Guilty as Charged

For all the talk of upcoming crypto regulations, the issue occupying regulators’ minds at the moment is how to fend off the ever-impending collapse of the present market system. A simple shift in public policy in the UK recently caused a potentially catastrophic collapse in the strength of sterling, leaving pension funds on the brink of disaster.

For years the financial markets have been used to incredibly low-interest rates which made government bond purchases low-yield investments. Pension funds were duty-bound to invest in safe-haven assets such as government bonds, and also to secure enough of a yield to finance future payouts.

The solution to this quandary in the UK was a scheme called Liability Driven Investment (LDI) which aimed to hedge bond investments against fluctuations in interest rates. Hedging normally means that an investment is de-risked and consequently has a lower overall yield.

The difficulty in hedging low-yield bond purchases is that the de-risked yield becomes even lower, making the investment practically useless. What makes LDIs different is that they incorporate a degree of leverage into their positions.

For every £1 of gilts, or UK government bonds, hedged with an LDI the pension funds only needed to provide 25% collateral. This meant that they could invest in bonds, hedge them, and with the remaining funds they could invest in riskier stocks to gain the return they needed to ensure the fund grew in line with their requirements.

LDIs rapidly grew in popularity amongst pension funds as they enabled them to have highly liquid investments in stable products such as gilts and extra resources for riskier trades. This meant they would pass the requirements for stress testing as gilts are usually considered highly liquid and stable assets.

Problems began to surface during the quantitative easing measures central banks implemented to tackle the covid crisis. It was obvious to most economists that money printing would lead to currency devaluation in the form of inflation. However, the boost of liquidity in the money supply caused stocks to soar and the pension funds were reluctant to reverse their very profitable strategy.

Even when the writing was on the wall, pension funds continued to scale into LDIs as recently as June 2022. The Bank of England (BoE) was much slower to raise interest rates than the US Federal Reserve, so pension funds thought they had enough time to offset their positions gradually.

What the markets failed to predict was the catastrophic effect a change of leadership and political ideology within the UK would have. Weeks after the country’s new Prime Minister was appointed they issued a mini-budget, outlining their future plans for growth which involved several tax cuts funded by increased borrowing.

What spooked the markets wasn’t the size or scale of the tax cuts which were estimated at around £70 billion. It was the change in monetary policy from quantitative tightening (QT) to quantitative easing (QE). This was the opposite approach to that being taken by the US and IMF.

Prior to the mini-budget, the UK had already announced they would subsidize UK energy bills in a move that would cost somewhere between £40 — £60 billion. Markets hadn’t reacted badly to that news as it was considered the only way to prevent rising energy costs from feeding into inflation. However, giving people more disposable income by reducing taxes was seen as feeding inflation, so markets predicted the BoE would have to raise rates aggressively.

This meant the government’s new policy would be undermining its own central bank’s policy. The result was an immediate increase in the price of gilts, which ordinarily isn’t too much of a problem. However, for the pension funds who were hedging such rises with leverage, it was disastrous.

As the margin calls started to come in, pension funds were facing no option other than to sell their gilts to raise capital, or face having their positions liquidated. Fearing a leverage cascade the BoE stepped in, announcing they would buy as many gilts as they needed to in order to stabilize the market. This meant that both the government and its central bank had now pivoted to QE.

With the BoE understanding their measures had to be extremely time-limited the pressure was on the government to reverse course and get back into lockstep with the US and IMF. What’s now certain is that the next interest rate rise in the UK will be higher than previously anticipated in August, and the government is now bowing down to pressure from the market.

When the UK finally manages to recover from its moment of madness it will experience a deeper and longer recession than previously thought. Whilst regulators can control market participants to some degree this shows they have no control over politicians who can undo hard-won gains in a matter of moments. It also shows they have little forethought or ability to prevent systemic risks to markets within the present financial system.

Previously we’ve seen how regulators seem unable or unwilling to stop money laundering in major banks, such as Credit Suisse. Now it appears they are unable to prevent systemic risks in the pension sector as well. It seems strange that they’re focused on attempting to restrict innovation in the cryptocurrency market while failing to do their main job of regulating the current global financial system.