The Bank of England (BoE) has said that its £65bn ($73) invention last week saved Britain from being on the brink of a financial crisis.
A letter from Sir Jon Cunliffe, deputy governor of the BoE, highlighted that there was fear of “severe disruption of core funding markets and consequent widespread financial instability”
He added that pension funds would have been forced to dump £50bn worth in government bonds into a chaotic market.
“The Bank received market intelligence of increasing severity from a range of market participants, and in particular from LDI fund managers, reporting that conditions in core markets, should they continue to worsen, would force them to sell large quantities of long-term gilts in an increasingly illiquid market.
“Taken at face value, this market intelligence would have implied additional long-term gilt sales of at least £50 billion in a short space of time, as compared to recent average market trading volumes of just £12bn per day in these maturity sectors.”
LDI, or liability-driven investment, is a popular product sold by asset managers to pension funds, using derivatives to help them "match" assets and liabilities so there is no risk of shortfall in money to pay pensioners.
LDI was worth about £400bn in 2011, quadrupling to £1.6tn by 2021, according to the Investment Association.
Cunliffe added: “With the gilt market unable to absorb further large sales, had large sales been attempted yields would have been pushed even higher, forcing further gilt sales in an attempt to maintain solvency. This would have led to a self-reinforcing spiral of price falls and further pressure to sell gilts.
“Had the Bank not intervened on Wednesday 28 September, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties."
It comes in response to a series of questions from the Treasury committee chair, Mel Stride after Threadneedle Street announced a programme of temporary purchases of long-dated UK government bonds on 28 September.
The BoE said it would buy up to £65bn in gilts over a 13-day period in response to chancellor Kwasi Kwarteng’s mini-budget. The finance minister announced £45bn in unfunded tax cuts which caused volatile trading for both the pound and stock markets.
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This was the first gilt purchase announcement that the Bank has justified on financial stability grounds. Long-term borrowing costs, which had surged to their highest level in two decades, plunged after the BoE revealed its intervention.
The Treasury had since asked for an outline of the events leading up to the intervention, why the move was judged necessary, whether there will be any implications on monetary policy, and how the Bank will determine whether the intervention has been successful – and is no longer required.
The UK central bank agreed on Thursday to buy almost £154m of long-dated gilts. It also rejected £126.9m of gilts which it was offered, concluding that it did not need to stump up any more to preserve financial stability.
The Bank could spend as much as £5bn per day on long-dated gilts, but has currently only bought around £4bn in total.
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