Explained: Financial Turmoil in UK and Future Implications

Last week on Monday, the Bank of England (BoE) has been busy with calls saying some British pension funds were struggling to meet margin calls. By Wednesday, the situation has become more urgent. Fluctuations in British financial markets in response to the government’s Sep. 23 “mini budget” meant that Britain’s pension system was at risk, which has raised concerns about the country’s financial stability. British Finance Minister Kwarteng’s budget statement included dramatic plans to slash taxes and pay for it with borrowing, which drove government bond yields soaring. In the following days, Britain’s borrowing costs surged the most in decades, while the pound plunged to a record low.

While these reactions have been expected, there was also a hidden impact for the financial market. At risk of blowing up were obscure financial instruments meant to match long-term pension liabilities with assets, which had never been tested by bond yields moving so far or so fast.

At the center of the concerning parties were funds that manage so-called liability-driven investments (LDI), a seemingly simple hedging strategy at the heart of the blow-up.

The LDI market assets, which boomed in the last decade, total nearly £1.6 trillion ($1.79 trillion), or more than two-thirds the size of the British economy.

Pension schemes were forced to sell government bonds known as gilts after they found it hard to meet emergency demands from the LDI funds for collateral on ‘under-water’ derivatives positions, where the value is less than on a fund’s books.

LDI funds were calling for the urgent cash to shore up loss-making positions. The funds were themselves facing margin calls from their relationship-banks and other key financial players.

The BoE, facing a market meltdown, provided a £65 billion ($72.3 billion) package to buy long-dated gilts. The central bank said it was committed to do whatever it took to bring financial stability.

Although the BoE’s move has brought an immediate relief, it is still not clear how long it will last as shockwaves reverberate through global markets from Truss’ plan, which as well as spooking investors drew a rare IMF rebuke.

Truss defended her plan on Sunday and gave no signal that she would back down, although she said the proposal to cut taxes for the richest was Kwarteng’s idea.

Many pension funds were liquidating their positions by the end of the turbulent week to meet collateral requests.

by the end of Monday, fund managers at pension schemes thought they would be in serious trouble if this continues. By Wednesday, they were convinced that this was a systemic problem, it was like 2008 but on steroids because it happened so fast.

The risk of spillover throughout Britain’s financial industry had been real. If the LDI funds defaulted on their positions, banks which had arranged the derivatives would be sucked in too.

This massive turmoil on a major economy’s financial system has also had global affects. Even safe haven U.S. Treasuries and top rated German bonds have been hit.

While the BoE intervention sent yields plummeting, pushing the 30-year bond yield back to Sept. 23 levels and easing fears of an immediate crisis; fund managers, pensions experts and analysts say Britain is far from safe.

It is still unknown how much the schemes will need to sell, and what will happen once the BoE stops buying bonds on Oct. 14.

Britain’s central bank is now in the unenviable position of having postponed its plan to sell bonds, resulting in monetary loosening, and at the same time tightening with interest rates.

In November, it is expected to raise rates further and it has said it will stick to a plan to sell its bonds.

The turmoil has caused investor confidence to be shaken, and not just in Britain.

Meanwhile, demand for U.S. dollars in currency derivative markets surged to its highest level since the height of the COVID-19 crisis in March 2020 on Friday, as the market turmoil sent investors in search of cash.

Exactly one week after the British financial markets first felt the impact, Truss reversed the cut to the highest rate of income tax. Kwarteng said the decision to scrap the top rate tax cut had been taken with “some humility and contrition.”

While Conservative Party lawmakers said the decision was inevitable, the government’s credibility is damaged.

While the removal of the top rate of tax only made up around £2 billion out of the £45 billion of unfunded tax cuts, it was the most divisive element of a package that drew the wrath of markets by failing to set out how it would be paid for.

The decision to reverse course is likely to put Truss and Kwarteng under even greater pressure, the latest embarrassing political U-turn in a country that has had four prime ministers in the last six years.

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