Of course that leverage needs to be well managed. The rise in yields in late September – 130 basis points in the 30-year nominal yield in just a few days – caused a significant fall in the net asset value of these leveraged LDI funds, meaning their leverage increased significantly. And that created a need urgently to delever to prevent insolvency and to meet increasing margin calls. The funds held liquidity buffers for this purpose. But as those liquidity buffers were exhausted, the funds needed either to sell gilts into an illiquid market or to ask their DB pension scheme investors to provide additional cash to rebalance the fund. Since persistently higher interest rates would in fact boost the funding position of DB pension schemes[1], they generally had the incentive to provide funds. But their resources could take time to mobilise. The issue was particularly acute for one small corner of the LDI industry – pooled funds. In these funds, which make up around 10-15% of the LDI market, a pot of assets is managed for a large number of pension fund clients who have limited liability in the face of losses. The speed and scale of the moves in yields far outpaced the ability of the large number of pooled funds’ smaller investors to provide new funds who were typically given a week, in some cases two, to rebalance their positions. Limited liability also meant that these pooled fund investors might choose not to provide support.
And in a stress, that can lead both to sudden spikes in demand for liquidity – either to support the financing of leveraged positions or as deleveraging leads to forced sales – and a corresponding contraction in liquidity supply, with potentially systemic consequences. Leverage is of course not the only cause of systemic vulnerability in the non-bank system – as we have seen with liquidity mismatch driving run dynamics in money market funds (MMFs) and open-ended funds (OEFs) during the dash for cash. [4] But it is important where any form of leverage is core to a non-bank’s business and trading strategy. Indeed what happened to LDI funds is just the latest example of poorly managed non-bank leverage throwing a large  rock into the pool of financial stability. From Long Term Capital Management in 1998; to the 2007 run on the repo market; to hedge fund behaviour in the 2020 dash for cash; and the failure of Archegos in 2021. These episodes highlight the need to take into account the potential amplifying effect of poorly managed leverage, and to pay attention to non-banks’ behaviours which, particularly when aggregated, could lead to the emergence of systemic risk. I see systemic risk from leverage in the non-bank system arising through two different channels of contagion: to markets – both those non-banks invest in and those they borrow from; to counterparties – who either provide cash, or take the other side of instruments that are used to provide synthetic leverage.