There has been a lot of market volatility this week largely driven by what's happening in the UK. It has a lot to do with pension funds, gilts, and the Bank of England. I put together an easy-to-understand summary. The entire situation is a bit more complicated and I might have missed a point or two, but I tried to keep this as high-level as possible.
- Pension funds have to pay retirees a fixed amount
- They purchase UK government bonds (gilts) because they are one of the safest investments (gov’t backed)
- The gilts’ value fluctuates based on interest rates so pension funds need to employ a strategy to hedge against those fluctuations
- Pension funds turn to Liability-driven Investment (LDI) funds to manage an LDI strategy, which uses derivatives such as interest rate swaps to hedge against fluctuations
- But in order to enter into and secure these contracts and swaps, you need to post an underlying asset as collateral (i.e., your contract has to be backed by some sort of asset), which in this case is gilts (and some cash)
- As part of a swap agreement, there are margin requirements, meaning the value of the underlying collateral has to meet a minimum required amount
- But gilts suddenly collapsed in value (due to selling off) when the UK chancellor and prime minister announced their tax cut strategy last week
- Why did the UK chancellor and prime minister announced tax cuts? Because they wanted to “spur economic growth”
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People became fearful for several reasons:
- a tax cut means that the government will have to take on greater debt at a time when interest rates are rising to fund whatever projects or spending they require
- More debt leads to fears of greater inflation
- Greater inflation leads to potentially greater rate hikes
- Greater rate hikes mean greater cost to borrow
- It is a vicious loop if not managed properly
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As a result of fear and uncertainty, and low confidence in the future, people began dumping the pound and the value of the pound plunged. The UK market and markets in general sold off
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Gilts, which are supposedly one of the safest investments in the UK began to sell off and collapse in value as fear set in
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When the value of gilts collapsed, pension funds had to post additional collateral (margin call) to meet those margin requirements per the swaps contracts
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This meant that pension funds had to find cash to provide to LDI funds to meet the margin call, or slash positions in gilts in order to get hold of cash
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Most pension funds did not have the necessary cash reserves to meet those margin calls — no one expected such a sharp drop in gilt value
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If pension funds aren’t able to pay up they get kicked out of their derivatives positions. When they are kicked out, they then have naked exposure to further sharp moves in in rates and therefore value of gilts
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This would potentially have been disastrous given that pension funds might not have been able to meet their future liabilities (payments to retirees). This is a big deal given the size of total pension fund market (in UK ~$3.59T). Imagine tens of thousands (if not hundreds of thousands?) of people relying on their pension fund for retirement and potentially not being able to receive their guaranteed amt. Imagine in the worst case scenario where ~$3.59T is wiped out, pension funds become insolvent, and the trickle-down implications it could have for the broader economy. This is why some compared this to an almost Lehman Brothers event
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Pension Funds asked the Bank of England (BOE) to step in and intervene
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BOE states they will temporarily buy gilts and do whatever necessary and pledge unlimited purchases to help stabilize the situation
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How would this stabilize the situation? Because purchases of gilts would prop up the value of gilts (think increase in demand to meet large supply) and reduce or eliminate margin calls for pension funds. No margin calls = pension funds can keep their derivative positions to continue hedging their gilts
Lots of uncertainty and fear right now. Let's see what the next weeks look like.
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