UK. MPs told ‘illegal’ LDIs fanned gilt crisis

The flames of the crisis in the gilt market following the Mini Budget were fanned by widely used liability driven investments (LDIs) that were “almost certainly illegal”, MPs were told yesterday.

At a hearing in front of the Work and Pensions Select Committee, experts criticised LDIs for being highly leveraged, causing “carnage” for some pension schemes, and blamed regulators for not acting previously.

Bond market veteran Dr Con Keating, now head of research at the specialist insurer Brighton Rock Group, said borrowing by pension funds was not permitted, but that regulators had not stepped in over LDI.

Keating told MPs: “There’s a question of legality there.”

Pension funds were relying on a “mistransposition” to use LDIs, he said, from when an EU directive on the use of derivatives by pension funds was turned into UK rules.

“Use of derivatives to hedge liabilities is almost certainly illegal,” he said.

“No English court would support that transposition,” he explained, saying a key word in the EU original was dropped and a sentence, explicitly permitting derivatives investment, added.

A survey looking into LDI by the Pensions Regulator in 2019 was “not worth the paper it was written on” because of methodological flaws and the absence of a numerical risk estimate, he said.

Gilt prices tumbled at the end of September following the Mini Budget announced by then Prime Minister Liz Truss and former Chancellor Kwasi Kwarteng.

The budget spooked financial markets with surprise tax cuts and spending plans expected to add to already high inflation and government borrowing.

Pressure on gilt prices was made much worse because LDIs forced pension funds to put up collateral to honour their leveraged bets on gilts, forcing them to sell more bonds.

The Bank of England stepped in with a taxpayer-funded £65bn gilt-buying package on the grounds of financial stability.

Keating told MPs that the chaos was “entirely predictable,” but that anyone raising the issue would have been “dismissed as nutters”.

In a later session, consultants and actuaries strongly rejected the criticism of LDIs, saying they had helped to close huge funding deficits for pension funds, as well as reducing volatility.

Leah Evans, chairwoman of the pensions board at the Institute and Faculty of Actuaries and a partner at EY, said LDI was “a valuable part of strategy”.

She disagreed that leverage in LDI was necessarily bad and warned about the danger of any “knee-jerk bans on leverage”.

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