The Bank of England’s deputy governor for financial stability has said it is important that lessons are learned from last week’s liability-driven investment (LDI) crisis - warning a large number of pooled LDI funds would have fallen into "negative net asset value" if the bank had not intervened.
In a letter to the Treasury Committee, Sir Jon Cunliffe said the BoE, The Pensions Regulator and the Financial Conduct Authority are "closely monitoring the progress of LDI funds as they take action to put their positions on a sustainable footing for whatever level of asset prices prevails at the end of the [BoE's QE] operation.
The letter also said the three bodies are working to ensure LDI funds are "better prepared for future stresses given the current volatility in the market".
Cunliffe said: "While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured."
The letter was published by the Treasury Committee, which shows correspondence from the BoE on its recent purchasing of gilts to shore up the UK's financial stability, in response to questions from committee chair Mel Stride.
The central bank's Cunliffe said on 23 September, "liquidity conditions were very poor, and market intelligence calls identified the first concerns from LDI fund managers about the implications of market developments, should they persist". On that day, Sterling fell by around 4% in US dollar terms and around 2% in Euro terms, while long-term gilt yields rose by 30 basis points.
On the evening of Sunday 25 September, when Asian markets opened, it became apparent that sterling was falling further and there was a risk that gilt yields might also continue to rise on Monday morning.
On Tuesday 27 September, the BoE said it was informed by a number of LDI fund managers that multiple LDI funds were likely to fall into negative net asset value, and it was likely these funds would have to begin winding up the next morning.
That meant a large quantity of gilts was likely to be sold on the market, "driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability", according to the letter.
The Bank's intervention on 28 September led to a more than 100 basis point fall in 30 year gilt yields over that day.
Cunliffe said in the letter: "In practice, the move in gilt yields last week threatened to exceed the size of the cushion for many LDI funds, requiring them to either sell gilts into a falling market or to ask DB pension plan trustees to raise funds to provide more capital."
He added that in some LDI funds, the speed and scale of the moves in yield and decline in net asset value "far outpaced the ability of the defined benefit (DB) pension fund investors to provide new capital in the time available". This problem was exacerbated for pooled LDI funds, given the large number of smaller pension schemes.
The letter went on to warn that if the BoE had not intervened on September 28, a "large number of pooled LDI funds" would have been left with negative net asset value and would have faced shortfalls in the collateral.
"DB pension fund investments in those pooled LDI funds would be worth zero," Cunliffe went on to say. "If the LDI funds defaulted, the large quantity of gilts held as collateral by the banks that had lent to these funds would then potentially be sold on the market."
