The UK financial watchdog has urged asset managers to develop stress testing and risk management for liability-driven investment (LDI) funds with a “matter of urgency.”
The Financial Conduct Authority (FCA) issued guidance to enhance the resilience of LDI funds and improve risk management because there are significant deficiencies in the management of LDI fund risks, including a lack of stress testing and scenario planning.
The lack of risk management across the sector was highlighted last September when the spike in yields triggered a spiral of collateral calls and forced gilt sales, leading to market dysfunction.
The Bank of England was forced to intervene and buy UK government bonds to help bring down yields and relieve the pressure on LDI funds.
To strengthen the resilience of LDI strategies, the FCA recommends special considerations given to liquidity risks as well as stress testing.
According to the watchdog, liquidity management measures – such as fund liquidity buffers – and changes to clients’ liquidity are a “necessary but only partial solution to address vulnerabilities.”
As a result, LDI managers must appropriately design stress tests that consider multiple and simultaneous scenarios.
Combined scenarios could include both external events, such as a change to prices, or operational events, including incidents like a supplier failing or a cyber-attack.
Stress testing should also consider potential sequences of events, such as how market, operational or client challenges may arise at different points during a stress scenario.
The FCA advises all stress tests are reviewed regularly and particularly when circumstances alter, which includes material changes to the products.
In the guidance, the FCA stated: “Robust stress testing allows firms to better prevent and manage the adverse outcomes arising from a wide range of risks, including those in the broader value chain.”
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