Lessons from the LDI debacle

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The pearl-clutching induced by the Bank of England opting to keep interest rates on hold this week was rather twee.

In June, the BoE had bumped up the benchmark rate by half a percentage point — a hefty increment by typical standards. Another quarter-point rise this month was seen as a close call but the likely option. Instead, governor Andrew Bailey ended up casting the deciding vote to stay still. 

“The decision to pause with inflation still at high levels is going to cause consternation in some corners,” wrote Oliver Blackbourn, multi-asset portfolio manager at investment house Janus Henderson. The BoE “continues to suffer from lower credibility” than its peers in the US and euro area, he said. The surprise was enough to shove sterling 0.7 per cent lower against the dollar to the weakest point since March.

For sure, it was all a drama. But this collective case of the vapours is all a sign that nature is healing. If you cast your mind back to this time last year, UK markets were in full-blown crisis. Government bonds and sterling convulsed with sufficient violence to threaten the country’s entire financial system and push prime minister Liz Truss out of office. The contrast with now underlines how far, psychologically, we have moved on. At the same time, everyone accepts complacency would be foolish.

The peril markets faced last year was intense. On Friday September 23, then chancellor Kwasi Kwarteng had announced his “mini Budget” to parliament, telling the nation he was about to embark on £45bn of unfunded tax cuts. Sterling cratered and so did government bonds. Informed of this in parliament, Kwarteng observed that “markets will react as they will”. He was not wrong.

The real problem set in, though, when gilts fell so heavily in price that they blew a hole in certain pension funds’ rate hedging in so-called liability-driven investment, or LDI for short — strategies that sought to match income and assets with future retirement promises. Burnt on these hedges, the LDI managers, and sometimes their underlying pension fund clients, had to stump up cash to meet collateral, or margin, calls on their positions. To raise cash, they sold the most liquid stuff they could find, which was gilts. So gilts fell further. So then they had to sell more gilts. The BoE stepped in early in the following week to prevent a financial stability accident. 

Even now, bankers and investors say the whole episode is holding back the flow of money in the UK towards illiquid assets, as funds are nervous about holding paper they cannot sell in a hurry. The good news is that the LDI business has acted fast to prevent a rerun. Bankers say clients operating these strategies have widened their tolerance bands for shifts in bond yields. Previously no reasonable person had ever imagined gilt yields could jump by a percentage point or so in a couple of days. It turns out they can, and strategies have adapted accordingly. 

They have also padded out cash buffers, so that if they are called upon to feed funds to their banks to meet obligations, they can do that without resorting so quickly to selling assets. Some progress has also been made, bankers say, towards the use of so-called “dirty” collateral agreements, so that the funds posted do not have to be cash or gilts. Instead, users can post corporate bonds or non-sterling assets. In a real fix, this all helps.

It did not take a finger-pointing regulator to force this kind of change. “It happened immediately,” one senior bond trader said. “The week after, we were talking to clients about getting new docs.”

Could or should everyone have thought of this earlier? Sure, but retrospect is a wonderful thing. The point is that now, an LDI crisis could still happen again in theory, but it would need something considerably more disruptive to markets than Liz Truss to trigger it, and it’s hard to imagine what that might be.

Nonetheless, the incident is still bugging policymakers at the most senior level because the lesson is that wherever you have leverage in the financial system, and wherever you have products that impose margin calls on users, you have a particular sort of risk. That risk is generally routine, benign, boring even. But the LDI crisis showed that even conservative, socially useful leverage can quickly become systemically horrible.

“The LDI crisis highlighted that after the 2008 financial crisis, the agenda was to reduce counterparty risk through margining,” one former policymaker said. That makes sense. Bank failures are bad. “But that had this knock-on effect of transforming counterparty risk to liquidity risk,” he said. “You get these dashes for cash.” 

Authorities are increasingly taking note, ramping up the warnings on the financial stability vulnerabilities nestling outside the banking system. Reform of the financial system after the global financial crisis was the right thing to do. But it has taken a decade and a half to really figure out what the long-term trade-off is. The UK’s gift to the world one year ago was to give a technicolour example of what authorities around the world must strive to avoid in future. You’re welcome.

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