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The Luxembourg and Irish regulators, the CSSF and CBI, have recently published several formal rules applicable to sterling denominated LDI funds. This paper summarises the new rules and what this means for LDI investors as well as referencing our views, as shared in the recent consultation process.
The Luxembourg regulator, the Commission de Surveillance du Secteur Financier (“CSSF”) and the Irish regulator, the Central Bank of Ireland (“CBI”) have recently published several formal rules applicable to sterling denominated LDI funds, with the European Securities and Markets Authority (the EU’s financial markets regulator and supervisor) publicly stating its agreement with the new measures.
These announcements follow market consultations on the proposals by the CSSF and CBI on 23 November 2023. As a leading LDI manager with LDI funds domiciled in Luxembourg (most LDI funds are domiciled in either Luxembourg or Ireland), we responded to the CSSF consultation and subsequently engaged directly with the regulator to discuss our response.
In this note, we summarise the new rules and discuss what this means for LDI investors as well as referencing our views, as shared in the recent consultation process.
As a leading LDI manager with LDI funds domiciled in Luxembourg, we responded to the CSSF consultation and subsequently engaged directly with the regulator to discuss our response.
We note that the CSSF and CBI consultations were conducted in parallel, resulting in the sharing of feedback and intentionally identical rules. We welcome this cross border collaboration and the regulatory consistency that it delivers. Overall, the rules are intended to codify guidance that had already been published, and therefore the overall market impact is modest. We support the spirit of what the rules are seeking to achieve and are grateful for the opportunity to have engaged with the CSSF to help share our perspective.
Scope of application
These rules specifically apply to sterling denominated LDI funds only. The definition of LDI funds is clear and managers are required to adopt a prudent approach to applying the definition. We agree with the regulatory view that the sterling and euro markets are different. We see the euro market as having materially greater depth and breadth of issuers and investors, meaning that the likelihood of experiencing a systemic shock similar to that seen in the UK market during the gilt crisis of 2022 is lower. That said, we made several enhancements following the gilt crisis which were equally applicable to both euro and sterling funds. For example:
- we enhanced the buffer reporting we provide to regulators in respect of our euro LDI funds;
- we enhanced our operational processes consistently across both fund ranges; and
- we have reduced leverage within our euro fund range, albeit not to the extent that we did for our sterling fund range.
Buffer level
All sterling denominated LDI funds must maintain a yield buffer, or resilience, of 3% or more, with this level being viewed as a minimum rather than a target. This is consistent with our existing approach, whereby we monitor all LDI portfolios to this threshold daily and use it as a trigger for initiating a fund recapitalisation. The calculation of the buffer must include a consideration for convexity, again, consistent with our current calculation methodology. In our response to the consultation, we stressed the importance of accounting for convexity but suggested that the regulator not be overly prescriptive about the precise calculation given the variety of methodologies available. We are pleased to see these views reflected in the final drafting.
The 3% buffer cannot also be used to support derivatives that provide non-sterling rates exposure (e.g. synthetic equity and credit exposure). This is consistent with our current buffer setting approach in that we will define a higher than 3% aggregate minimum buffer where we need to account for any other derivatives exposure a portfolio may have.
Reporting and buffer flexibility
Monthly average buffer levels are to be reported to the CSSF, the requirement being that the monthly average will be equal to or greater than 3%. We currently report buffer levels to regulators weekly, so the monthly requirement is less onerous. Such reporting is the responsibility of the LDI fund manager and so has no client impact.
During the consultation, we highlighted the difficulty of adhering to a backwards looking metric because in the absence of successfully predicting future market moves, one only has visibility of being below the relevant threshold after the fact. The purpose of the buffer is to protect the LDI strategy from market shocks so we must be able to use it for this purpose in extreme situations. We therefore welcome the practical flexibility that the CSSF has built into this rule: Firstly, a fund may be below the 3% threshold for one month in four, and secondly, the CSSF may disapply the yield buffer requirements in response to a significant market shock. We note that the CSSF expect market participants to notify them if they anticipate a prolonged deviation below 3% and clarification that taking advantage of the ‘one month in four’ rule does not require notification. These notifications are the responsibility of the LDI fund manager.
Buffer composition
Only assets that sit on an LDI fund’s balance sheet (i.e., within the fund, so it does not include any assets held alongside the fund) may be included in the buffer calculation, which is consistent with our feedback during the consultation process. Buffer assets should then be eligible to meet margin or collateral calls or transformable into such assets with “requisite speed” with the time taken to transform such assets being aligned “with the settlement period of a fund’s leverage”. It is also expected that assets which require transformation should account for a limited part of the buffer. Buffer assets should therefore be assets such as gilts, cash, money market funds/assets and corporate bonds, which are either eligible collateral/margin, or can be transformed into eligible collateral/margin on a T+1 basis or quicker, to align with the settlement cycle of collateral and margin calls within the fund. This is consistent with typical buffer assets currently held within multi-client pooled LDI funds and so will not have any investor impact.
Buffer assets should therefore be assets such as gilts, cash, money market funds/assets and corporate bonds, which are either eligible collateral/margin, or can be transformed into eligible collateral/margin on a T+1 basis or quicker, to align with the settlement cycle of collateral and margin calls within the fund.
Of relevance to bespoke LDI funds (funds of one), this definition excludes many funds such as multi-asset funds, diversified growth funds and credit funds which, whilst daily dealt and highly liquid, are likely to have longer settlement cycles than T+1. These assets remain appropriate “tier 2” collateral waterfall assets from which you top up your “tier 1” assets (cash, money market funds, gilts, directly held credit bonds), and it remains highly advantageous to hold them within your bespoke LDI fund for reasons of expediency and governance. However, some clients may need to make modest adjustments to collateral waterfall triggers to reflect this definition.
Timeframes
While existing sterling denominated LDI funds must comply with the new rules by 29 July 2024, new sterling denominated LDI funds launched prior to this date must be compliant from inception. Given the modest nature of the changes, we see this timeframe as realistic for the industry. From our perspective, the main action point will be developing and testing the required monthly reporting before the deadline.
Summary
Overall, these new rules are largely consistent with our current strategy and processes and so we expect little or no material impact on our multi-client pooled fund investors. They potentially have some marginal impact on bespoke fund investors, depending on the nature of the current collateral waterfall and associated buffer top-up triggers. The comments to above regarding buffer composition (eligibility and liquidity) will need to be considered to ensure that portfolios are compliant with these definitions. However, where clients hold non-LDI assets within these portfolios to support the collateral pool, it is generally done to minimise the governance burden and maximise expediency of response rather than materially contributing to the regulatory defined buffer.
We will separately contact any clients who we believe may need to adjust their collateral waterfalls because of these new rules, but please let us know if you would like to discuss any aspect of this note in more detail.
The full wording of the CSSF’s announcement, consultation and consultation responses can be found here:
