The mysterious world of shadow banking – LDI in Dublin and Luxemburg

Illustration supplied by the Irish Central Bank in their explanation of Shadow Banking

There’s a good rule for investors, whether institutional or retail – whether you are looking after other people’s money or your own. Shadow banking ,  like the dark web, is probably something that most of us should not get involved in.

If you can’t understand what’s going on, don’t invest. I have seen over 40 years selling financial products , that the simple ideas last and the complicated ideas don’t. Leveraged LDI was a complicated product that relied on trust in those who devised and marketed it ..and those that regulated it.

The way it works is well explained in this article by Citywire’s “the secret fund manager“. If you read the article – you realise that leveraged LDI was not a set and go product, that one that needed ongoing review and fast reactions. As such , it may well be seen to have been an inappropriate strategy for most trustees who don’t have the capacity to get under the bonnet of such a product , nor the speed of response to react to it – if it went out of control. You wouldn’t drive a Ferrari in your slippers.

One of the alarm bells that might have rung for a pension trustee was that these supposedly low-risk funds were actually domiciled abroad, outside the regulatory perimeter of the UK regulators.

So just what supervision was there on these “non-dom funds”. An article from Jo Cumbo in last week’s FT tells us a little about how they have gone about regulating LDI pooled funds, but only since the crisis struck.

financial market regulators in Europe’s main fund hubs have stepped up surveillance of derivative-linked funds used by UK pension schemes in an effort to prevent a repeat of the turmoil that roiled the gilt market last month.

Is this surprising? It surprises me that it took a near melt-down of financial markets in the UK for them to put in place surveillance of the most basic kind. This “stepping up” we are told involves  the  pooled funds seeking

“central bank approval ahead of any action that increases leverage levels”.

The Central Bank’s general explanation of its relationship to shadow banking can be read here

The Luxemburg authorities are less transparent telling the FT

“our teams on the investment funds side have closely followed up on the matter and intervened as required, in collaboration with relevant authorities”

No doubt the actual level of supervision of these funds will emerge as a result of the enquiries set up by Westminster Select Committees, but what we’ve heard so far suggests that the Irish and Luxemburg fund authorities weren’t over-vigilant. This may be their problem as well as ours.

Though these countries don’t directly carry the financial risk of an LDI fund blowing up, they have a responsibility to preserve the financial stability of the European finance industry and their reputation is at risk if they are seen as a soft-touch for “shadow banking”.

“It’s alright – it’s a regulated fund”

Isn’t much of a pitch if the regulatory system you’ve chosen to regulate your fund is not doing its job. While both Dublin and Luxemburg are well established centres for fund registration , questions remain as to why they are appropriate for the management of UK pension money.

The FT is also asking questions about what legal powers . These leveraged LDI funds have over trustee funds.

“No you can’t have your money back” – yet

The FT tells us that the powers of these pooled funds are much greater than many trustees might have supposed.

“On some funds, managers are now requiring pre-clearance checks for leverage increases,” said James Brundrett, senior investment consultant at Mercer UK, the professional services firm.

“However on the bigger pooled funds, some managers have gone a step further and are no longer allowing releveraging.

This means the fund won’t distribute cash to the pension scheme when gilt yields fall, as they would have normally. This change has the effect of protecting the fund’s liquidity, particularly when gilt yields are still volatile.”

All  of which suggests that if you are looking to invest in a fund which you don’t fully understand – you probably shouldn’t.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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