Tougher stress tests and better risk management in order to strengthen resilience to market shocks need to be deployed by managers of LDI funds, the FCA says.

The regulator published guidance Monday 24 April in the wake of last September’s crisis sparked by severe volatility in gilt markets. “The sector is now much more resilient to potential risks,” said the FCA, “but there is more to be done”.

It goes on: “’This guidance sets out what we expect in terms of risk management, stress testing and client communication, so that the necessary lessons are learned from last September’s extreme events.” And, it says: “Many of these lessons will be relevant to firms beyond the LDI sector.”

Market stability

Setting out its “observations and expectations” the FCA says: “We expect firms in all sectors to manage their products and services in a way that will enable these to perform in line with their stated objectives. They should also do so in a way that does not create risks to either the orderly functioning or the stability of UK financial markets.”

It says: “Strengthening the resilience of LDI strategies requires realistic contingency planning and the application of appropriately designed stress tests.”

Asset managers will be expected to set liquidity buffers for each sub-fund within any LDI strategy that would allow those funds to survive “sever but plausible” stresses. And plans to deal with adverse market conditions should be reviewed regularly.

Correct strategy

Investment managers should also take on greater responsibility for ensuring that pension scheme clients are using the right LDI strategy.

The full recommendations, with background on the regulator’s thinking, can be found on the FCA’s website.

The crisis last year – when gilt market yields rose from 0.974% at the start of the year to 2.803% at the start of August and then to 4.514% after the mini budget – led to calls for a rethink of regulation, and sparked questions about issues that went deeper. The FCA’s latest announcement is part of the response to those debates, but reading them now could strike observers as simply a plea for common sense to be applied.

But, as Rob Mason, Director of Regulatory Intelligence at Global Relay, our parent company, said: “The point here is that interest rates were at less than 1% in UK and similar in the US. Scenario planning may have been to see them double or triple in 6-12 months. To see such a huge move in such a short period was remarkable, which caught most historic planning schedules out.”