FCA publishes guidance to enhance resilience in Liability Driven Investment

On 24 April 2023, the FCA published guidance and recommendations to Liability Driven Investment (LDI) managers to "enhance the resilience" of the LDI market, particularly in the context of pooled funds.

Background

Since the events that occurred in the gilt market in September 2022, the FCA have been “closely monitoring asset managers using LDI strategies as they make improvements and the sector is now much more resilient to potential risks, but there is more to be done.”

This latest guidance sets out what the FCA expects in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events. The FCA has noted conflicts of interests as a key obligation that managers must be mindful of in this area.

The FCA considers that many of these lessons will be relevant to firms beyond the LDI sector. As such whilst the observations in its statement apply principally to FCA-authorised investment managers providing services in relation to LDI strategies (this includes UK MiFID firms managing separate accounts for pension schemes and pooled or single-client LDI funds), the FCA expect other market participants to consider their own practices and to take appropriate lessons from the relevant observations in this publication.

Key Observations and Expectations

In this paper the FCA sets out its recommendations on how firms can increase their resilience to future market volatility:

• Risk Management and stress testing recommendations:
  • The FCA says that it expects firms to develop their own scenarios to test resilience for their business and their specific sources of risk – stress tests and contingency plans should consider multiple and simultaneous scenarios (combined scenarios could involve both external (e.g. a change in price or liquidity for an asset type) and operational events (e.g. a critical system or supplier failing or a cyber-attack)).
  • Stress tests and contingency plans for dealing with such scenarios should be reviewed regularly and particularly when circumstances alter. This includes when there are material changes to the product design, client base or the markets to which strategies are exposed.
  • Liquidity management measures such as fund liquidity buffers and changes to clients’ liquidity waterfalls are a necessary but only partial solution to address vulnerabilities in the FCA’s view. Liquidity buffers should be set for each sub-fund at a level that allows them to: withstand severe but plausible stresses in the gilt market; meet margin and collateral calls without adding to market stress; and withstand the foreseeable demands that may be made. Buffers should also reflect the composition of the client base of that fund or sub-fund.
  • Managers are expected to clearly understand the risk factors relevant to their portfolios (and the FCA sets out a non-exhaustive list of the considerations it considers effective risk management to include).

• Operational arrangements, communications and clients: 
  • The FCA observes that in general firms’ systems were not set up to allow them to react with the speed that was needed during the LDI crisis.
  • As part of their contingency planning, risk management and client obligations, the FCA expect Managers to:
    • Review the design of product operations, including features such as recapitalisation processes and buffer triggers to enhance their effectiveness even in stress scenarios;
    • Make any necessary changes to their operations to enable clients to be able to deliver collateral to their LDI vehicles within five days or sooner. Where this isn’t possible, other liquidity measures (e.g. buffers) should be increased to reduce the additional risk;
    • Inform clients clearly both what they will need to do if identified circumstances arise and the consequences if clients are unable or unwilling to take these actions;
    • Verify that they and their key stakeholders (such as bank counterparties) have operational and contractual arrangements in place to carry out any required action which the fund is dependent on;
    • Have established, tested and appropriately detailed crisis response protocols for the various stress scenarios that may arise;
    • Have visibility of underlying processes at critical suppliers that are necessary to the smooth running of their products. This would include how these processes might operate in stress scenarios where activity volumes, and the protocols for managing these may be different;
    • Anticipate and be fully prepared for the likely information needs of key stakeholders, including regulatory bodies, in such events;
    • Consider the operational stresses identified and how they impact on their firm’s ability to remain within its impact tolerances for its important business services;

• Additional expectations on client relationships and conflicts of interest 
  • While product selection decisions are made by pension schemes with their advisers, the FCA considers that Managers have a role in aiding schemes’ assessment of the LDI approach that is most appropriate to their needs. This would include both the LDI strategy and the contractual form, whether a fund or a segregated mandate. The FCA guidance notes that some pooled fund clients may have been better served by having had greater operational flexibility than the pooled fund model offers.
    • Managers should support engagement with LDI clients to establish that they are using the most appropriate products for delivering the intended outcomes.
    • Managers should also be mindful of potential conflicts, which the FCA noted can arise in different ways here - between clients in the same fund (e.g. regarding information provision / access); between clients in different funds (e.g. based on their positions, strategies or approaches); between LDI and non-LDI clients; and between the firm and one or other of these groups of clients. The FCA specifically flagged that conflicts may also arise between Managers and their LDI clients where Managers encourage LDI clients to make changes to how and where they allocate their non-LDI assets in response to September 2022’s events. Managers should therefore review their approach to conflicts in the light of all the issues experienced and make any necessary improvements to how these are identified and fully managed.

Next Steps

LDI Managers are expected to complete and embed as a matter of urgency all necessary improvements to their operating practices to address the deficiencies identified. The FCA will be working with firms to assess their progress in addressing vulnerabilities. In collaboration with other authorities, it is also engaging with the sector on its implementation of and compliance with guidance or requirements issued by other authorities, including the Bank of England Financial Policy Committee publication in March 2023 which set out how resilience of LDI funds should be addressed on a more durable basis, and the Pension Regulator’s guidance on using leveraged LDI  issued in April 2023.

Firms should reflect on the feedback provided by the FCA in the context of their risk management, operational and conflicts framework for LDI strategies and products, and consider where uplifts may be necessary or prudent (e.g., firms may wish to simulate / stress test the LDI crisis as part of their control framework going forward, and also reflect on lessons learnt from the events of September last year).

The FCA’s guidance can be found here.