Domestic and international financial watchdogs must take regulatory action to strengthen the resilience of liability-driven investment arrangements, the Bank of England said.
"There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to U.K. financial stability, and to improve governance and investor understanding," the bank's financial policy committee said in its December report.
Given the shortcomings in the resilience of LDI arrangements, as well as the "challenging macroeconomic outlook," the Pensions Regulator, the Financial Conduct Authority and overseas regulators must take regulatory action in the interim, the committee said. Such action is necessary "to ensure LDI funds remain resilient to the higher level of interest rates that they can now withstand and defined benefit pension scheme trustees and advisers ensure these levels are met in their LDI arrangements," according to the report.
In the longer term, "further steps will also need to be taken to ensure regulatory and supervisory gaps are filled, so as to strengthen the resilience of the sector," the report said. The bank is working with domestic and international regulators to ensure "LDI vulnerabilities are monitored and tackled."
The financial policy committee also said that investment banks, which act as counterparties in LDI arrangements — sitting on the other side of gilt repurchase arrangements — "should apply a prudent approach when providing finance to LDI funds, taking into account the resilience standards set out by regulators and likely market dynamics in relevant stressed conditions." Banks have around £200 billion ($245.1 billion) in outstanding repurchase lending to LDI funds, the report said.
The report identified LDI arrangements as one example of the "need for urgent international action to reduce risks in non-bank finance" in 2023. It has previously highlighted the need to strengthen the resilience of the non-bank finance sector, and said it will "begin an exploratory scenario exercise" next year to help to better understand and reduce risks.
On Sept. 28, the Bank of England was forced to intervene in U.K. gilt markets, after rising interest rates and gilt yields — and therefore falling prices — led to turmoil in the bond market. Pension funds were subject to huge collateral calls to retain interest-rate hedges put in place under LDI arrangements.
Defined benefit funds sold around £14 billion of gilts between Sept. 23 and Oct. 14, while LDI funds sold around £23 billion in gilts over the same period.
However, the BOE estimated that LDI funds and pension plans received more than £70 billion in margin and collateral calls between those dates. The report said the difference in gilt sales and collateral calls shows assets other than gilts were used to meet the requirements.
The report also highlighted the continued fall in cryptocurrency assets, noting that the "sudden failure of FTX … has highlighted a number of vulnerabilities."
While direct risks to U.K. financial stability remain limited, the committee said falling prices and FTX's collapse "have highlighted how systemic risks could emerge if cryptoasset activity and interconnectedness with the wider financial system increase. They underscore the need for enhanced regulatory and law enforcement frameworks to address developments in crypto markets and activities."
Institutions and investors "should take an especially cautious and prudent approach to any adoption of these assets until the necessary regulatory regimes are in place," the report added.
