European pension funds might find it more economical to begin clearing their derivatives trades through central counterparties sooner rather than later, due to incoming bilateral rules.
Central clearing has become mandatory for most players in the over-the-counter derivatives market under the European Market Infrastructure Regulation, except for pension funds. To clear in this way, they must post collateral with the central counterparty in the form of cash for variation margin or high-quality liquid assets for initial margin.
But difficulties in sourcing the assets CCPs will accept as collateral have pushed the European Commission to extend an exemption — originally scheduled to end Aug. 16, 2017 — through August 2018, allowing pension funds breathing room on complying with the regulation. The European Commission granted an exemption until Aug. 16, 2018, late last year, concluding CCPs need additional time to find solutions for pension funds.
Following the decision, the regulator is due to conduct a review of EMIR in the first quarter of 2017, in consultation with asset owners, which will assess whether the current exemption could be prolonged further or made permanent.
While the exemption had sources at pension funds relieved, the realization of incoming requirements for non-centrally cleared derivatives trades, or bilateral trades, might have made that relief short-lived. After March 2017, bilateral trades will be subject to new margin rules under the Basel Committee on Banking Supervision and the International Organization of Securities Commissions framework, under which all users of uncleared OTC portfolios will need to exchange variation margin daily. And, this might just mean pension funds choose to get a head start on central clearing anyway.
Option for LDI users
David Brown, head of derivatives operations at Royal London Asset Management in London, said: “Bilateral rules are to kick in from March 1 ... and we do not know what sort of impact this will have on the market. It may be that the cost of non-cleared derivatives will increase to a level that pension funds will find it more economical to use cleared derivatives,” he said.
According to Ido de Geus, Utrecht-based head of fixed income at PGGM, which has e200.2 billion ($208.9 billion) of assets under management “it is not inconceivable that non-cleared (trades) become even more expensive than cleared. Some pension funds might go into clearing because of that.”
Central clearing also reduces counterparty risk, said Alasdair Macdonald, head of advisory portfolio management at Willis Towers Watson PLC in London. “Some pension funds may see an incentive in reduced counterparty risk if they were to enter the trades sooner.”
Sources cited pension funds using liability-driven investing strategies as those likely to see central clearing as a viable option because LDI providers help them access clearing houses and clearing members.
Mr. Macdonald added that while using specialist LDI providers has left pension funds more prepared for bilateral rules, pension funds using dispersed currency hedging providers will certainly face the issue with bilateral rules.
According to data from money manager Record Currency Management, a pension fund would typically need to hold collateral of 5% to 10% of its currency hedging program in order to be able to comply with them.
While pension fund executives continue to consider their options, they are searching for new ways to raise the cash they would need for centrally cleared derivative trades.
According to Mr. de Geus: “Although bilateral rules are becoming more urgent, this does not mean that our concerns towards central clearing have disappeared.”
Amaury Boyenval, head of the solutions and structuring group at AXA Investment Managers based in Paris, added: “If pension funds were to post cash, they do not only bear the cost of sourcing the cash but also the funding of cash. And if they want to sell credit bonds or equity to get cash, they have to shorten the duration, which means they lose out on the return.”
On the hunt
According to Anton Wouters, head of customized and fiduciary solutions at BNP Paribas Investment Partners in Amsterdam, “institutional investors can create cash ... through repurchase agreement, holding money market funds, or creating your equity exposure through futures.”
Mr. de Geus said: “Money market funds are a workable alternative to cash. We have proposed that in consultation with the regulator, but the problem is a geographical fragmentation in this market, which makes it difficult to access.”
Although Europe's money market fund industry is still growing, pension funds pointed out during the EC's consultation process on the issue that it would not be sufficient to provide the required liquidity.
Rather, a CCP-led solution would be a much better alternative, such as if central counterparties were to begin accepting equity instead of cash for these collateral requirements.
Mr. de Geus said: “The European bond market would need to increase four times in order for us to have the capacity to avoid the use of derivatives.”
There is an expectation in the market that a solution will be developed in the end. “Pension funds have a large place in the derivatives market and we are” not able to prosper if the regulator and counterparties aren't flexible on trade terms, Mr. de Geus said.
The EC official said the commission is aware of the issues and a more permanent solution will be discussed during the EMIR review in the first quarter of next year. “The permanent exemption is one of the options considered as part of the EMIR review,” the official said in a telephone interview.
This article originally appeared in the January 9, 2017 print issue as, "Pension funds weigh their options on clearing".