On 28 September 2022, the Bank of England announced it would begin temporary purchases of long-dated UK government bonds. The official justification was unusual for a central bank. The Monetary Policy Committee was not loosening policy. The Financial Policy Committee was not intervening in a bank failure. The Bank was buying gilts because a private sector "hedge" had started to threaten the market the Bank itself used to price every other UK asset.
The mechanism behind that intervention matters more than the calendar week it happened in. UK defined benefit pension funds had spent roughly two decades building liability-driven investment (LDI) structures to match their long-dated pension promises. By 2022, those structures had become one of the largest holders of long-dated gilts in the world. When gilt yields rose sharply after the UK government's fiscal announcement on 23 September, the LDI vehicles started to receive margin calls. To meet those calls, they sold gilts. The selling pushed yields higher. The higher yields triggered more margin calls. Within days, the Bank of England judged the loop large enough to threaten UK financial stability.
The lesson is not that LDI was a stupid idea. The lesson is that a hedge built on top of leverage is no longer purely a hedge. Once the structure needs cash to keep working, the cash itself becomes the position.
What LDI Was Supposed To Do
UK defined benefit pension schemes owe their members a stream of payments that can stretch out for decades. The largest single risk on a scheme's balance sheet is that the interest rate used to discount those future payments falls, which raises the present value of the liabilities faster than the assets grow.
In the late 1990s and 2000s, an answer to that problem spread across the UK pensions industry. Liability-driven investment pooled schemes' long-dated bond exposure into dedicated vehicles. The core idea was simple. If you own assets whose cash flows broadly match your liabilities, the discount rate on the liabilities and the yield on the assets move together, and the funding ratio becomes less sensitive to interest rate swings.
For most of its history, the model worked. As long as gilt yields drifted in narrow ranges and LDI vehicles held only modest leverage, the structure did what its name promised.
What Changed By 2022
By the late 2010s, the UK defined benefit pension sector had built up roughly £1.5 trillion of LDI exposure. That scale matters. It is comparable to the annual output of a mid-sized G7 economy, all of it leveraged, all of it long-dated, and most of it sitting on top of a single domestic government bond market.
Three things happened at once.
First, gilt yields were at historically low levels after a decade of post-2008 policy support. Pension scheme liabilities were unusually sensitive to rate moves because a small absolute yield increase translated into a large percentage drop in liability value.
Second, LDI vehicles had become much more leveraged. Industry estimates put typical leverage at three to five times capital, achieved through repo financing or total return swaps collateralised by gilts. The collateral posted against that leverage was thin. Many LDI funds had buffers calibrated to historical moves, not to a sharp repricing of the kind that hit in late September.
Third, the LDI sector had become concentrated. A small number of large providers, and through them a small number of pension schemes, controlled a large share of the long-dated gilt market. That meant that when one vehicle had to sell, it was selling into a market where other LDI funds were doing the same thing for the same reason.
None of those features were visible in the marketing materials LDI providers sold to pension trustees in the 2010s. The leverage was routinely described in industry materials as an efficient use of capital. The buffers were routinely described as robust under historical stress. The concentration was not described at all, because most trustees were not in a position to compare their own exposures to those of every other scheme in the country.
The Week In September
On Friday 23 September 2022, the new Chancellor of the Exchequer Kwasi Kwarteng announced a fiscal package that markets had not been led to expect. Long-dated gilt yields rose sharply over the following Monday and Tuesday, putting the LDI sector under immediate margin pressure. By Wednesday 28 September, the Bank of England judged that the long-dated gilt market was no longer functioning normally, and announced temporary purchases.
The Bank's own December 2022 Financial Stability Report described what happened in unusually direct language. LDI funds experienced a "vicious spiral of collateral calls and forced gilt sales." The buffers held by those funds were "too low and less usable in practice than expected." The concentration of long-dated gilt holdings among a small number of LDI vehicles amplified the selling pressure at exactly the wrong moment.
The Bank's purchases were not quantitative easing. They were not aimed at lowering yields to support the economy. They were aimed at breaking a feedback loop between margin calls and forced selling that was pushing the price of a core UK asset away from anything the Bank could call orderly.
The intervention worked. Yields stabilised within days, the LDI funds raised fresh capital or restructured their leverage, and the operation was wound down by 14 October as originally scheduled. The Bank did not take a loss on the trades. The episode ended with no scheme forced into the Pension Protection Fund.
The reason the episode ended quietly is precisely the reason it is worth studying. The outcome was not inevitable. It was the product of a central bank that was willing, able, and fast enough to step in. The structure that caused the problem is still in place.
The Mechanism
The mechanism is worth being precise about, because it is not the same as a typical hedge fund blowup.
A typical hedge fund blowup happens because the fund is leveraged and wrong. The fund loses money, the leverage amplifies the loss, the counterparties cut the fund off, and the fund fails.
LDI did not blow up because it was wrong about interest rates. The funds were hedged in the only sense the word usually carries. Their long gilt positions were specifically designed to gain in value when yields rose, which is exactly what happened.
The problem was that the funds were not allowed to keep those gains in cash. The leverage embedded in their structure meant that as gilt prices fell, they had to post more collateral against their borrowings. The collateral had to be cash or very liquid gilts. To raise cash or very liquid gilts, they had to sell.
So the funds were correctly hedged against interest rate risk, and at the same time forced to sell into a falling market because of the way the hedge was financed. The hedge worked. The hedge also needed cash. Those two facts do not contradict each other.
This is the part that does not fit comfortably into the standard hedge fund story. The LDI sector did not lose money in any aggregate sense. Most funds ended up in a stronger funding position than they had been in for years. The crisis was about the path, not the destination. A fund that must sell an asset to keep its exposure to that asset is not hedging. It is managing a funding position.
The Counterweight
It is tempting to read the LDI episode as proof that all hedging is dangerous. That reading would be wrong, and it would be dangerous.
The pension promises that LDI was built to match are real. UK defined benefit schemes will be paying out for decades. Without some form of long-dated interest rate exposure, those promises are not safely funded. LDI is, in its basic structure, a sensible answer to a real problem.
The part that failed was specific. It was the combination of leverage and concentration, sold to trustees who were not equipped to evaluate either. A modestly levered LDI vehicle, with a buffer sized to a once-in-a-generation gilt move rather than a once-in-a-decade one, would have ridden out September 2022 with no more than a brief funding dip. The structure that broke was not the structure that had been sold.
This matters because the regulatory response, correctly, has focused on those two features. The Pensions Regulator issued new guidance on minimum resilience levels. The Bank of England and the Financial Policy Committee have called for "urgent and robust measures to fill regulatory and supervisory gaps." The leverage is being forced down. The buffers are being forced up. The industry has stopped describing three to five times leverage as efficient.
None of that changes the lesson. A hedge is not safer than the financing that holds it together. If the financing depends on collateral that can only be raised by selling the very thing you are trying to hedge, you do not have a hedge. You have a position that pretends to be a hedge, with a margin call built in.
The Verdict
The cleanest version of the LDI story is not that derivatives went wrong, or that pension trustees were incompetent, or that the Bank of England should have warned everyone in advance. The cleanest version is that a structure designed to reduce risk was rebuilt, over many years, in a way that put a different risk in the same place.
The old risk was that interest rates would move against the pension scheme. The new risk was that interest rates would move against the pension scheme in a way that required cash before the hedge had time to work. The two risks have different probabilities, different costs, and different effects on the institutions that hold them. They call for different risk management, different disclosure, and different regulation.
For most pension trustees, and most readers of this site, the practical question is whether the instruments on their own balance sheet behave like a hedge or like a position that needs financing. The September 2022 episode is the cleanest recent case study of how those two things can look identical on a marketing page and behave very differently in a margin call.
The lesson is not "avoid hedges." The lesson is that any hedge with embedded leverage should be priced, monitored, and disclosed as if it were a leveraged position. Because under stress, that is what it is.
Disclosure: Margin of Pain publishes research and commentary about traders, markets, and risk. This article is not investment advice or a recommendation to buy, sell, short, or hold any security, derivative, futures contract, currency, commodity, or asset.
Source trail
Primary sources:
- Bank of England, "Bank of England announces gilt market operation," 28 September 2022: <https://www.bankofengland.co.uk/news/2022/september/bank-of-england-announces-gilt-market-operation>
- Bank of England, Financial Stability Report, December 2022 (Section: "The resilience of liability-driven investment funds"): <https://www.bankofengland.co.uk/financial-stability-report/2022/december-2022>
- Bank of England, Financial Policy Summary and Record, December 2022: <https://www.bankofengland.co.uk/financial-policy-summary-and-record/2022/december-2022>
- Bank of England, "Statement from the Governor of the Bank of England," 26 September 2022: <https://www.bankofengland.co.uk/news/2022/september/statement-from-the-governor-of-the-boe>
- The Pensions Regulator (TPR), guidance on LDI resilience: <https://www.thepensionsregulator.gov.uk/en/document-library/regulatory-guidance/db-scheme-funding-and-investment>
Secondary sources:
- Bank of England, "LDI minimum resilience," Bank Staff Paper, 2023: <https://www.bankofengland.co.uk/financial-policy-summary-and-record/2023/bank-staff-paper-ldi-minimum-resilience>
- Financial Stability Board, "Vulnerabilities in Liability-Driven Investment (LDI) Funds and Other Yield-Driven Strategies," September 2023: <https://www.fsb.org/2023/09/vulnerabilities-in-liability-driven-investment-funds-and-other-yield-driven-strategies/>
- Bank of England Market Notice, 28 September 2022 (operational details of the gilt purchase programme): <https://www.bankofengland.co.uk/markets/market-notices/2022/september/market-notice-28-september-2022-gilt-market-operations>
Editorial notes, not for publication:
- Counterweight section deliberately pushes back on the "LDI was a mistake" reading so the article does not collapse into anti-LDI commentary.
- LDI leverage range (3-5x) is from the FSB and Bank of England Staff papers, not a specific company filing. Cite qualitatively rather than as a precise number if the article is challenged.
- £1.5 trillion figure for UK DB scheme LDI exposure is from FSB and BoE FSR Dec 2022 background material. Order-of-magnitude, not an exact balance-sheet number.