Balance needed on LDI following market turmoil

Industry experts have argued that “no one” could have predicted the recent gilt market volatility and subsequent issues around liability driven investment (LDI), suggesting that a balance between the risks and benefits of LDI is needed going forward.

Addressing the Industry and Regulators Committee, Legal & General (L&G) chair, Sir John Kingman, argued that while there was “nothing unforeseen” about a market scenario that could create liquidity concerns, "no one anticipated the government would choose to create such extraordinary instability in its own sovereign debt market".

He stated: “No one involved in this, the regulators, the central bank, the government, the advisers, the funds, the sponsors, or us, believed that it was a plausible scenario that the government would do something that would create such extraordinary market instability in two trading days."

Adding to this, L&G chief executive, Nigel Wilson, argued that the mini-Budget “caused all of us to reconsider how much risk there is in this area, and in many parts of the economy”, noting that the unprecedented volatility in the gilt market was “well outside any of the models we had ever considered”

"It was very much driven off the mini-Budget because it was very inconsistent with the message the Bank of England was giving the day before," he continued, explaining that the firm's modelling had "never taken account of this degree of stress".

When pressed by the committee as to whether the government’s signalling over the
summer should have been enough for providers to shift their stress testing, both Wilson and Kingman argued that while the direction of travel may have been expected, the lack of funding for the measures announced, and subsequent market reaction, was not.

"One thing I'm certain took the market by surprise, was the government presented these very expensive measures, but gave no indication of how they might be paid for," explained Kingman.

"The second thing, which was very significant in terms of influencing market actors, was the apparent reaction from government over the weekend, which was an indication that not only did the government think it had done the right thing, but that there was a lot more to come."

"The market reaction was way more than expected," agreed Wilson, clarifying however, that changes have been made, and this has now been incorporated into the provider's stress testing, with the headroom held by funds doubled.

"We think that’s an appropriate way to behave right now," he added, suggesting that, when the dust settles, there will be a broader review of what the appropriate stress test is.

Indeed, Kingman said that "probably the most important thing" to take from the recent experience is considering how extreme a scenario should LDI vehicles be insulated from.

"At the moment we‘ve worked with authorities to make sure [LDI funds] are extremely well insulated,", Kingman stated, suggesting that while it is unlikely anyone will advocate going back "simply where we were", there is a balance to be found between protection and cost.

"We can operate with whatever level of risk protection everyone wants, but there is no free lunch, and the more protection there is in the system, the greater the cost will be to pension funds and their sponsors," he stated.

Kingman suggested that this should be considered as part of a process of reflection, emphasising the need to also consider the benefits provided by LDI over 20 years, alongside the "clear risk exposure" highlighted by recent events.

"We certainly believe, and I think the pensions industry believes and their sponsors believe, LDI has created enormous value for pension funds over a long period," he stated.

In addition to this, Kingman suggested that greater consideration is needed around the type of collateral that can be used in conditions of liquidity stress, arguing that this "would have greatly eased the situation we’ve just been through".

Although Kingman supported the idea of regulating investment consultants, following suggestion from the Financial Conduct Authority (FCA) that there is a “gap in regulation” around investment consultants, he argued that this is unrelated to the recent issues around LDI.

"I think the debate around regulating consultants has nothing to do with this, I don’t think that were consultants regulated this episode would have been avoided," he stated.

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