FCA provides LDI guidance to ensure 'lessons are learned’ from gilts market crisis
24 April 2023 UK
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The Financial Conduct Authority (FCA) has set out guidance on risk management and operational arrangements for liability driven investment (LDI) managers.
Following the gilts market crisis in September 2022, the FCA has been working with regulatory partners and engaging directly with firms involved in the management of LDI portfolios to develop and maintain increased resilience to deal with possible future volatility.
The major repricing of UK financial assets that took place last year, particularly the rise in bond yields, exposed vulnerabilities associated with LDI funds. This triggered a sharp increase in collateral calls, pushing some LDI funds into forced sales of their gilt holdings that threatened further market dysfunction and a threat to UK financial stability.
Within its risk management and stress testing recommendations, the FCA says that liquidity management measures, such as fund liquidity buffers and changes to clients’ liquidity waterfalls, are a necessary but only partial solution to address vulnerabilities.
Further, the Authority believes that 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 FCA informs.
Moreover, the FCA asks managers to clearly understand the risk factors relevant to their portfolios. Effective risk management considerations include asset and exposure concentrations — such as an exposure to a particular duration or asset type or counterparty. The Authority asks firms to consider sensitivity to developments in the macroeconomic environment, including changes in interest rates and inflation expectations, as well as the speed and extent of any such alterations.
In addition, 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, must also be considered.
The FCA’s recommendations follow comments from the Bank of England (BoE) in December 2022 that banks must apply a prudent approach when providing funding to LDIs. The BoE recently published a working paper dissecting the gilts market crisis.
It discussed how a sharp rise in gilt yields following the UK mini-budget of 23 September 2022, led to some pension fund and asset managers, with significant exposure to highly-leveraged LDI strategies, experiencing a deterioration of their repo and derivatives positions and significant rises in collateral and margin requirements.
Some were forced to liquidate gilt positions to access cash to meet these margin requirements, triggering a further rise in gilt yields and liquidity tightening in gilt markets, prompting the BoE to intervene to restore orderly market functioning.
Sarah Pritchard, executive director of markets at the FCA, says: “We have been clear that asset managers must take the necessary steps so that their LDI portfolios are resilient to future market volatility.
“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.”
She continues to explain that the FCA guidance sets out what the Authority expects in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events.
Pritchard concludes: “Many of these lessons will be relevant to firms beyond the LDI sector.”
The FCA will continue to work with regulatory partners in engagement with this sector on implementing or complying with any further guidance or requirements issued by other authorities, including the BoE’s Financial Policy Committee recommendations of March 2023 and The Pension Regulator’s guidance issued in April 2023.
Following the gilts market crisis in September 2022, the FCA has been working with regulatory partners and engaging directly with firms involved in the management of LDI portfolios to develop and maintain increased resilience to deal with possible future volatility.
The major repricing of UK financial assets that took place last year, particularly the rise in bond yields, exposed vulnerabilities associated with LDI funds. This triggered a sharp increase in collateral calls, pushing some LDI funds into forced sales of their gilt holdings that threatened further market dysfunction and a threat to UK financial stability.
Within its risk management and stress testing recommendations, the FCA says that liquidity management measures, such as fund liquidity buffers and changes to clients’ liquidity waterfalls, are a necessary but only partial solution to address vulnerabilities.
Further, the Authority believes that 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 FCA informs.
Moreover, the FCA asks managers to clearly understand the risk factors relevant to their portfolios. Effective risk management considerations include asset and exposure concentrations — such as an exposure to a particular duration or asset type or counterparty. The Authority asks firms to consider sensitivity to developments in the macroeconomic environment, including changes in interest rates and inflation expectations, as well as the speed and extent of any such alterations.
In addition, 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, must also be considered.
The FCA’s recommendations follow comments from the Bank of England (BoE) in December 2022 that banks must apply a prudent approach when providing funding to LDIs. The BoE recently published a working paper dissecting the gilts market crisis.
It discussed how a sharp rise in gilt yields following the UK mini-budget of 23 September 2022, led to some pension fund and asset managers, with significant exposure to highly-leveraged LDI strategies, experiencing a deterioration of their repo and derivatives positions and significant rises in collateral and margin requirements.
Some were forced to liquidate gilt positions to access cash to meet these margin requirements, triggering a further rise in gilt yields and liquidity tightening in gilt markets, prompting the BoE to intervene to restore orderly market functioning.
Sarah Pritchard, executive director of markets at the FCA, says: “We have been clear that asset managers must take the necessary steps so that their LDI portfolios are resilient to future market volatility.
“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.”
She continues to explain that the FCA guidance sets out what the Authority expects in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events.
Pritchard concludes: “Many of these lessons will be relevant to firms beyond the LDI sector.”
The FCA will continue to work with regulatory partners in engagement with this sector on implementing or complying with any further guidance or requirements issued by other authorities, including the BoE’s Financial Policy Committee recommendations of March 2023 and The Pension Regulator’s guidance issued in April 2023.
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