Who was watching the ticking time bomb in the pension industry?

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Ask questions about responsible investing and it’s striking how well people who are otherwise financially savvy know it. Hey, we’ve all been on a crash course over the past few days – including the pound, the gilt market and the Chancellor of the Exchequer.

Yet even those immersed in this corner of the retreat world have valuable difficult answers. Is the market big? How fast did he grow? What is the derivative exposure within it? How has the leverage increased?

“In terms of who’s doing what business and with what leverage, I don’t think anyone in the market has a particularly good picture,” said Simeon Willis of consultancy XPS Pensions.

Take a step back from this week’s crisis intervention by the Bank of England to calm the gilt market. LDI makes perfect sense for a pension fund. Basically, it involves buying assets, often government bonds, to meet future liabilities. Perhaps £1.5 trillion of liabilities, although no one seems quite sure, is covered using LDI.

Some of that money will use leveraged derivatives, like interest rate swaps or reverse repos, to match liabilities and protect against market moves. Defined benefit pension funds have been pushed in this direction by none other than the government. “Government pressure for de-risking programs has encouraged financial engineering to get the most out of assets,” says Patrick Bloomfield, a partner at consultancy Hymans Robertson.

To take a simplified example, a pension fund buys £100 worth of gilts and then resells them to a bank with an agreement to buy them back in a year at a specified price. (Collateral is due on the transaction depending on whether the gilts go up or down.) The fund takes the £100 it got for its gilts and does it again: another £100 worth of gilts, another repo transaction. And even. And even.

The result is that when gilts fall, the fund is forced to make margin calls on several hundred pounds worth of contracts against its original £100 worth of gilts. A sharp drop causes a collateral rush, triggering more sales and downward pressure on prices. On Tuesday, before the BoE stepped in, there was a liquidity crunch: some funds couldn’t get cash fast enough to meet increasingly urgent collateral demands.

Regulators were aware of the growing use of these derivatives, described this week as a ticking time bomb by the boss of Next. A 2019 survey for The Pensions Regulator and the BoE found that almost half of the schemes surveyed had increased their use of leverage. Pension funds can make their own deals, but many invest through pooled vehicles, managed primarily by Legal & General, BlackRock or Insight. The leverage allowed varied, at that time, from an alarming 1 to 7 times.

Oddly, this work has not been updated. The pensions watchdog says the funds don’t provide the information, even on leverage, as part of their annual filings (and no one apparently thought to ask).

The BoE, which monitors system-wide risk, conducted a one-time stress test in 2018 and concluded that there appeared to be “no major systemic vulnerabilities.” But he added that “more comprehensive and consistent monitoring is . . . required” and that “the data currently communicated to supervisors of non-banking institutions is not sufficient to measure the risks associated with the leverage effect”.

There’s a definite whiff of a collapsing bargain here between different watchdogs, each trained to their own problem. LDI funds are generally offshore. The regulation of asset management companies is carried out by the Financial Conduct Authority, which has been talking to them since July. The BoE, which oversees banking counterparties in transactions, was clear that this market could cause problems despite everything clear in 2018: a 2021 article on the “cash rush” at the start of the pandemic mentions the role of “ LDI investors facing margin calls”. At the very least, regulators have collectively identified a vulnerability but haven’t fully addressed it.

It would be too convenient to simply blame the watchdogs. Let’s be clear: if the government puts a bomb under the gilt market, then someone somewhere is going to explode. The sell-off since last Friday’s “mini” budget was 2.5 times that seen during the 2020 run for cash, far exceeding what was considered an extreme stress test in 2018.

Regulators may seem uncoordinated or slow to focus on the potential implosion of this murky corner of the pension world. But it was ultimately the government that lit the fuse.

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