Regulators outline their expectations regarding LDI fund resilience
06 December 2022
The Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier have written to GBP-denominated liability-driven investment funds outlining actions to protect fund resilience in the event of market shocks. Bob Currie reports
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The European Securities and Markets Authority (ESMA) has provided its backing to the actions of financial regulators in Ireland and Luxembourg designed to protect the resilience of liability-driven investment (LDI) funds.
The Central Bank of Ireland (CBI) and the Commission de Surveillance du Secteur Financier (CSSF) have each written to LDI fund managers asking them to maintain the current level of resilience of their GBP-denominated LDI funds and to ensure that there is no significant rise in the risk profile of GBP LDI funds under their management.
This action marks a response to the vulnerability experienced by some GBP-denominated LDI funds in the wake of the UK mini-budget, when funds found themselves needing to meet sizeable margin calls following the volatility surge in the UK gilts market in September 2022.
According to the letters written by Irish and Luxembourg national competent authorities (NCAs), fund managers wishing to reduce yield buffers for GBP LDI funds below their current levels will be expected to inform their NCA in advance, explaining the justification for this change.
ESMA indicates that it welcomes this action from CBI-Ireland and CSSF and reiterates the importance of strengthening funds’ resilience, given that large and unexpected shocks can develop rapidly under current economic conditions.
With this in mind, ESMA encourages information sharing and coordinated regulatory activity across NCAs to address risks associated with LDI funds and, more broadly, with risks which may threaten financial stability.
In its letter to LDI funds, CBI highlighted that recent volatility in yields linked to UK gilts gave rise to a concerning cycle of collateral calls and forced sales for some GBP-denominated LDI funds.
The CBI and CSSF indicate that they engaged proactively with managers of GBP LDI funds throughout this period of instability and, subsequently, resilience of these funds across Europe has improved, with an average yield buffer of 300-400 basis points.
A ‘yield buffer’ refers to the level of yield adjustment on long-term gilts that a fund is insulated from, or may absorb, before its capital reserves are used up. These capital reserves are the capital held in the fund, excluding any shared pool of assets or other investor capital that the fund may have access to.
The letter, signed by CBI head of securities markets and funds supervision Darragh Rossi, states that: “Given the current market outlook, the NCAs expect that levels of resilience and the reduced risk profile of GBP LDI funds are now maintained, and do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture.”
Should the resilience of a LDI fund fall below this level [ie “below the levels that were achieved in the period following the dislocation in the UK gilt market”], the fund manager must inform its relevant supervisory authority, provide justification based on detailed risk assessment, and submit a step-by-step plan for returning the GBP LDI fund to this required level of resilience.
In cases where the changing market environment results in an inadvertent reduction in the resilience of GBP LDI funds — including a decrease in the market value of assets held by the fund — the CBI and CSSF requires the fund manager to have procedures in place to recapitalise or de-risk their portfolios through a timely reduction in their exposures. This must take into account the “second-round effects” of actions by other market participants on the individual LDI funds, for instance the market impact of asset disposals triggered by rising yields.
CBI and CSSF indicate that these measures apply to GBP-denominated LDI funds and are not applicable to LDI funds in other currencies for the time being.
However, NCAs require LDI managers to maintain an appropriate level of resilience for all LDI funds at individual sub-fund level to ensure they can absorb possible market shocks. This, again, must include possible “second-round effects” of actions taken by other market participants, including the potential impact of forced sales.
UK Pensions Regulator
Responding to these statements from CBI and CSSF, the UK Pensions Regulator has also issued a guidance statement requiring pension scheme trustees that use LDI funds as part of their investment strategy to maintain an appropriate level of resilience in leveraged arrangements, thereby improving the scheme’s ability to “withstand a large and significant rise in bond yields”.
The Pension Regulator (TPR) also requires trustees to improve operational governance arrangements for pension funds investing in LDI programmes that apply significant leverage — that is funds that use debt, or borrowed capital, to engage in an investment or project.
As part of this guidance, the regulator provides specific practical steps to ensure that pension schemes are able to respond quickly to stresses as they develop in the market. This includes more detailed analysis of how these stresses will impact margin calls and collateral requirements, including the size and timing of margin calls, whether assets may need to be sold to meet these margin requirements and when collateral will settle.
TPR indicates that some defined-benefit pension schemes may opt to establish a line of credit with their sponsoring employer to ensure access to liquidity under stress conditions. These arrangements should be clearly documented and reviewed frequently, detailing the time period, size of the credit line and the conditions under which these may be exercised. The regulator specifies that such facilities should only be used on a short-term basis and for liquidity purposes.
Charles Counsell, chief executive of The Pensions Regulator, says: “LDI funds are regulated in the country their provider is based and, in most cases, these are EEA countries. We are very pleased therefore to see these joint statements from regulators in Ireland and Luxembourg setting clear expectations for the resilience of LDI portfolios.”
With this in mind, Counsell confirmed that TPR had issued a guidance statement for trustees and pension fund advisers confirming the regulator’s expectations regarding their funds’ exposure to LDI funds.
“I urge trustees to read the statement and consider how they can meet the steps it outlines to ensure their scheme buffer is sufficient to cover a swift and substantial increase in yield at the level set by the NCAs.”
Many pension funds should be expected to model these stresses — such as those created by the bond yield rises that followed the UK mini-budget — on an ongoing basis as part of their wider investment risk analytics and stress testing framework. As such, these funds should not be expected to make radical changes to current investment strategies to align with the TPR’s expectations.
For some asset owners, however, this experience does reinforce the need to develop a deeper understanding of how LDI funds react under conditions of market stress and the impact this may have on scheme resilience. This experience will also require some financial regulators to strengthen their ability to monitor the build up of market stress and to provide appropriate guidance. A sharp and significant rise in gilt yields was widely predicted in the period leading up to the UK mini-budget on 23 September, but resulted in significant disruption as LDI funds responded to margin calls and threat of forced sale of assets.
In concluding, TPR indicates that it is continuing to discuss these issues with other regulators and external stakeholders to provide clarification of its longer-term expectations in this area. It plans to issue additional information as part of an update to its annual funding statement in April 2023.
The Central Bank of Ireland (CBI) and the Commission de Surveillance du Secteur Financier (CSSF) have each written to LDI fund managers asking them to maintain the current level of resilience of their GBP-denominated LDI funds and to ensure that there is no significant rise in the risk profile of GBP LDI funds under their management.
This action marks a response to the vulnerability experienced by some GBP-denominated LDI funds in the wake of the UK mini-budget, when funds found themselves needing to meet sizeable margin calls following the volatility surge in the UK gilts market in September 2022.
According to the letters written by Irish and Luxembourg national competent authorities (NCAs), fund managers wishing to reduce yield buffers for GBP LDI funds below their current levels will be expected to inform their NCA in advance, explaining the justification for this change.
ESMA indicates that it welcomes this action from CBI-Ireland and CSSF and reiterates the importance of strengthening funds’ resilience, given that large and unexpected shocks can develop rapidly under current economic conditions.
With this in mind, ESMA encourages information sharing and coordinated regulatory activity across NCAs to address risks associated with LDI funds and, more broadly, with risks which may threaten financial stability.
In its letter to LDI funds, CBI highlighted that recent volatility in yields linked to UK gilts gave rise to a concerning cycle of collateral calls and forced sales for some GBP-denominated LDI funds.
The CBI and CSSF indicate that they engaged proactively with managers of GBP LDI funds throughout this period of instability and, subsequently, resilience of these funds across Europe has improved, with an average yield buffer of 300-400 basis points.
A ‘yield buffer’ refers to the level of yield adjustment on long-term gilts that a fund is insulated from, or may absorb, before its capital reserves are used up. These capital reserves are the capital held in the fund, excluding any shared pool of assets or other investor capital that the fund may have access to.
The letter, signed by CBI head of securities markets and funds supervision Darragh Rossi, states that: “Given the current market outlook, the NCAs expect that levels of resilience and the reduced risk profile of GBP LDI funds are now maintained, and do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture.”
Should the resilience of a LDI fund fall below this level [ie “below the levels that were achieved in the period following the dislocation in the UK gilt market”], the fund manager must inform its relevant supervisory authority, provide justification based on detailed risk assessment, and submit a step-by-step plan for returning the GBP LDI fund to this required level of resilience.
In cases where the changing market environment results in an inadvertent reduction in the resilience of GBP LDI funds — including a decrease in the market value of assets held by the fund — the CBI and CSSF requires the fund manager to have procedures in place to recapitalise or de-risk their portfolios through a timely reduction in their exposures. This must take into account the “second-round effects” of actions by other market participants on the individual LDI funds, for instance the market impact of asset disposals triggered by rising yields.
CBI and CSSF indicate that these measures apply to GBP-denominated LDI funds and are not applicable to LDI funds in other currencies for the time being.
However, NCAs require LDI managers to maintain an appropriate level of resilience for all LDI funds at individual sub-fund level to ensure they can absorb possible market shocks. This, again, must include possible “second-round effects” of actions taken by other market participants, including the potential impact of forced sales.
UK Pensions Regulator
Responding to these statements from CBI and CSSF, the UK Pensions Regulator has also issued a guidance statement requiring pension scheme trustees that use LDI funds as part of their investment strategy to maintain an appropriate level of resilience in leveraged arrangements, thereby improving the scheme’s ability to “withstand a large and significant rise in bond yields”.
The Pension Regulator (TPR) also requires trustees to improve operational governance arrangements for pension funds investing in LDI programmes that apply significant leverage — that is funds that use debt, or borrowed capital, to engage in an investment or project.
As part of this guidance, the regulator provides specific practical steps to ensure that pension schemes are able to respond quickly to stresses as they develop in the market. This includes more detailed analysis of how these stresses will impact margin calls and collateral requirements, including the size and timing of margin calls, whether assets may need to be sold to meet these margin requirements and when collateral will settle.
TPR indicates that some defined-benefit pension schemes may opt to establish a line of credit with their sponsoring employer to ensure access to liquidity under stress conditions. These arrangements should be clearly documented and reviewed frequently, detailing the time period, size of the credit line and the conditions under which these may be exercised. The regulator specifies that such facilities should only be used on a short-term basis and for liquidity purposes.
Charles Counsell, chief executive of The Pensions Regulator, says: “LDI funds are regulated in the country their provider is based and, in most cases, these are EEA countries. We are very pleased therefore to see these joint statements from regulators in Ireland and Luxembourg setting clear expectations for the resilience of LDI portfolios.”
With this in mind, Counsell confirmed that TPR had issued a guidance statement for trustees and pension fund advisers confirming the regulator’s expectations regarding their funds’ exposure to LDI funds.
“I urge trustees to read the statement and consider how they can meet the steps it outlines to ensure their scheme buffer is sufficient to cover a swift and substantial increase in yield at the level set by the NCAs.”
Many pension funds should be expected to model these stresses — such as those created by the bond yield rises that followed the UK mini-budget — on an ongoing basis as part of their wider investment risk analytics and stress testing framework. As such, these funds should not be expected to make radical changes to current investment strategies to align with the TPR’s expectations.
For some asset owners, however, this experience does reinforce the need to develop a deeper understanding of how LDI funds react under conditions of market stress and the impact this may have on scheme resilience. This experience will also require some financial regulators to strengthen their ability to monitor the build up of market stress and to provide appropriate guidance. A sharp and significant rise in gilt yields was widely predicted in the period leading up to the UK mini-budget on 23 September, but resulted in significant disruption as LDI funds responded to margin calls and threat of forced sale of assets.
In concluding, TPR indicates that it is continuing to discuss these issues with other regulators and external stakeholders to provide clarification of its longer-term expectations in this area. It plans to issue additional information as part of an update to its annual funding statement in April 2023.
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