Views from the LDI desk – December 2024

Bank of England System Wide Explanatory Scenario
What does it mean for risk managing pension schemes?

Estimated reading time: 7 minutes

While the Bank of England (BoE) System Wide Explanatory Scenario (SWES) sounds like a dull and technocratic exercise only relevant to risk management geeks, it has important real-world implications for UK pension schemes and how they structure their investment strategies and governance approaches.

Three key takeaways:

• The SWES exercise has shown that while LDI resilience is much improved following recent reforms, potential risks persist around repo and credit markets.
• Further BoE repo facilities that will allow direct access to pension schemes may help add capacity to the market, but in a stressed market environment who your manager is and how they risk manage repo matters.
• Integrated LDI approaches that allow access to the full range of tools to manage collateral waterfall risk including CCGR/Credit repo and flexible rebalancing are key for schemes of all sizes.

What was the System Wide Explanatory Scenario?

The SWES was designed to evaluate the resilience of the UK's financial system. Operating within a specific timeline, this scenario-based analysis investigated the dynamic interactions between various market participants under stress conditions. The primary objective of SWES is to understand how the financial system might respond to significant economic shocks, and the implications for the stability of the broader economy.

One of the distinguishing features of SWES is its focus on the interactions among different market participants, rather than merely stressing individual institutions' data. This approach recognizes that the financial system's stability depends on the complex web of relationships and dependencies that exist between various entities. By capturing these interactions, SWES provides a more holistic view of the system's vulnerabilities and strengths.

Participants in SWES include a diverse array of financial institutions, each playing a different role in the financial ecosystem. Banks play a central role in lending and liquidity provision, and market dynamics are influenced by insurance companies’ and pension funds’ long-term investment strategies and risk management practices. Other investors such as hedge funds also participate, contributing to the understanding of how various participants respond to and influence market stress.

The exercise aimed to capture interconnectivity across the financial system

What were the shocks?

The SWES exercise included several predefined scenarios designed to stress different parts of the financial market. These scenarios covered a wide range of shocks, including:

• Market Risk Shocks: Significant declines in asset prices across various markets, such as equities, bonds, and real estate. This included rapid drops in equity indices, substantial widening of credit spreads, and decreases in property values.
• Liquidity Shocks: Sudden tightening of liquidity in key funding markets. This included a reduction in the availability of funding through short-term instruments such as repos and commercial paper, impacting the ability of institutions to meet their short-term obligations.
• Interest Rate Shocks: Unexpected and significant changes in interest rates, affecting the cost of borrowing and the value of interest-sensitive assets. In comparison to the gilt crisis of 2022, where there was a rapid rise in gilt yields, the SWES scenarios envisioned similar shifts to test the capacity of institutions to manage sudden interest rate volatility. This included modelling a scenario where gilt yields increased by several hundred basis points in a very short timeframe, mirroring the experience during the 2022 crisis.
• Operational Risk Shocks: Hypothetical scenarios involving disruptions to critical infrastructure, such as payment systems or key service providers, leading to operational challenges for financial institutions.

The shocks were assumed to occur suddenly, with little to no warning, to simulate a real-life crisis scenario. This required institutions to react swiftly and effectively to manage the immediate impacts. The overall magnitude of the shocks was a combination of the conditions experienced in the March 2020 COVID shock and the 2022 gilt crisis.

In the later stages of the SWES exercise, participants were asked to make additional assumptions to reflect changing conditions and further test their resilience. This included availability of Repo Financing.

What are the conclusions and what do they mean for UK pensions?

The final report from the Bank of England is detailed in its findings but draws six conclusions. Some of these such as conclusions 5 and 6 are more relevant to the wider financial industry and the next steps for regulators, but some very directly relate to how pension schemes set their governance and the choices they make in the investment strategies and products they use.

BoE conclusions from the SWES

On a positive note for Pension Schemes and the wider LDI industry that supports them, conclusions 1 and 3 found that the changes made to LDI resilience were successful in avoiding volumes of gilt sales that markets would be unable to support in an orderly manner. Continued vigilance of collateral resilience, including accurate measurement of all collateral risks remain key, but for the shocks specified in the SWES exercise the buffers calibrated following the guidance from the Financial Policy Committee in 2023 passed the test.

However, conclusions 2 and 4 are worth diving into further and thinking about as these were areas where the BoE found particular risks. Understanding these risks and how all pension schemes, whether using pooled or segregated LDI solutions, can take steps to manage them is vital.

Conclusion 2 – Repo Market Risks

The exercise highlighted significant repo market risks, particularly concerning the willingness of banks to continue offering repo balances to their counterparties. The findings indicated that in a market stress as outlined in the SWES, banks are likely to prioritize higher profit relationships, potentially leaving smaller or less profitable clients of the banks without access to necessary repo financing. This could create substantial liquidity issues for those counterparties unable to secure repo balances, either to maintain hedges or to raise cash to post as margin.

The BoE are taking steps to improve repo market resilience as Deputy Governor David Ramsden outlined in a recent speech. This includes further facilities for commercial banks to access reserves, as well as the new Contingent Non-Bank Repo facility, which we wrote about previously and will offer pension schemes and LDI funds the option to raise temporary liquidity from the BoE. BlackRock continues to work closely with the BoE and other industry bodies on the operational development of this facility to ensure our clients can access it if they choose to.

But as we wrote about in our November Repo Update, having a broad panel of counterparties, strong relationships as a key trading partner and carefully risk managing repo term profiles and roll risk also remain extremely important in mitigating these risks and managing financing costs.

Conclusion 4 – Credit Market Risks

On conclusion 4, the Bank of England made the following points:

The SWES identified how the sterling corporate bond market may be impaired as a source of liquidity and real economy financing after a SWES-like shock due to relatively price insensitive sellers rapidly acting to obtain liquidity or derisk through this market.

Many investors in the sterling corporate bond market do not tend to act quickly in a countercyclical fashion. For instance, they noted needing further time to access financing and to perform necessary due diligence to assess the corporate bond market. In addition, some end-investors use delegated fund managers to manage a large proportion of their investments, and not all of these arrangements build in flexibility to take advantage of market dislocations. This means that, in the timeline of the SWES, falling corporate bond prices do not lead to significant purchases.

Source: Bank of England SWES Final Report, November 2024.

While LDI resilience has been dramatically improved, much of this increased resilience is built upon the ability to sell credit assets to top up eligible collateral and as was experienced in Autumn 2022, being forced to sell into a stressed market after a material sell off can result in negative implications for funding levels.

Experiences of Autumn 2022 showed the potential impacts of selling into a stressed market can be material

Given the funding position of many schemes, credit is making up an increasingly large part of asset allocations, but what can be done to mitigate the risks of needing to sell credit in a stressed environment?

1. Expand collateral eligibility – managing your credit assets and LDI side by side and making use of tools such as Credit Collateralised Gilt Repo (CCGR) and credit repo can allow credit to be retained while broadening the collateral pool and increasing resilience.
2. Ensure flexibility around what should be sold – many traditional recapitilisation mechanisms require a specific fund or asset to be named as the source of capital should the LDI strategy require this. Moving to an asset allocation approach can help by ensuring better performing assets are rebalanced or allowing a mix of assets to be sold.
3. Diversify – diversify beyond sterling credit into more liquid markets but also consider diversifying beyond corporate bonds alone and the type of vehicle used, for example Fixed Income ETFs.

Some of these risk management techniques had until now been difficult for smaller pension schemes to achieve, but with the launch of new generation integrated pooled funds that combine LDI hedging and credit allocations, cost effective access to strategies such as CCGR, credit repo and flexible rebalancing are accessible to all schemes. These conclusions are not isolated to the BoE – the Bank for International Settlements recently stated in an extensive recent paper that:

“Our findings speak to the issue of LDI regulation because they suggest that balance sheet segmentation and operational frictions were fundamental drivers of the crisis. Therefore, regulatory reforms that aim to better integrate the balance sheets of pensions and their LDI investments could be effective at averting future crises.”

Integration and avoiding balance sheet segregation is key to robust risk management for pension schemes.

Three key takeaways:

• The SWES exercise has shown that while LDI resilience is much improved following recent reforms, potential risks persist around repo and credit markets.
• Further BoE repo facilities that will allow direct access to pension schemes may add capacity to the repo market, but in a stressed market environment who your manager is and how they risk manage repo matters.
• Integrated LDI approaches that allow access to the full range of tools to manage collateral waterfall risk including CCGR/Credit repo and flexible rebalancing are key for schemes of all sizes.

The opinions expressed are as of January 2025 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

Risks

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Past performance is not a reliable indicator of current or future results.

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

Important information

This material is for distribution to Professional Clients (as defined by the Financial Conduct Authority or MiFID Rules) only and should not be relied upon by any other persons.

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: + 44 (0)20 7743 3000. Registered in England and Wales No. 02020394. For your protection telephone calls are usually recorded. Please refer to the Financial Conduct Authority website for a list of authorised activities conducted by BlackRock.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

© 2025 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, and iSHARES are trademarks of BlackRock, Inc. or its affiliates All other trademarks are those of their respective owners.