The Bank of England's system-wide exploratory scenario exercise final report

Summary

The Bank of England’s system-wide exploratory scenario (SWES) exercise explores how the UK financial system would respond to a market shock. It is the first exercise of its kind globally.

The aims of the SWES are to:

1. enhance understanding of the risks to and from non-bank financial institutions (NBFIs), and the behaviour of NBFIs and banks in stress, including what drives those behaviours; and
2. investigate how these behaviours and market dynamics can amplify shocks in markets and potentially pose risks to UK financial stability.

The SWES is a ‘system-wide’ exercise, incorporating a wide range of financial firms and business models. It therefore provides insights into the behaviour of different parts of the financial system under stress, as well as dynamics driven by their interactions and how these can affect outcomes in markets core to UK financial stability and the financial system as a whole.

To date, system-wide analysis carried out by central banks has tended to be model-based without the direct participation of firms. These model-based exercises are well suited to investigating system-wide dynamics, but have limitations, such as struggling to capture complex behaviours in a stress, which have limited their influence on surveillance and policy making. Conversely, traditional firm-focused stress tests actively involve firms and have become an essential part of the regulatory and financial stability toolkit. But these exercises are not designed to explore system-wide dynamics – they typically focus on a single sector and do not capture interactions with other parts of the financial system. The SWES takes a new approach: it takes a system-wide perspective, and incorporates complex firm behaviours and interactions through the active engagement of around 50 different financial firms. This unique system-wide perspective provides benefits for authorities and market participants. It highlights where there are mismatches in firms’ expectations of how each other will act in a stress, supporting better risk management approaches. It improves both our and market participants understanding of risk management within the financial system. And it informs the UK authorities in their work to address vulnerabilities in market-based finance domestically, and internationally through the work led by the Financial Stability Board (FSB).

The exercise is not a test of the resilience of the individual participants. Its focus is system-wide, including on important UK financial markets and their resilience in stress. As with any exercise of this type, the scenario, actions and outcomes are hypothetical and not a forecast. And changes in the financial system, the strategies or starting positions of market participants, or the magnitude and type of shock, would have led to different outcomes. We focus in this report on system-wide and behavioural insights from the SWES, beyond the specifics of any given scenario.

Approach

Key risk transmission channels under investigation in the SWES

We asked around 50 participating firms, including banks, insurers, pension schemes, hedge funds, asset managers and central counterparties, to evaluate how they would be affected by, and respond to, a hypothetical stress scenario.

The SWES scenario comprises a sudden, sharp and severe shock to global financial markets due to sudden crystallisation of geopolitical tensions. The market shock was designed to be faster, wider ranging and more persistent than those observed in recent stress episodes. Rates and risky asset prices move sharply, and these moves persist. Counterparty credit risk becomes elevated and eventually crystallises with the default of a non-participating hedge fund. The scenario lasts for two weeks and ends with uncertainty and the risk of a broad-based macroeconomic downturn.

The SWES was a collaborative exercise conducted over multiple rounds of engagement, allowing us to explore feedback and amplification effects. By analysing responses across participating firms and supplementing this with qualitative information, including conversations with non-SWES participants, we have been able to explore sectoral behaviours, cross-sectoral interactions and interconnections between different firms, and the combined impact on financial markets. We also carried out sensitivity analysis, which varied by sector, on key aspects of the exercise.

The shock was global, and modelling of the impact on firms and their actions was undertaken on this basis. We focussed our market-level analysis on a set of financial markets that are core to UK financial stability: the gilt market, the gilt repo market, the sterling corporate bond market and associated derivatives markets.

Outcomes

The hypothetical shock causes significant losses for some SWES participants in the exercise, triggering a spike in variation margin calls. Increased volatility causes initial margin required by CCPs to increase, and some funds experience redemptions. Taken together, this leads to a significant redistribution of liquidity across the financial system.

NBFI liquidity buffers fall at the start of the shock, and some firms then quickly act to rebuild them. Many NBFIs act in response to increases in their risk and leverage metrics. Sometimes these metrics approach or hit internal risk limits, but in other cases firms take precautionary action due to the uncertainty in the scenario, or because they adopt a ‘risk off’ stance given the macroeconomic outlook. Investment mandates and commercial pressures also drive the behaviour of SWES participant in markets. As a result, many firms need to deleverage, derisk, or recapitalise quickly.

These actions have an impact on other financial firms and market outcomes. Some firms seeking liquidity redeem from money market funds (MMFs) and open-ended funds (OEFs), leading those sectors to sell assets. Price insensitive sell orders driven by the liquidity needs of some firms lead to greater price falls in the assets sold, or risk a ‘jump to illiquidity’ in markets used as a source of liquidity by others. Banks are willing to temporarily take on some risk from NBFIs as market makers, absorbing part of the shock. But they do not have sufficient willingness in all markets, meaning some come under pressure. Gilt repo market conditions tighten largely due to bank derisking and counterparty credit concerns, and some NBFIs do not receive all the repo financing they expect. And, while the gilt market can largely absorb selling pressures, the sterling corporate bond market experiences a sudden jump to illiquidity due to the rapid speed of desired sales and limited bank market making capacity. In the SWES firms are often not able to anticipate how their counterparties, investors, or markets they operate in behave in the stress, which could leave them underprepared in a real stress.

Conclusions

Through running the SWES the Bank, working closely with and with the full support of the Prudential Regulation Authority (PRA), Financial Conduct Authority (FCA) and The Pensions Regulator (TPR), has drawn six key financial stability conclusions. These relate to financial firms’ risk management, as well as authorities’ policymaking and risk monitoring. In addition to these six conclusions, Box C describes findings from the SWES that speak to sector-specific issues, and Annex 1 summarises findings related to how firms may interact in stress and mismatches in their expectations of each other.

The SWES scenario, or a similar shock, would significantly impact participating sectors. Some firms rapidly sold assets, needed to recapitalise or limited their intermediation activity, amplifying the shock.

Some NBFI sectors – such as insurers, LDI funds, and MMFs – have higher starting resilience than at the onset of historic stresses. For example, insurers have widened the eligible assets they can post as collateral, and LDI funds and MMFs had buffers well above regulatory minima. Collectively this reduces the severity of amplification and, combined with positions in core markets at the reference date and the specifics of the scenario, mean that the gilt market does not come under severe stress in the SWES. But this result is contingent – particularly as the higher resilience of some sectors is not required by regulation. Lower NBFI resilience would result in a greater demand for liquidity under stress, and more NBFIs taking derisking actions due to risk or leverage constraints, leading to greater risks to financial stability.

Next steps: This highlights the importance of continuing to monitor core UK markets, and considering appropriate resilience across various sectors through domestic and international policy making processes.

Many firms in the SWES rely on repo to manage liquidity or monetise assets. In the exercise banks have the capacity to lend cash in the gilt repo market. Despite this, they tighten terms for maturing financing, will generally not provide additional repo financing at the onset of the shock, and in some cases may not even roll maturing repo. By contrast, many NBFIs expected they would be able to access additional repo that is unlikely to be available in the scenario.

Next steps: Further policy work to increase repo market resilience, could, alongside central bank facilities, help support repo market resilience and the effective functioning of other markets during stress. The Bank is expanding its tools with the Contingent NBFI Repo Facility (CNRF), which will allow the Bank to provide repo directly to eligible NBFIs if required to address severe gilt market dysfunction.

The gilt market provides safe assets used to manage liquidity by the financial system, a benchmark for the pricing of finance to households and businesses, and is an important source of financing for the UK government. Following the SWES shock, gilt selling pressures and purchasing in the gilt market – including by banks temporarily holding risk as market makers – are broadly balanced, demonstrating how actions by authorities and market participants have increased market resilience. However, additional sales would quickly exhaust banks’ willingness to buy, making further price falls likely. And these outcomes are sensitive to initial conditions – including firms’ balance sheets at the reference date, levels of NBFI resilience (see conclusion 1) and banks’ ability to intermediate.

In the SWES, LDI funds are recapitalised by their pension fund investors, and would have opted to sell gilts had this been unsuccessful. This underlines the importance of the Financial Policy Committee’s (FPC’s) recommendation and the FCA’s and TPR’s 2023 guidance to increase the financial and operational resilience of pension schemes’ LDI positions, and emphasises the importance of maintaining it.

Next steps: Gilt market resilience will be supported by actions under conclusions 1 and 2. The SWES illustrates that the functioning of the gilt market depends on the resilience of the financial sector (conclusion 1) and the markets that support it – particularly gilt repo (conclusion 2), and the derivatives markets that banks use for hedging.

The SWES identified how the sterling corporate bond market may ‘jump to illiquidity’ after a shock due to sales pressure by firms in several sectors that need to access liquidity or derisk. Banks’ willingness to warehouse risk is limited, and potential countercyclical investors only enter the market relatively slowly. Some rapid sales arise from pension schemes meeting recapitalisation calls from LDI funds seeking to rebuild headroom over regulatory buffers. These findings underscore the important role of pension funds to UK financial stability.

The sterling corporate bond market becoming illiquid in stress risks reducing its effectiveness as a source of financing for the real economy, particularly if poor conditions persist or repeated periods of illiquidity reduce longer-term confidence in that market.

Next steps: Greater transparency through improved data collection and disclosures could help to mitigate these risks by raising awareness of potential correlated asset sales. TPR will explore with industry potential improvements to existing data collections to improve contingency planning by pension schemes and reduce risks to corporate bond market functioning. TPR also plans to engage with pension schemes to better understand their behaviour in stressed markets, and explore options to reduce behaviour that amplifies market shocks.

The SWES has provided valuable insights into how changes to the resilience, behaviours and interconnectedness of financial firms could affect market dynamics in stress events. The exercise also identified counterparties’ inconsistent expectations during a stress and the possible consequences. Insights from the SWES derived from interactions across the system would not be apparent from sector-specific analysis alone.

Next steps: The Bank alongside the FCA will use the experience of the SWES as a framework for future system-wide analysis and embed it into how we conduct market-wide surveillance. To support this we will invest in our in-house capacity to model system-wide dynamics, supported by continuing our engagement with market participants to ensure our understanding of key dynamics remains current. This will allow us to update the SWES findings periodically in a proportionate way as the financial system and risk-taking evolve. We will engage financial institutions and other regulators as we develop this approach.

In addition, SWES-style exercises are a useful tool that the FPC, and other UK authorities, could deploy to investigate other markets in future.

The SWES has provided significant benefits for the Bank, PRA, FCA, TPR and market participants. All the authorities have worked closely on the exercise and support the analysis in this report and its conclusions. It will be beneficial for international authorities considering their own system-wide exercises, and the results are informative for a range of international policy workstreams.

Next steps: The SWES highlights the importance of financial institutions considering system-wide dynamics in their internal risk management and stress tests, and provides an evidence base to support this. Annex 1 provides a summary of findings which may be relevant to financial institutions’ risk management, with cross-references to further detail.

Acknowledgements

We are grateful to the firms that participated in this important exercise, which would not have been possible without their constructive engagement. We are also grateful to the non-SWES participants that we met with, all authorities that made contributions to the SWES, and international regulators.

Structure of this report

This report begins with background to the SWES exercise, including our methodology, in Section 1. We then describe in detail the responses of firms to the SWES scenario in Section 2, including highlighting mismatches in their expectations of each other (Section 2.3). Section 3 explains what firms’ combined behaviours mean for the SWES ‘markets of focus’. Our detailed conclusions can be found in Section 4, and a summary of wider SWES findings in Annex 1. Annex 2 lists firms which participated in the exercise. Annex 3 and Annex 4 provide more detail for readers interested in specific topics or individual participating sectors.

1: Background

1.1: Motivation

The SWES is a first of its kind exercise globally which explores how the UK financial system would respond to a global financial market shock.

In recent years, events in a number of global financial markets have illustrated how liquidity conditions can quickly deteriorate, and have brought to light vulnerabilities arising from ‘market-based finance’ (MBF). MBF refers to the system of markets (eg equity and debt markets), non-bank financial institutions (NBFIs – including investment funds, hedge funds, pension funds and insurers) and infrastructure (such as central counterparties (CCPs) and payments providers) which, alongside banks, provide financial services to support the wider economy.

It is important that the financial system is resilient enough to absorb, and not amplify, financial and economic shocks, so that it can continue to support the provision of financial services to UK households and businesses. But key recent events, including the 'dash for cash' at the onset of Covid in global markets and the 2022 LDI episode in the UK, have highlighted vulnerabilities in the financial system and the risks these pose to UK financial stability.

In light of these events, in June 2023, the Bank of England (the Bank) launched its first system-wide exploratory scenario (SWES) exercise with market participants, to complement the FPC’s work programme to address risks in MBF and ongoing work to ensure the resilience of the banking sector.

The SWES aims to improve our understanding of the behaviours of banks and NBFIs during stressed financial market conditions, and how those behaviours might interact to amplify shocks in a specific set of financial markets that are core to UK financial stability – the SWES ‘markets of focus’.

The SWES is not a test of the resilience of individual participating firms; it focuses on resilience at a system-wide level. Carrying out a system-wide exercise provides important benefits. By incorporating the responses of a wide range of firms and sectors, and how these interact under stress, the SWES allows us to examine the key dynamics that might amplify shocks to the financial system as a whole. These dynamics, such as interdependencies between sectors or inconsistent expectations of each other’s actions, are the key value added by system-wide analysis.

The Bank conducted this exploratory exercise under the guidance of the FPC and the PRC. Both committees support this exercise and consider it an important contribution to understanding and addressing vulnerabilities in MBF.

The Bank engaged with international regulatory partners and benefitted from working closely with, and with the support of, the PRA, FCA and TPR.

1.2: SWES markets of focus

We focused our detailed analysis on a specific set of financial markets that are core to UK financial stability – the SWES markets of focus:

• the gilt market;
• the gilt repo market;
• the sterling corporate bond market; and
• associated derivative markets, where market participants can achieve economically similar returns and/or hedge relevant risks (eg, gilt and SONIA^{footnote [1]} futures; and interest rate swaps, inflation swaps, and cross-currency swaps with a sterling leg).

Figure 1 illustrates the relationships between the different types of market participant and the SWES core markets. It also summarises the three key transmission channels which we set out to explore and which formed the basis of analysis for the SWES: 1) drivers of firms’ liquidity needs under the market stress, 2) firms’ actions in response to those liquidity needs, and the liquidity available to them, and 3) additional actions taken to deleverage, reduce risk exposures, or rebalance portfolios.

Figure 1: The SWES investigates a range of risk transmission channels

Key interactions between participating sectors and core UK financial markets in the SWES

1.3: Participants

The Bank worked with the PRA, FCA and TPR to identify around 50 firms to participate in the exercise, with the aim to select a sample of firms which are representative of core UK financial markets. The selection was based on firms’ activity, business models and investment strategies to ensure diversity in the sample. The sample provides high coverage of important markets and sectors. For example, entities included in SWES participants’ responses accounted for over 60% of total turnover in the gilt market in 2023, and participating banks’ gilt repo activity represents around 74% of total bank gilt repo activity in the 12 months to 31 October 2023.^{footnote [2]} And we estimate that participating firms cover over 90% of the levered LDI market^{footnote [3]} with higher coverage of pooled LDI funds.

Participating firms come from a range of different sectors, reflecting the wide range of institutions engaged in UK financial markets. This includes large banks, insurers, CCPs, and a variety of funds (including pension funds, hedge funds, and funds managed by asset managers). Many asset managers submitted separately for different fund strategies. A full list of SWES participants can be found in Annex 2. In addition to these participating firms, we spoke to around 20 other firms for further insights. These include non-bank trading firms, rating agencies, pension fund consultants, and various investors.

1.4: Scenario

We asked SWES participants to evaluate how they would be affected by, and respond to, a hypothetical scenario in which a sudden crystallisation of geopolitical tensions results in a shock to global financial markets.

The market shock was designed to be faster, wider ranging, and more persistent than those observed in recent stress episodes, cause a significant redistribution of liquidity, and place some firms under stress. It incorporates severe but plausible shocks to a wide range of market prices and indicators over 10 business days. The largest moves are in risk-free rates and credit spreads, which spike to around their historical maxima at the same time. For example, gilt yields are shocked to +115 basis points over the 10-day scenario (slightly less than the equivalent cumulative moves seen during the 2022 LDI episode), whilst credit spreads on sterling investment corporate bonds are shocked to +130 basis points (roughly equal to equivalent cumulative moves seen during the 2020 ‘dash for cash’). The scenario also includes the widening of the ‘basis’ between bonds and bond futures (explained in detail in Annex 4: Hedge funds). That said, not all market indicators are stressed to historical peaks, eg equities (Chart 1).

Chart 1: The SWES hypothetical scenario combines shocks to rates and risky asset prices

Comparison of 10-day moves in selected SWES variables against the largest observed since 2001, and those observed during the 2020 dash for cash and 2022 gilt market stress episodes ^{(a) (b)}

Footnotes

• Sources: Bank of England, Bloomberg Finance L.P, Board of Governors of the Federal Reserve System (US), Refinitiv Eikon from London Stock Exchange Group and Bank calculations.
• (a) Data for gilt yields, US Treasury yield, corporate bond spreads, and equity prices start from 1 January 2000. The data for gilt yields includes September 2022, when yields peaked unusually sharply.
• (b) The increase in yields on US Treasuries is similar to that applied to all non-UK advanced economy government debt of similar maturity. This figure displays yields on 10-year US Treasury yields for indicative purposes.

The Bank provided participants with a day-by-day scenario narrative as well as quantitative price paths for around 40 key market variables (see annex to the scenario launch document). The narrative aimed to capture the uncertainty built into the hypothetical scenario and participants were encouraged to consider their actions in this context. It also included:

1. The default of a mid-sized relative value hedge fund, markedly elevating concerns around counterparty credit risk.
2. Single notch downgrades of several jurisdictions (including the UK) and a small number of financial institutions and corporates.
3. The unexpected announcement by sovereign wealth funds that they will reduce holdings of advanced-economy debt.
4. The expectation of longer-term shocks to economic fundamentals beyond the horizon of the 10-day scenario, meaning that participants needed to consider realistic actions in the context of protracted uncertainty.

1.5: Methodology

At the start of the process, the Bank gathered initial information from SWES participants to inform the design of the exercise – including the stress scenario. The scenario design was informed by a mixture of firms’ internal stress testing, historical shocks, Bank modelling of the impact of different shocks on firms, and Bank staff judgement. We calibrated our model of the impact on firms using data from participants on their exposures and sensitivities to a range of changes in market variables. We then used this to estimate the impact of a given scenario on a firm and what actions they might take (eg based on their waterfall of actions to source liquidity during market stress). The information gathered from participants was then supplemented with an intelligence-gathering round with non-SWES market participants.

We implemented the main scenario phase of the exercise in two rounds:

In round 1 we provided participants details of the SWES scenario. We asked NBFI participants to model the impact of the shock on their business on a day-by-day basis, and to explain how they would respond to it and the rationale behind those actions. We asked banks to provide data on how they would expect to act during the stress with detail on their interactions with their NBFI counterparties and how they would expect to act in the SWES markets of focus, including in a market making capacity. And we asked all participants, including CCPs, to provide estimates of the margin they would expect to post to and/or receive from other participants in the stress. We reviewed firm submissions individually, clarifying specific points with firms where necessary. We then aggregated the firm and sector-level information and scaled this up to build a picture of the impacts at the level of the financial system as a whole, including in the SWES markets of focus. We used our aforementioned internal modelling to sense check the results. We also compared responses to observe interactions and to assess where there were mismatches in participants’ expectations of how other participants would behave.

In round 2, the Bank, FCA and TPR met with participants to discuss key sectoral and system-wide observations from the first round. We highlighted risks of amplification to corporate bond markets and potential mismatches in expectations regarding the availability of repo financing. We also sought to understand better what drove participants’ actions in core UK markets, particularly where their actions were different to those taken during previous stress events, as well as to ensure that we had correctly interpreted their submissions, provide them with feedback (eg where they might have had mismatched expectations of other participant’s behaviours), and to probe certain elements.

Based on the collective responses of firms in round 1, in round 2 we updated the scenario, increasing the shock to credit spreads, and further deteriorating sterling repo credit conditions and the availability of derivatives used to hedge activity in core UK markets. Participants were then asked to consider how their response might change in light of the updated scenario, for example updating their expected asset sales or purchases given price changes. The second round was also used to refine some participants’ responses in light of feedback from round 1, and to sensitivity test the results to understand how they could differ if key judgements or markets conditions had been different.

The Bank also supplemented information captured through firms’ quantitative and qualitative submissions through discussions with participants, regulators and other non-SWES market participants and, where relevant, their advisors.

We aggregated data submitted by firms and augmented it to produce the system-wide results in this report in several steps. First, we made a limited number of adjustments to firms’ submissions to address discrepancies, often identified in follow-up discussions with firms. Second, we combined firms’ submissions with other data and information sources to try to account for gaps in SWES coverage – for example, the fact that a greater share of SWES participants are larger firms than in financial markets more widely. Scaled numbers presented in this report are those where we have mapped aggregate SWES results to markets or sectors as a whole, ie estimating actions for firms outside of the SWES sample. A key judgement in this scaling was the treatment of non-participating pension schemes. We relied on TPR data, information from participating LDI funds and pension schemes, and extensive industry engagement to understand likely reactions to LDI recapitalisation requests by non-participating pension schemes.

1.6: Interpreting the outcomes

As with any simulation, the SWES is a hypothetical exercise and not a forecast. The results reflect the actions that firms reported they would take in the scenario, given the background information and assumptions the Bank provided. It is also stylised, given the practical limitations on the level of detail that can be modelled by firms and the Bank.

Specific SWES results are affected by the design of the exercise…

The SWES was designed to investigate interactions between market participants in the face of a sharp liquidity shock. This means it primarily focuses on a short period of time (two weeks) to allow us to investigate market interactions in detail. However, this also makes it unsuitable for testing the resilience of all parts of the financial system. For example, it did not stress bank balance sheets with significant credit losses, given that in the two weeks of the SWES scenario banks would not understand the longer term macroeconomic impact of the shock (and how that would impact their loan portfolios). Therefore, the exercise focused on how the uncertainty at the start of a shock would impact the services they provide to NBFIs operating in financial markets. And more generally, the specifics of the scenario (see Section 1.4) affect the impact it has on different sectors and firms.

The SWES also necessarily includes some simplifying assumptions. Financial markets are complex ecosystems with many thousands of participants and asset classes, some of which trade at extremely high frequencies. For the exercise to be practicable, it was necessary to abstract from some of this complexity. For example, to facilitate firms’ modelling, the scenario assumed parallel shifts in yield curves, which is not always the case in a real-world shock.

In addition, the SWES incorporated a representative sample of the firms most active in core UK markets. This means that, as described in Section 1.3, although we have strong coverage (particularly of the LDI sector), the sample is necessarily skewed towards larger financial institutions and focuses on their largest positions and entities. This means that dynamics affecting smaller firms may be less well captured in the results.

…and by firms’ starting positions.

The SWES was carried out taking firms’ balance sheets and risk positions as of 31 October 2023 as a starting point, and projecting forward into the stress scenario. Because where firms start the stress has an important effect on the outcomes, running the exercise with a different cut-off date could lead to different results. For example, in some sectors resilience levels were comparatively high at the start of the exercise (see Section 2.2), meaning outcomes in markets and for other sectors are less severe than they might otherwise have been.

Firms’ positioning in financial markets is also dependent on the timing of the exercise. For example, in the gilt repo market, hedge funds – which were net cash lenders in October 2023 – have repositioned over the course of 2024 and are now significant cash borrowers in aggregate (see Section 2.4). This positioning affects how firms are impacted by the shock, and therefore the results of the exercise.

But the main value of the SWES comes from providing insights into behaviours and interactions in the financial system under stress.

Where possible, we have controlled for these factors. For example, we ran the scenario in two rounds to incorporate feedback effects, sensitivity tested key elements of the exercise, and engaged in qualitative discussions about our observations, including with non-participants. Despite this, the assumptions embedded in the scenario, and the date of the exercise – which affects the resilience and positioning of firms at the start of the scenario – have a material effect on the quantitative results, and underlines the importance of ongoing surveillance and exercises of this type.

Overall, this means that SWES results are less effective as a prediction of the precise impacts of an equivalent real-world shock or detailed firm-specific issues. Instead, SWES results are most effective as a means to gain insights into participants’ behaviours in response to a stress, understand interactions between firms, and draw wider insights into how the financial system as a whole response to stress. These are insights that apply beyond the specifics of any given scenario and are the key benefit of system-wide exercises such as the SWES.

2: Outcomes: response to the shock

This section focuses on the impact that the SWES shock has on participants and how they respond. By describing the drivers of the actions taken, it aims to illustrate how the actions and interactions of firms can impact financial stability and core UK markets.

In this section, and Section 3 on market outcomes, all figures are scaled to the level of markets or sectors as a whole, including estimates for firms not participating in the SWES, unless otherwise stated.

2.1: Liquidity impact of the shock

The large and rapid market shock generates a significant liquidity need for NBFIs.

Under the SWES scenario, risk-free rates and credit spreads increase rapidly, leading to a fall in asset prices. The resulting margin calls, redemptions, use of financing, and trading activity results in significant cash and collateral moves across the financial system.

Many NBFIs, including LDI funds, pension schemes, insurers, OEFs and hedge funds, face significant immediate liquidity needs. In large part, these liquidity needs stem from requests to post additional margin given the stressed market conditions, with NBFIs needing to meet approximately £94 billion of margin calls in aggregate. Some rates products faced near-record one day margin calls reflecting the rapid onset of the scenario. Overall, approximately 85% of NBFIs’ reported liquidity needs arise from variation margin (VM) calls, around 8% from initial margin (IM) calls and around 7% from redemptions from UK investors. For example:

• Pension schemes, LDI funds and insurers sustain losses on their leveraged gilt and derivative positions. Their banking counterparties then call on them to pay margin calls totalling £92 billion.
• Hedge funds make losses of around -0.6% of NAV on average, but with a very wide range of outcomes for individual funds, reflecting the range of strategies they adopt and how they were positioned going into the stress. The sector makes net margin payments of around £2 billion. The increase in volatility causes internal risk limits to become more binding, and some hedge funds take action to reduce risk exposures. Some hedge funds are reliant on leverage provided by banks via repo, and may be forced to sell assets if repo financing was not available. The sector’s borrowing using gilt repo has increased considerably since the SWES balance sheet date (see Section 2.4). Participating hedge funds do not face significant redemption pressures given their usually infrequent (eg quarterly) redemption terms.
• Open-ended funds (OEFs) and MMFs face redemptions from their investors (including other SWES participants), who seek to redeem to meet their own liquidity needs.

In the SWES, peak daily VM calls are approximately in line with recent historic peaks for interest rate products. VM calls for other products are substantially lower than recent peaks, reflecting the scenario design which focused on shocks in rates and credit markets rather than, for example, equities and commodities.

2.2: Firms’ responses

Firms report that they take a wide variety of actions in the SWES, many of which are driven by their investment mandates or due to commercial considerations. In addition to these types of actions, which firms judge to be sensible risk adjusted trades, firms have overarching internal risk appetites. These control how much risk firms can take, and, in some cases, are subject to specific regulatory requirements. In addition, firms take a number of actions to reduce risk that are not driven by immediate proximity to risk limits or regulatory constraints, that we have labelled as precautionary to reflect that these actions are being taken even in cases where firms are far away from those constraints.

Figure 2 summarises the actions firms take in response to the SWES shock, including those motivated by the liquidity impact of the shock, by non-liquidity impacts (such as risk and leverage impacts), and by investment mandates or commercial considerations. It illustrates the key dynamics modelled and quantified within the SWES. Figure 2 is not exhaustive and so does not cover all the ways NBFIs were impacted nor all the actions they took in response. It also excludes some interconnections for simplicity (eg where many firms take actions in cash or derivative markets, they are often doing so via an OEF). The rest of this section explores all the actions participants took in more detail, with the consequences in core UK financial markets set out in Section 3.

Figure 2: Firms take a wide range of actions in response to the SWES shock

Participant responses to the SWES scenario ^(a)

Footnotes

• Sources: SWES submissions and Bank calculations.
• (a) Panel A: Pledging assets, marked in dark blue, represents 80% of the immediate actions reported by participants. Panel B: P&L, leverage, and liquidity are interdependent. For example, a loss on a bilateral derivative leads to a VM call (representing a need for liquidity) as well as an increase in leverage as the fund’s equity falls. Panel C: As most firms typically do not hold a significant amount of cash as dry powder, undertaking actions for investment or commercial reasons will require selling assets, raising financing, or securing additional capital from investors.

NBFIs meet much of their initial liquidity needs by running down buffers of available collateral and cash, and some then quickly act to restore them.

At the exercise start date, many participating NBFIs had higher financial resilience levels than before previous shocks, reflecting regulatory changes or lessons learned from those stresses. These include a greater ability to post a wider range of collateral, larger cash buffers or lower leverage. In particular:

• Insurers have often negotiated bilateral agreements with banks that allow them to post corporate bonds in addition to sovereign bonds as collateral (see Annex 4: Insurance). They have also reduced liquidity risks in derivative portfolios, and have arranged committed funding from banks. This leads to lower redemptions from OEFs and MMFs in which insurers are an end-investor, as they have less need for cash to meet immediate liquidity demands. It also reduces the risk of insurers, and the MMFs and OEFs they invest in, engaging in forced sales under stress.
• Following the 2022 LDI episode, the FPC made a recommendation, implemented via TPR guidance and requirements in Ireland and Luxembourg, that LDI funds should hold higher buffers of eligible collateral that allow them to withstand a yield shock of around 250 basis points.^{footnote [4]} On top of this, many LDI funds maintain management buffers over and above the guidance. As a result, they now typically hold much larger collateral buffers which they pledge in response to the margin calls. Operational and governance issues were a key feature of the 2022 LDI episode, prompting the FCA to issue guidance to managers. Procedures have since been improved which allow LDI funds to more easily be recapitalised by their pension fund investors, in line with the FPC’s judgement that schemes should be expected to be able to deliver collateral to their LDI vehicles within five days (see Annex 4: DB pension schemes and LDI strategies).
• MMFs have built up higher liquid asset buffers since 2020, allowing them to meet outflows by letting their short-term assets mature. Despite fewer redemptions by insurers, MMF outflows peak at around 8-9% of assets under management (AUM) for individual participating MMFs, compared with the sector as a whole seeing redemptions of around 11% in March 2020.

Some of these changes are driven by regulatory requirements, such as LDI buffers. However, others are not underpinned by regulation, and therefore resilience could fall over time as memories of recent market events begin to fade. This includes MMFs, where high levels of resilience observed in the SWES have been so far driven by the firms themselves, not regulatory requirements.

Chart 2 summarises the aggregate liquidity need faced by NBFIs in the SWES, the immediate actions they take in response, and the asset sales they make to restore collateral buffers or acquire additional liquidity. These actions are a subset of their responses to the scenario shown in Figure 2. The majority of NBFIs’ liquidity need is met by pledging eligible securities (further details on the use of non-cash collateral are shown in Chart 3). To restore collateral buffers or acquire additional liquidity, NBFIs also sell assets, in sterling and non-sterling markets; the majority of these sales arise from pension funds responding to recapitalisation calls from LDI funds (Figure 3).

Some NBFIs rely on a significant amount of short-term repo being refinanced, and their liquidity needs could have been much larger had they been unable to roll repo that matured within the two weeks of the market stress. The amounts in question vary over time, but for the gilt repo market can be in the order of magnitude of tens of billions of pounds – since 2020, net borrowing by hedge funds (most of which matures in two weeks or less) has varied from -£45 billion to almost +£60 billion (Chart 6). SWES firms are also active in non-sterling repo markets and use repo secured on assets other than gilts. Restrictions in these markets could also greatly increase the quantum of liquidity needs. Section 3.2 explores the impact of restrictions in the gilt repo market on core UK markets in more depth, and Box B discusses how hedge funds expected to respond if they had faced restrictions in UST repo.