dependent on.
- Have established and tested crisis response protocols for the various stress scenarios that may arise. These should be appropriately detailed. For example, they should explicitly cover access to resources (capability and capacity), risks, and the consequences of redeploying resource to deal with crisis situations.
- Have visibility of underlying processes at critical suppliers that are necessary to the smooth running of their products. This would include how these processes might operate in stress scenarios where activity volumes, and the protocols for managing these may be different.
- Anticipate and be fully prepared for the likely information needs of key stakeholders, including regulatory bodies, in such events.
- Consider the operational stresses identified and how they impact on their firm’s ability to remain within its impact tolerances for its important business services. See PS21/3 for more information.
Additional expectations on client relationships and conflicts of interest
While product selection decisions are made by pension schemes with their advisers, Managers have a role in aiding schemes’ assessment of the LDI approach that is most appropriate to their needs. This would include both the LDI strategy and the contractual form, whether a fund or a segregated mandate. Some pooled fund clients may have been better served by having had greater operational flexibility than the pooled fund model offers. We recognise that pooled funds may have attributes in terms of contractual terms, liability, and operational cost, that would lead some schemes to continue to see them as their preferred option.
- Managers should support engagement with LDI clients to establish that they are using the most appropriate products for delivering the intended outcomes. Relevant considerations of appropriateness for investors should include operational and communication preferences, as well as investment objectives, risk management and charges. Where pooled fund clients may decide to switch to a different solution, Managers should identify and mitigate the associated transition risks that may arise.
- Several conflicts of interest can arise. These include between clients in the same fund; between clients in different funds; between LDI and non-LDI clients; and between the firm and one or other of these groups of clients. Inter-client conflicts include the allocation of resources to support some business activities rather than others; the prioritisation of client engagement; and the management actions taken, either on a BAU basis or in crisis situations. Managers should consider how they prioritise: 1) their interests against those of their clients; 2) how they prioritise actions or resources between different groups of clients.
- Conflicts may also arise between Managers and their LDI clients where Managers encourage LDI clients to make changes to how and where they allocate their non-LDI assets in response to September’s events. In these client engagements, Managers should give full consideration to any potential conflicts of interest that arise.
- Managers should review their approach to conflicts in the light of all the issues experienced and make any necessary improvements to how these are identified and fully managed. As we set our February 2023 letter to the asset management sector, good governance is particularly important during periods of heightened uncertainty. We noted that we expect your governing bodies to be composed of members with sufficient expertise, who receive timely and appropriate management information about risk, and who effectively oversee issues within your firm. We also observed in our portfolio letter that different market and pricing shocks have caused liquidity issues for a variety of products and strategies, including but not only LDI. In a more volatile market environment, liquidity risks are relevant across a broader set of products. Your governing body should understand the level of exposure your firm has to the risks that we have set out in this publication.
4. Next steps
Where they have not already done so, we expect LDI Managers to complete and embed as a matter of urgency all necessary improvements to their operating practices to address the deficiencies identified. We will be working with firms to assess their progress in addressing vulnerabilities. In collaboration with other authorities, we are also engaging with the sector on its implementation of and compliance with guidance or requirements issued by other authorities, including the Financial Policy Committee publication in March 2023 and the Pension Regulator’s guidance issued in April 2023.
Recent periods of sustained volatility have resulted in heightened financial, credit and operational risks in many parts of the markets. In volatile environments, the nature of the risk taken can transform, sometimes rapidly, with operational or counterparty risks sometimes leading to novel or elevated market risk.
As part of their responsibilities under Principle 11, we also expect firms to notify us promptly of developments in their operations or the markets which may pose a risk of harm to consumers or to market function. SUP 15.3 sets out additional rules and guidance on when the FCA would expect notice of matters relating to a firm. Material risks might include market conditions which could severely impair or disrupt the operation of important business services; where participants may be unable to fulfil their obligations to clients or counterparties; where there are risks to the stability and operation of financial market infrastructure; or there are other systemic risks which may cause disruption to the normal function of markets. This list is not exhaustive.
We expect other market participants, including asset managers, to consider their own practices and to take appropriate lessons from the relevant observations in this publication.