Between summer holidays, interest rate cuts and bouts of market volatility it is easy to miss some of more niche but important announcements being made in the market and there are two recent pieces released by the Bank of England (BoE) that we’d like to draw attention to:
We provide BlackRock’s initial thoughts and observations on both in this piece.
Contingent NBFI Repo Facility
What is it?
The Bank of England (BoE) has formally announced the implementation of a new liquidity facility, the Contingent Non-Bank Financial Intermediation Repo Facility (CNRF), in a provisional market notice on 24 July 2024.
Ultimately, the aim of this facility is to provide a backstop in a scenario where banks are no longer willing or able to intermediate in the bi-lateral repo market, to allow eligible counterparties to continue to roll repo positions and access cash to collateralize cleared derivatives. This was more of a concern in the March 2020 dash for cash than the September 2022 Gilt crisis, but none the less is a potential avenue of market discord.
The notice included further details on eligibility, design, and operations:
- The CNRF will provide sterling liquidity, in the form of central bank reserves, to eligible entities against gilt collateral in times of severe market stress.It will be activated by the BoE's Financial Policy Committee (FPC) if it judges that NBFI funding conditions are deteriorating significantly, posing a threat to financial stability.
- The eligible non bank financial intermediaries (NBFI) include insurance companies, pension funds and investment funds used primarily for LDI that are regulated by a relevant body, meet ‘an appropriate standard of financial health’; and make a ‘material contribution to the Gilt market’.
- The eligible NBFI will need to pre-qualify for the CNRF by signing a legal agreement with the BoE and providing information on their business model, funding sources, liquidity profile and collateral holdings.
- The eligible NBFI will be able to access the CNRF either directly or through an agent (for example a bank), who will act as intermediaries between them and the BoE.
- The eligible NBFI will pay a fee to the BoE for the use of the CNRF, which will be set at a level that reflects the risk and cost of providing liquidity insurance, including an ongoing annual fee.
Many key details such as what is a material contribution, the annual fee, and other conditionality for counterparties are as yet unknown. The BoE expects to take applications for the CNRF from Q4 2024 and we would expect more details will become available then.
Will BlackRock enable clients to access it?
BlackRock can facilitate access to this facility for clients and fund ranges that request it. We note that this is still subject to a lot of unknown details.
Key decisions will need to be taken on whether to access the facility directly or via a bank intermediary as more information on how the facility will be operationally setup become known.
What next?
BlackRock plans to engage further with the Bank of England on the practical operation and setup of the facility to ensure a smooth and efficient process for clients who wish to access this facility when it comes online.
Key takeaways
This facility has the potential to provide a backstop to the use of repo to gain leverage which is exposed to roll risk and to the use of cleared derivatives that require cash margin, in a scenario where commercial banks can no longer provide it.
However, many uncertainties remain around cost, attractiveness, and other conditionalities of this, as well as operational details and constraints.
Fire Sales of safe assets
What does the paper cover?
The paper is very detailed and academic in nature, covering a lot of ground on the impact of LDI driven gilt sales post the market volatility triggered by the Mini Budget held by the previous Government in September 2022. It aims to quantify the impact of sales, why buyers may not have emerged to oppose these moves and some of the reasons sales may have been required by LDI.
What are the conclusions?
The paper’s conclusions are not unfamiliar in flagging that the sale of assets was mostly prompted by operational frictions. These paragraphs are the most substantive in terms of the authors’ findings:
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. The FPC’s recommendations on streamlining operational processes at pensions and LDIs are aligned with this thinking. Further measures could include establishing automated collateral transfer facilities during periods of market stress (Kodres, 2023) and encouraging pension schemes to create repo facilities that can quickly generate liquidity from existing assets.
Additionally, encouraging pensions to invest in LDIs through segregated mandates would naturally facilitate better integration of their balance sheets.
This discussion raises a broader question: why were LDI funds originally structured in a manner that seemingly did not prioritize preventing fire sales? Given the mutual benefits for both LDIs and their pension investors in avoiding such scenarios, the private sector’s failure to adapt its contracting and operational arrangements in advance of the crisis is puzzling. These considerations are crucial for understanding how decisions regarding capital structure and contract design, made well before crises emerge, can be optimized to avert future fire sales.
Existing LDI pooled fund structures were often structured to provide flexibility over asset allocation and in some cases in the market even manager selection, something that was more important to schemes when many needed to generate high levels of return to close deficits.
Many schemes have integrated their LDI and collateral waterfall assets into holistic single mandates post crisis and while we agree that integrating the balance sheet increases operational efficiency, reduces governance lags and that this is readily done in a segregated account structure, this approach is not suitable for all schemes given asset size and practical considerations.
BlackRock recently received FCA authorisation to launch new integrated LDI pooled funds, which bring together LDI and various credit assets in the same fund structure to overcome balance sheet separation for smaller schemes. This removes the need for any recapitilisation process external to the funds. The new integrated structure also allows pooled funds to take advantage of additional resilience tools such as credit repo and credit collateralised gilt repo that have otherwise only been available to segregated LDI investors.
Approaches to leverage management for new generations of LDI pooled funds are evolving
Source: BlackRock. Illustrative only.
Key takeways:
While regulators have been focussed on increasing collateral resilience through guidance to pension schemes (including that from the Pension Regulator and Central Bank of Ireland) and through considering how potential tail event scenarios in financing markets can be mitigated, they are also clear that good governance and operational setup remain focus areas as well.
In summary:
UK pension schemes and how they implement their investment strategies have been a key focus for regulators and the BoE following the 2022 gilt crisis prompted by the mini budget.
- They are following a three pronged approach:
- Ensuring schemes and funds are operating sufficiently large collateral buffers, aligned with the framework from the Financial Policy Committee and subsequent regulatory guidance from relevant local regulators.
- Providing a backstop to the Gilt repo market in scenarios where commercial banks are no longer willing or able to provide additional funding.
- Encouraging Pension Schemes to consider their governance arrangements to ensure operational frictions or ambiguous governance processes do not cause forced sale activity in the future.
BlackRock’s LDI team is aiming to ensure that pension schemes and their advisors have the tools in their armoury to adapt their risk management to be best in class. This includes innovations such as credit collateralised gilt repo, integrated approaches to managing segregated LDI mandates, the launch of new integrated LDI pooled funds and engagement on and facilitation of CNRF.
