On Monday 24 April 2023 both the Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) issued new guidance on leveraged liability-driven investments (LDIs) (see here and here respectively) aimed at preventing a repeat of the 2022 LDI crisis. In our last blog post on this topic, we discussed the key features of the LDI crisis as at December 2022. In this blog post, we explore some prominent themes in the two new sets of guidance and look ahead to what we can expect in the coming months.
The latest guidance follows from the Bank of England’s Financial Policy Committee recommendations published at the end of March 2023, in which it was recommended that TPR, in conjunction with the FCA and overseas regulators, take action to address the long term resilience of LDI funds to protect against a sudden rise in interest rates – as we saw unfold during Autumn 2022.
TPR’s guidance sets out practical steps that trustees should take to minimise risks when operating LDIs. The guidance recommends that trustees only invest in LDI arrangements which have appropriately sized buffers in place. This includes both operational buffers to protect against day-to-day market changes and a liquidity buffer of at least 250 basis points to provide resilience against market disruptions. These buffers, which should be tailored to each specific LDI arrangement, are aimed to ensure that the fund remains strong in the face of sharp market movement.
Ahead of the decision to invest in LDI, trustees should assess how LDIs fit within the overall strategies of their scheme. TPR also makes recommendations on governance and communication with other market participants: trustees are encouraged to understand what buffer arrangements and monitoring strategies LDI managers have in place to address potential vulnerabilities – the guidance stresses that trustees are ultimately responsible for how the assets in their scheme are responsibly invested.
The FCA’s guidance
The FCA’s guidance, published on the same day, includes a series of recommendations in which it proposes risk management strategies for LDI managers to consider, following what it described as “significant deficiencies in the management of risk” that were exposed during the crisis. The guidance recommends that LDI managers develop their own scenarios in order to test and subsequently enhance the resilience of parts of their businesses that are vulnerable to severe market stress. Such scenarios should incorporate both external events (interest rate hikes or inflationary pressures) and operational events (such as a cyber-attack).
The FCA expects LDI managers to implement appropriately designed stress tests and to regularly review contingency plans for dealing with future seismic market disruptions.
The consensus from both TPR and the FCA’s guidance seems to be that all participants involved in LDI arrangements, whether fund managers or trustees, must now exercise a greater degree of responsibility when engaging in LDI arrangements. Other relevant stakeholders should also reassess their own practices in an attempt to identify and subsequently address any vulnerabilities.
Looking ahead, we are still expecting the House of Commons Work and Pensions Committee to publish findings from its inquiry, launched in October 2022, into the lessons to be learned from the LDI crisis. The inquiry promised to consider the role of TPR in regulating the use of LDIs, amongst other things, so there will likely be more to come on this topic. If you would like to discuss any of the issues discussed in this blog post, please get in touch with your usual Freshfields contact or any of the authors.