Further guidance on enhancing resilience in Liability Driven Investment

The Financial Conduct Authority (FCA) has published guidance and recommendations for Liability Driven Investment (LDI) managers as regards the FCA’s expectations with respect to risk management, including liquidity risk management, stress testing, operations management, and internal governance. The guidance follows the publication of a recent paper entitled LDI minimum resilience – recommendation and explainer which was drawn up by the Financial Policy Committee (FPC) of the Bank of England and which sets out recommendations primarily for „The Pensions Regulator“ (TPR) as to a long-term approach for maintaining a minimum level of resilience among LDI portfolios (please see EventID 20431 in this context for more information).
The key expectations of the FCA are briefly described below; for more detailed, comprehensive information, please consult the original website or the enclosed document.
(1) General expectations: The FCA expects all firms to „manage their products and services in a way that will enable these to perform in line with their stated objectives“. Additionally, firms need to do so without creating risks for the stability or the functioning of the financial market. Particularly when leverage is part of a firm’s business model, must the company ensure to take adequate measures to mitigate any risks stemming from the leverage. Also, firms must ensure to mitigate the risks arising from specific operational arrangements, particularly those involving third parties that provide critical services to the entities.
(2) Risk management: The FCA expects LDI fund managers to adopt comprehensive risk management procedures to limit any potential effects from sudden, yet reasonable market movements. Considerations must thereby be given to issues such as
– concentration risks in terms of counterparties, asset, or specific asset criteria (e.g. duration);
– strategy concentration where several funds all may be impacted at the same time due to similar investment strategies;
– liquidity needs of funds and their pension clients;
– the level of leverage and the potential effects upon an LDI portfolio; or
– the sensitivity of the portfolio to macro-economic changes.
(3) Stress testing: In view of the above noted issues, the FCA strongly recommends LDI funds managers to adopt stress testing scenarios that are commensurate to their business scope and size. Stress tests shall, so the regulator, encompass any functional and operational dependencies to third parties; that is, the entire value chain should be considered. Additionally, stress test should cover „multiple and simultaneous scenarios“ where several potentially harming events take place at the same time (e.g. dramatic move in asset prices, increased liquidity needs, cyber attacks, etc.). Furthermore, stress tests should frequently be reviewed and adjusted based upon lessons learned from previous stress testing exercises.
(4) Operation management and governance: The Authority expects supervised LDI fund managers to have in place adequate liquidity buffers and liquidity trigger mechanisms. Additionally, they need to ensure that their clients are able to provide necessary collateral within five days following significant asset price movements that may trigger margin calls. If this collateral cannot be ascertained, LDI funds must increase their liquidity buffers accordingly. On top, LDI funds must have in place adequate „crisis response protocols“ that may be relied upon in cases of stress and that will lead the managers through the various steps that need to be taken in such event. Furthermore, LDI funds must be prepared to communicate with key stakeholders including pension schemes and regulators; again, appropriate protocols would be highly beneficial.
To conclude, the FCA notes that LDI fund managers must ensure that they prevent and – if not – mitigate any risks arising from conflicts of interest. Conflicts of interest may take various forms for LDI managers and it is important for fund managers to prioritize „their interests against those of their clients“ and to determine „how they prioritise actions or resources between different groups of clients“.