Too Many Cooks, Not Enough Risk Management: Gilt Market Dysfunction and Liability-Driven Investment (LDI)

In September and October 2022, the Bank of England intervened in the gilt market, buying up gilts and providing a new liquidity facility for a subset of gilt market participants—Liability Driven Investment (LDI) fund managers—to halt a potential fire sale of gilts. Such a fire sale would have impeded the normally functioning of the UK’s government market—raising yields and widening bid-ask spreads—with likely knock-on effects to the broader economy through a rapid and large tightening of financial conditions. Although the Bank of England’s gilt purchases and liquidity support appeared to be necessary, it has raised a number of questions about how a relatively small set of actors could cause such a large problem and what can be done to avoid a repeat of the event. Importantly, that small set of actors were non-bank financial institutions (NBFIs) that took on leverage without properly assessing and preparing for its liquidity implications. This paper explains how LDI strategies operate and how they led to gilt market instability, taking into account the underlying market conditions and the condition of UK defined benefit (DB) pension funds using these strategies. It then proposes solutions to avoid such situations in future, some of which have been suggested by other policymakers, but others are new. As well, the paper points out some misdiagnoses of the causes and misunderstandings about proposed policy solutions that could result in unintended consequences in the future.