Published on 17 December 2022


At the end of September 2022 a number of UK companies’ pension plans reportedly came close to collapse. This was to do with a financial instrument called a Liability-Driven Investment or LDI, which is a form of derivative contract.[1]

The explanations given for what occurred have ranged from ill-informed to denial to distraction.[2] This blog concentrates on just one element: why did pension funds have to sell investments to raise cash to place as security margin for these LDI derivatives if their contract counterparty was a clearing house?

Clearing houses and eliminating systemic risk from derivatives

One of the main actions after the Global Financial Crisis was aimed at reducing systemic risk in derivatives. Derivatives contracts, if entered into bilaterally or ‘over the counter’, were meant to be transferred via a legal process called ‘novation’ such that the original parties ceased to have one another as their counterparty but would instead have a clearing house like the London Clearing House.[3] The contract would be continuously revalued and eventually settled through the clearing house.

Parties would have to place security margin at the clearing house against their portfolio of contracts. The amount of margin would vary with market movements, but would at all times be adequate to ensure that the clearing house would not lose money if a party went bankrupt.

The upshot would be the elimination of systemic risk from derivatives.

Were LDIs ‘novated’ to clearing houses?

The concerning point about pension funds having to sell assets for cash is that clearing houses accept a wide range of types of asset as security margin, not just cash. Indeed, they accept gilts, which are the reference asset that LDIs are based on.[4] Pension funds having to sell gilts for cash strongly infers that LDI contracts were not novated to a clearing house, but remained as trades between the pension fund and a bank or even a non-bank financial institution.

This is exactly the type of situation that the measures to reduce systemic risk were designed to avoid.

It infers that a large volume of derivatives remains outside the scope of systemic risk-reduction.

Value-at-Risk in bilateral trades

It gets worse: LDI contracts are for very long maturities, possibly as long as 30 years, and have been put on while interest rates were very low. This combination translates into a high Value-at-Risk, or VaR, although how high will not have become clear until recently.

Banks, if engaged in a bilateral contract, must calculate the contract’s VaR: the maximum amount the bank believes it could lose if it had to replace the contract at then-current rates upon the bankruptcy of the other party. The bank must convert this VaR into a Risk-Weighted Asset by adjusting it for who the counterparty is (Counterparty Weighting) and for any security the bank has (Facility Weighting). The bank must then set aside capital as a portion of the Risk-Weighted Asset.

In fact, if the trade was between two banks, both banks would have to set aside capital.

Pension funds and other non-bank financial institutions are not subject to this regime, so they can build up portfolios of derivatives without setting aside capital.

Capital implications of trades through clearing houses and bilateral ones

This does not mean that pension funds and other non-bank financial institutions trade with one another on an unsecured basis. Bilateral contracts can be secured with margin, just like ones novated to clearing houses, and the margin amount can be calculated using similar VaR models.

When a bank places the margin required by the clearing house it does not need to set aside capital as well: the clearing house ranks, in the bank’s eyes, as a risk-free counterparty because it takes adequate security from all of its customers. Using clearing houses releases capital for banks compared to bilateral contracts which consume capital.

Pension funds and other non-bank financial institutions have to place margin with clearing houses just like banks do, but are not relieved from setting aside capital because they are not subject to the regime requiring them to do so in the first place.

On what basis have pension funds and other non-bank financial institutions traded?

It looks as if pension funds (and other non-bank financial institutions) have been able to build up portfolios of derivatives on a bilateral basis with banks and amongst themselves, and without having them novated to clearing houses.[5]

It looks as if only one party (the pension fund) had to place margin, whereas the pension fund had a risk upon the default of the other party, namely for VaR. The deal was one-sided: the pension funds margined the other party’s VaR risk but had no security for their own.

Cash appears to be the only form of margin accepted. We do not know if the amount of cash is as high as a clearing house would demand on the basis of its VaR calculations: it remains possible that banks and non-bank financial institutions have been presenting lower VaRs than clearing houses and therefore lower requirements for margin.

A lower ongoing margin requirement would certainly be to the taste of the pension funds, but it is only a provision, a form of ‘on-account’ payment: when the derivatives contracts go seriously out-of-the-money and quickly – as happened with LDIs – and the real bill comes in, it will be all the higher if the ‘on-account’ payment was low.

What are the lessons that should be learned?

The LDI crisis indicates that a large volume of derivatives, containing high VaR, has ballooned outside the scope of systemic risk reduction.

The terms on which these derivatives are secured may well be softer than would apply if they had been novated to a clearing house. When market prices move, this inherent under-collateralization will be rectified and the call for new margin will be larger. That in itself can trigger a systemic event as occurred with LDIs.

The lessons to be learned are that bilateral derivatives should be subjected to VaR calculations exactly equivalent to those used by clearing houses, and that bilateral business should be margined on exactly the same terms as business through clearing houses. Arguably non-bank financial institutions, outside the Risk-Weighted Assets regime, should be precluded from offering derivatives to their clientele and should only be allowed to use them for their own account. Pension funds could use derivatives, but could only enter into them with banks, and not with non-banks.

It is too late for many pension funds: their 2022 annual reports will show grievous losses on LDIs on a mark-to-market basis.[6] It remains to be seen whether they try to argue that LDIs continue to offer the benefits that they were put on to deliver, and/or that no loss in cash has been incurred. A quick course in Creative Writing is recommended. It remains to be seen how pension funds will account for the mark-to-market losses. Our examination of the John Lewis Partnership pension fund accounts for 2021 indicates that their losses on LDIs could be 75% of the fund’s 2021 value: a quick course in Creative Accounting could be needed there.

[1] accessed on 17 November 2022

[2] Our offering as per footnote 1 was deficient in the area that is the subject of this blog, an aspect which had not at the time come to light

[3] Such an organization is known by the term Financial Market Infrastructure and must by definition be resilient

[4] ‘Gilts’ or ‘gilt-edged securities’ are bonds issued by the UK government in £pounds

[5] Pension funds ought to have put their LDI trades on with banks and with other types of non-bank financial institution and not with one another. This is both a policy point and one of practicality: all the pension funds were trading in the same direction, namely receiving a fixed rate of interest and paying a variable one

[6] ‘mark-to-market’ means showing the current, lower value of the contract given the contract’s terms and its current replacement value