New swaps rules put pension execs between rock, hard place

The missing-money controversy surrounding MF Global Holdings Ltd. is leaving large corporate and public pension plan executives feeling pulled in two directions when it comes to using swaps.

While plan executives wonder if the next case of disappearing cash could involve them, they also are keeping a nervous eye on federal regulators who are finalizing new rules for derivatives trading, including swaps, that could sacrifice the collateral protection they now enjoy for greater transparency.

Pension plans use swaps for several reasons, including to hedge against drops in interest rates that can increase pension liabilities and harm cash flow. “Hedging is one of the very few things people can do to manage the volatility,” said an industry source who did not want to be identified. “Even plans that don't use it, feel strongly that they want to preserve that strategy.”

To make swaps more transparent to all parties involved in the transactions, the Dodd-Frank Wall Street Reform and Consumer Protection Act ordered the Commodity Futures Trading Commission to require that whenever possible, swaps go through registered derivatives clearing organizations. These organizations, while they practice legal segregation of customers' money, do not physically separate funds. That could become a big problem if the clearinghouses encounter financial problems like bankruptcy and cannot readily sort out commingled funds. Unless the clearinghouse has kept scrupulous records, another customer's losses could jeopardize all customers' assets.

That has alarmed institutional investors, who feel strongly that their current practice of using physically segregated accounts, where the third party — usually custodians or brokers — holding the swaps knows whose money is whose, is the safest.

By contrast, the CFTC's proposed rule simply stipulates the legal separation of collateral and does not explicitly allow for physical segregation, out of concern that it would contradict bankruptcy laws.

“You've gained some transparency but you've lost some protection,” argued Deborah Forbes, executive director of the Committee on Investment of Employee Benefit Assets, Bethesda, Md., which represents more than 100 of the largest U.S. corporate pension plans with a combined $1.5 trillion in defined benefit and defined contribution plan assets. “There is no reason that you can't have both.”

While CIEBA and groups representing other plan sponsors continue to press that point with the CFTC, the political reality is that the agency, under the gun to produce a slew of Dodd-Frank-mandated rules, is well along in the rule-making process on this issue, and is scheduled to vote on it Jan. 11.

Ironically, the MF Global crisis might have boosted the argument for physical segregation. Once futures broker MF Global filed for Chapter 11 bankruptcy protection in late October, the ability to detect where customers assets were, and which were even recoverable, became a longer term legal problem that left investors wondering if they would ever see their money again. It also raised questions about what federal regulators could have done to prevent it.

“We have an opportunity to learn a huge lesson from MF Global,” argued Kent Mason, an attorney with the Washington law firm Davis & Harman LLP, which represents several corporate pension plans. “Unless the proposed rules are changed, we're not going to have the option of protecting our collateral from the risk of dealer bankruptcy. Dodd-Frank was about decreasing risk; requiring clearing without collateral protection increases risk substantially. Why not allow us to continue to protect our collateral at our own cost?”

Pension plans already pay modest fees to third-party custodians handling their swaps; those costs would only go up if the CFTC mandates the use of clearing organizations.

Ms. Forbes of CIEBA said pension executives are particularly worried because “they are fiduciaries, and they take it very seriously to protect those assets.” If the CFTC rule becomes final as is, plan sponsors “are between a rock and a hard place. Each plan is going to have to decide if the reward is worth the risk. Some will stay in and hedge a lot less, and some will get out.”

Swaps are less common with public pension systems, where it takes a big fund like the $225.5 billion California Public Employees' Retirement System, Sacramento, to control the risks. Eric Baggesen, senior investment officer for CalPERS' $130 billion global equity portfolio, said in a telephone interview that they use futures contracts for listed derivatives that are “by nature” cleared transactions, as well as some over-the-counter swap agreements that are typically “plain vanilla.”

Mr. Baggesen understands why the CFTC wants greater transparency of futures contracts. “They are trying to understand how much leverage is in the system,” he said. “What became evident in 2008 and 2009 was that there was a tremendous amount of leverage in the financial markets. If the bets were big and if people couldn't perform, who makes up the losses? With cleared swaps, you avoid the build-up of liabilities.” Having transactions cleared also tends to decrease price spreads, he said. “You can see what's going on in the marketplace.”

Still, Mr. Baggesen said CalPERS “would prefer to have a tri-party custody agreement” or least new rules that do not diminish collateral security. The absence of that protection in the CFTC's proposed rules “does make us concerned,” he said.

That concern is starting to be understood on Capitol Hill as well as at the CFTC. On Dec. 15, Bart Chilton, CFTC commissioner, asked House Agriculture Committee Chairman Frank D. Lucas, R-Okla., to suggest yet another approach to how customer money in swaps is treated. To make sure something like MF Global “never happens again,” Mr. Chilton suggested in a letter “an overall revamping of how we treat segregated funds.”

In a Dec. 20 letter to CFTC Chairman Gary Gensler, ranking Agriculture Committee member Rep. Collin Peterson, D-Minn., echoed industry concerns that with the swaps market “vastly larger than the regulated market. ... It is critically important that counterparty collateral or margin will not become lost or tied up in the event of a dealer bankruptcy.” Absent the protections now in place, “confidence in the Dodd-Frank Act's system of swap clearing will be undermined before it gets started,” Mr. Peterson wrote.

Lawmakers and regulators “are recognizing that there is a legitimate concern on the part of pension plans” about segregated swaps, said Lynn Dudley, senior vice president for policy at the American Benefits Council, Washington. “They don't want to be in a situation where there is potentially less protection after Dodd-Frank than there was before.”