LONDON, Oct 8 (Reuters): A scramble for cash by Britain's pension funds after last week's bond market crash has raised questions about oversight of a 1.6 trillion pound ($1.8 trillion) business that has grown rapidly in recent years.
Pension funds had to post emergency collateral in liability-driven investments (LDI), which deploy a mix of both leveraged and unleveraged derivatives to safeguard against shortfalls in pension pots, after British government bond yields rocketed.
To halt freefalling prices, the Bank of England was forced to pledge to buy as much as 65 billion pounds ($73.63 billion) of long-dated government bonds, known as gilts.
Many pension funds struggled to find the extra cash at short notice. Some had to sell gilts in a firesale that put further upward pressure on yields and threatened a wider meltdown.
"Pension regulation is not the direct remit of Bank of England but stability of the financial system is," said Ian Tonks, professor of finance at the University of Bristol Business School.
After the global financial crisis of more than a decade ago, regulators tightened rules on banks. But pension funds, insurers and asset managers remain more loosely regulated, prompting warnings of even greater threats to financial stability.
LDI is a regulatory "grey area", one pensions industry source said. The Pensions Regulator (TPR) has day-to-day oversight of pension schemes to ensure they were well hedged, but it is not a financial regulator, meaning it is less focused on the risk behind the schemes' use of financial instruments.
Pension trustees decide on whether to use LDI, often based on advice from consultants which are not required to be regulated, and TPR guided in 2019 that it was common practice to use LDI to improve the matching of assets and liabilities.
LDI funds used by British pension schemes are largely listed in Luxembourg and Dublin, but their managers are based in Britain and regulated by the Financial Conduct Authority, while the BoE regulates banks, some of which act as counterparties.
LDI was born out of a need to plug shortfalls in defined benefit pension schemes, especially as central banks slashed interest rates after the global financial crisis.
Its popularity has boomed in recent years, helping many pension funds to not only meet those long-dated obligations but also generate a surplus.
But leverage in many LDI products was still rising in 2022 as central banks started hiking rates. That turned positions once largely designed to be defensive and protect from falling interest rates into riskier ones much more exposed to movements in rates and inflation as bond prices fell and yields rose.
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