REVIEW OF FINANCIAL MARKETS


targeted at pension funds. Concentration of ownership is a well-understood issue in financial markets. It lies behind the ‘free float’ rules for listed equity. It is also well known in the trading behaviour of individual bonds; it is not uncommon for issues to be reopened in order to maintain or enhance the liquidity, that is tradability, of benchmark bonds. Securities whose ownership is concentrated are more volatile than would otherwise be the case; in extreme circumstances, idiosyncratic risks can become systemically critical. GEMMs10


reported turnover of £132bn


in the week ending 23 September and £264bn in the week ending 30 September. This market turnover in the week ended 30 September approached 14% of the market value of all outstanding gilts, roughly twice the normal level of turnover. The one occasion when turnover of this level had been seen previously was March 2020 at the beginning of the pandemic.


CONTINUATION OF LDI The advocates of the continuing use of leveraged LDI, and this includes TPR, have offered two main arguments in support of its continuing use, with only minor modifications such as overall leverage restrictions. The first of these is that schemes


should be explicitly permitted to borrow since all other large financial institutions and even individuals can do so. This ignores the fact that all other institutions have equity capital which supports their borrowing. The future earning potential of an individual is the equity capital which supports and services their mortgage debts. All that a pension scheme has is recourse to the capital of the sponsor employer, and the sponsor may borrow if it chooses to, and of course that borrowing will be tax-advantaged. We have seen sponsor companies


issue bonds where the proceeds were applied to the scheme and its pension fund. This is quite a common practice


10UK Debt Management Office GEMMs weekly gilt turnover report


for state and municipal plans in the US. The simple fact is that borrowing by a


scheme raises the riskiness of the scheme and lowers the member security arising from the presence of the fund in the event of sponsor insolvency. These concerns were the motivation for the prohibition on scheme borrowing in the European IORP directive and its transposition into English law. The second argument is that LDI has


// MANY OF OUR LONG-TERM STABLE INVESTMENT INSTITUTIONS HAVE BECOME CONCERNED AND DRIVEN BY SHORT-TERM LIQUIDITY ISSUES //


been beneficial for schemes. This assertion needs some unpacking. LDI as simple hedging of liability valuations should have been neither positive nor negative for schemes. Schemes which were less than 100% hedged will have profited, but that is scarcely an argument in favour of LDI. The argument reduces to that as schemes use leverage through derivatives and repo to minimise the cost of LDI hedging; this enables the fund to buy other higher-yielding, riskier growth assets. It follows that this beneficial argument is simply a statement that the speculation has been successful thus far. Borrowing at short rates to buy long-dated fixed-rate securities can be expected to be profitable as long as rates remain low and long-term rates decline. Of course, this ceased to be the case at the end of 2021 and this process simply accelerated through 2022 as concerns with increasing and persistent inflation have influenced market yields and central bank activity. The Bank


of England’s QE portfolio, the Asset Purchase Fund, faces just this situation. The


£800bn of assets bought were financed at the rate paid on commercial bank reserves, and over the period of the fund’s existence it has contributed around £120bn to the Exchequer. However, with short rates now at 3%, the strategy is already cash flow negative, and its disposal is likely to realise substantial losses, perhaps larger than the earlier receipts.


66


We have also seen some official


responses about what is required for the continuance of leveraged LDI, but they do not inspire confidence. The statements from the Central


Bank of Ireland and Luxembourg’s CSSF that buffers need to be held at the levels of 300 to 400 basis points miss two points. The first is that assets will nonetheless need to be sold once the cash element of these buffers is exhausted, and these buffers will need to be replenished. It also completely fails to recognise that it was a two-day move of just 37 basis points which triggered the LDI liquidity spiral when buffers were reportedly set at 100 basis points. This is indicative of grossly inadequate risk modelling; the models in use are exercises in comparative statistics but the models needed are those based on the risk dynamics of these processes. The statements offered by many


that they were surprised by the speed and magnitude of the moves seen are recognition of the inadequacy of their existing risk management models and practices.


FINAL THOUGHTS The most important problem though is that the use of these strategies and instruments has converted many of our long-term stable investment institutions, DB pension schemes and their funds, into bodies concerned and driven by short-term liquidity issues. Commercial banks have precisely this form of exposure. They borrow short and lend long, and the resultant maturity mismatch is subject to Pillar 2 regulatory capital ‘add-ons’, which most unusually are not made public. We also have the issue that many


schemes are seen as funded to ‘buyout’ or much closer to that position than ever expected in the near term. However, this misses a crucial point. The depth of the buyout market historically has been between £20bn and £30bn a year. If we even assume that the market was able to underwrite £75bn in 2022 – and let us be clear, insurers can pick what funds to transact with as it is a buyers’ market – that still leaves the rest of the DB universe having to pay pensions in full, on time, as they fall due, with considerably fewer assets available to them to do so.


THE REVIEW MARCH 2023


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