It is alarming to listen to the regulators answering the questions of the House of Lords Industry and Regulators Committee. 

There were admissions from both the Pension Regulator and the FCA that they had insufficient information on LDI to properly regulate both the products and the advice being given on those products.

FCA admits being unprepared for ‘mini’ Budget’s threat to #pensions https://t.co/eIkH7Lr4oN

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

It becomes clear listening to the evidence, that the FCA considered it had insufficient grounds to intervene in the LDI problem because it happened outside its regulatory perimetre and it was also clear that the FCA and Bank of England had quite a view of what LDI was doing than the Pensions Regulator.

Counsell of TPR says “We didn’t have as much data on this (LDI strategy adopting) as we would liked to have had”.

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

It takes a pretty big regulatory hole for this problem to fall through the safety net

Rathi of the FCA says at the height of the #LDI crisis, these managers faced losses of “tens of billions” of pounds, due to having gilts they could not sell.

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

The conversation took place on another day when the problems with leverage in the crypto-currency market (where the FCA has taken decisive action). The FCA  warned investors against putting investments onto the FTX platform using the only lever it has (money laundering provisions). This was discussed late in the session where the rights to market cryptocurrency and its derivatives, were discussed in the light of forthcoming legislation in the forthcoming Online Harms Bill.

As I have said previously, the capacity of the Pension Regulator looks severely compromised by its inability to understand what LDI was doing and the risks that it presented schemes if yields spiked.

The stress testing done in 2018/19 was insufficient, the market moved by around 160bps and the stress testing considered the maximum spike to be 100 bps.

And just as the FCA does not know how many people and how badly those people have been impacted by FTX, so the Pensions Regulator does not seem to know the extent of the damage done by LDI.

Rathi of the FCA says some #LDI managers are “soul searching” about whether LDI going to be the same product doing forward.

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

Bitcoin and in particular the less established alternatives (collectively known as “shitcoin”) represent a different order of financial abstraction, but the impact appears to be the same – purchasers losing billions of pounds, while regulators are powerless.

Nikhil Rathi is having to deal with the sale of complex financial products to unsophisticated investors who have a high net worth, but limited financial capability.

The line between the ownership of wealth and the competence of its fiduciaries , is nowhere more fine than in the relationship between trusts, sponsors and beneficiaries of defined benefit occupational schemes.

And the line is stretched to maximum tension when the advice given to pension trustees is not regulated by either the FCA or TPR. The issue under discussion was “trustee vulnerability”.

The Committee asked some serious questions about the regulation not just of investment consultants but trustees. Professional Trustees are not regulated but are encouraged to be accredited. In the world of smaller schemes, professional trustees were described as being used to implement LDI strategies. This becomes a greater worry when the Pensions Regulator itself appears to be pushing schemes towards LDI.

Pressed by MPs, Charles Counsell of TPR says the regulator encouraged schemes to use hedging strategies, to protect their funding positions. #LDI

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

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Was LDI created by the wrong accounting standard?

Baroness Donaghy asked a fundamental question about why LDI happened (12.11) . She focussed on  the impact of adopting market rates of discount (typically based on the gilt rate).

Baroness Bowles talked about the self-referencing loops that allowed LDI to continue at levels of leverage that were not stress-tested

She made the arguments made on this blog by Iain Clacher and Con Keating that economically leveraged LDIs were “borrowing” and that the regulators had allowed “subversion of the intents of the regulation“.

The Pension Regulator’s response was that the use of derivatives were allowed for efficient portfolio management and that Swaps and Repos were derivatives and therefore legitimate investments.

This was sharply challenged by Bowles who went on to refer to a “funny money world” where schemes with 25% less assets could be considered solvent as a result of the jump of yields; she told the regulator that their “sliding about the principle, was the most positive interpretation you could put on it“.

Bowles mentioned that both the FCA and the BOE referred to LDI as borrowing and Bowles asked Nickil Rathi whether he knew that borrowing was going on , in contradiction with Charles Counsell’s denial that Repos and Swaps added up to borrowing.

Was LDI really de-risking?

Counsell again stressed that the 2004 Pension Act (that introduced the accounting standards whose impact was criticised by Bowles, Donaghy and others) , set off the direction of travel that has continued with the introduction of a new duty on trustees to consider the employer covenant and has travelled on to the powers given to TPR in the 2021 Pension Schemes Act. The Lords questioned why this had led to the onus placed on schemes to invest in low performing assets and adopt a gilts based discount rate.

It was interesting to hear the Lords questioning why a discount rate more accurately reflecting the long-term nature of liabilities isn’t sustainable. Employers at this time are not going to put up with further cash calls. We were left to wonder how many schemes lost their hedges when long dated gilt yields were at 5% and how their scheme funding positions look now that gilt rates have fallen back to 3.7%.

Bowles comment was sharp, “swaps are just a means of swapping one risk with another”.

Until we are able to consider risk in other ways than with relation to funding against a gilts based discount rate, the Pension Regulator cannot move from its current position- one that could best be described as “exposed”.

Will things change?

There were radically different answers on this from TPR and the FCA. Here is the FCA response

Rathi of the FCA says some #LDI managers are “soul searching” about whether LDI going to be the same product doing forward.

— Josephine Cumbo (@JosephineCumbo) November 15, 2022

The Committee questioned whether there is likely to be any change in position from TPR.

It remains difficult to see how TPR can change its position without the DWP revisiting the fundamental questions on scheme funding. This appears more likely , not least because of what has happened over the past two months.