It is easy to be wise after the event, less easy to face up to the reasons for wisdom’s late arrival. After the crisis caused by the use of liability-driven investment (LDI) strategies in the pensions industry the question of ‘how could we possibly have let this happen?’ is being widely discussed. Which means the focus rapidly turns to whether this was a failure of regulation.

There are certainly questions to be asked of regulators and the regulation process, especially when they have admitted, as Financial Conduct Authority chief Nikil Rathi did, that the issue was “not at the top of our radar”. And Charles Counsell, chief executive of The Pensions Regulator, conceded his organization “didn’t have as much data” on the use of LDI strategies “as perhaps we would like to have”.

Think about that for a moment. Total worldwide LDI assets under management were estimated by specialist website Pensions & Investments to be worth $3.9trn by the end of 2021, with UK pension schemes accounting for £1.4trn ($1.9trn) of laibilities. The Financial Times calculated that “some LDI funds allowed pension schemes to buy an exposure worth up to £7 in gilts for every £1 invested in a derivative contract”. But it all went under the radar, and the regulator didn’t have as much data as it would “perhaps” have liked.

Liquidity crisis

To be fair to the regulators, and as Rathi himself pointed out, no one predicted the UK government led by Liz Truss and Kwasi Kwarteng, pictured above, would prompt a 250-basis-point move in index-linked gilts in just five days that would spark a huge liquidity crisis. That was genuinely unprecedented. And the fact that detailed information about derivative trades in the gilt market is not released publicly did create a regulatory blind spot.

But (and you knew that word was coming) identifying the bottom line in this whole affair involves a much simpler analysis than one which attempts to use the complexity of the financial instruments deployed to blur the picture. As Sarah Breedon, the Bank of England’s Executive Director for Financial Stability said: “The root cause is simple. Poorly managed leverage.”

Leverage is in the headlines not just because of the LDI crisis, but also because it has a central role in the frankly astonishing tale of the crash of crypto exchange FTX. There seems to be a lack of understanding of what leverage really is, and a lack of awareness of the exposure that can come with it.

There seems to be a lack of understanding of what leverage really is, and a lack of awareness of the exposure that can come with it.

Regulators in Ireland and Luxembourg have already begun to ask asset managers to inform them if they increase leverage in the funds they manage. This has led some fund managers to block attempts to releverage. Conversation among UK regulators and policymakers has already prompted discussion of stress tests and the promotion of a more general awareness of potential consequences alongside calls for more detailed information to enable some kind of reliable measure to be applied.

However, there is more than a chance that all of this will only amount to dealing with symptom rather than cause. That’s certainly the view of Terry Smith, chief executive of Fundsmith LLP. Writing in the FT just after the crisis blew up, he questioned the basic premise of LDI.

“The idea was that a fund would estimate its future liability to pay out pensions by buying bonds or gilts to match those liabilities at maturity. This approach is flawed,” he wrote. “Why not try to invest in assets that should produce a higher return than gilts over the long term, such as equities?”

Energy of volatility

LDI strategies sought to harness the energy of volatility, but Smith argues that, for long-term investments such as pension funds, if you try “to eliminate price volatility from your portfolio, you will not only fail, but more importantly you will end up focused on the wrong risk”.

The discussion about greater or better regulation of LDIs looks set to continue, but should it really be focused on promoting a greater understanding of the nature of risk and the consequences of actions, rather than simply better measurement of a strategy that may be inherently flawed?