Fire sales of safe assets

Summary

Focus

We examine the significant price pressures in the UK gilt market during a period of extreme volatility from September to October 2022. We investigate the impact of forced sales by liability-driven investment funds (LDIs) on gilt prices, the reasons behind the inability of LDIs to recapitalise quickly and the scarcity of liquidity providers during this period. The findings provide insights into the mechanics of fire sales, the process of arbitrage and the limits of market efficiency.

Contribution

We use detailed trade-level data covering nearly all UK gilt, repo and derivatives transactions to offer a precise view of the fire sale dynamics and arbitrage behaviour. We document the evolution of the LDI sector's balance sheet, measure the impact of LDI selling on gilt prices and explore the factors that delayed capital inflows into the market. We also examine the internal contracting frictions within pooled LDIs and their effect on the severity of the fire sale.

Findings

Our analysis reveals that forced sales by LDIs led to significant price discounts, accounting for roughly half of the total decline in gilt prices during the crisis. Pooled LDIs, which faced greater coordination problems among multiple pension schemes, sold more gilts and reduced their repo borrowing more aggressively than single LDIs. We find that hedge funds delayed their market entry until the bottom of the fire sale, contributing to the slow-moving capital. Additionally, we highlight that the segmentation between LDI and pension balance sheets, along with institutional barriers, impeded timely collateral transfers, exacerbating the fire sale. Our findings suggest that regulatory reforms aimed at better integrating the balance sheets of pensions and their LDI investments could help prevent future crises.

Abstract

We use trade-level data to study price pressure effects in the UK gilt market from September to October 2022. During this period, forced sales by liability-driven investment funds (LDIs) led to price discounts on the order of 10%, accounting for roughly half the total decline in gilt prices. Balance sheet segmentation and operational issues slowed equity injections into LDIs by well-capitalized pension investors, leading LDIs to instead sell gilts. This effect was most pronounced for pooled LDIs, which invest on behalf of multiple pension schemes, because of coordination problems between pensions. Hedge funds also appear to have delayed entry to time the bottom of the fire sale. Overall, our findings illustrate how capital can be slow moving internally, due to contracting frictions, and externally, due to strategic arbitrager behavior.

JEL classification: G01, G23, G12, G18, G32, G33

Keywords: fire sales, limits to arbitrage, slow-moving capital, non-bank financial institutions