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The European Securities and Markets Authority (ESMA) has provided its backing to the actions of financial regulators in Ireland and Luxembourg designed to protect the resilience of liability-driven investment (LDI) funds.
The Central Bank of Ireland (CBI) and the Commission de Surveillance du Secteur Financier (CSSF) have each written to LDI fund managers asking them to maintain the current level of resilience of their GBP-denominated LDI funds and to ensure that there is no significant rise in the risk profile of GBP LDI funds under their management.
This action marks a response to the vulnerability experienced by some GBP-denominated LDI funds in the wake of the UK mini-budget, when funds found themselves needing to meet sizeable margin calls against their collateralised exposures following the volatility surge in the UK gilts market in September 2022.
According to the letters written by Irish and Luxembourg national competent authorities (NCAs), fund managers wishing to reduce yield buffers for GBP LDI funds below their current levels will be expected to inform their NCA in advance, explaining the justification for this change.
ESMA indicates that it welcomes this action from CBI-Ireland and CSSF and reiterates the importance of strengthening funds’ resilience, given that large and unexpected shocks can develop rapidly under current economic conditions.
With this in mind, ESMA encourages information sharing and coordinated regulatory activity across NCAs to address risks associated with LDI funds and, more broadly, with risks which may threaten financial stability.
In its letter to LDI funds, CBI highlighted that recent volatility in yields linked to UK gilts gave rise to a concerning cycle of collateral calls and forced sales for some GBP-denominated LDI funds.
The CBI and CSSF indicate that they engaged proactively with managers of GBP LDI funds throughout this period of instability and, subsequently, resilience of these funds across Europe has improved, with an average yield buffer being established of 300-400 basis points.
The CBI letter, signed by head of securities markets and funds supervision Darragh Rossi, states that: “Given the current market outlook, the NCAs expect that levels of resilience and the reduced risk profile of GBP LDI funds are now maintained, and do not consider that any reduction in the resilience at individual sub-fund level is appropriate at this juncture.”
Should the resilience of a LDI fund fall below this level [ie “below the levels that were achieved in the period following the dislocation in the UK gilt market”], the fund manager must inform its relevant supervisory authority, provide justification based on detailed risk assessment, and submit a step-by-step plan for returning the GBP LDI fund to this required level of resilience.
In cases where the changing market environment results in an inadvertent reduction in the resilience of GBP LDI funds — including a decrease in the market value of assets held by the fund — CBI and CSSF require the fund manager to have procedures in place to recapitalise or de-risk their portfolios through a timely reduction in their exposures. This must take into account the “second-round effects” of actions by other market participants on the individual LDI funds, for instance the market impact of asset disposals triggered by rising yields.
CBI and CSSF indicate that these measures apply to GBP-denominated LDI funds and are not applicable to LDI funds in other currencies for the time being.
However, NCAs require LDI managers to maintain an appropriate level of resilience for all LDI funds at an individual sub-fund level to ensure they can absorb possible market shocks. This, again, must include possible “second-round effects” of actions taken by other market participants, including the potential impact of forced sales.
