Derivatives rules could put chill on LDI in Europe

New regulations aimed at reducing risk on derivatives trading could inadvertently deter European institutions including pension funds from liability-driven investing, say consultants, managers and other industry experts.

Under the European Union's European Market Infrastructure Regulation directive, the cost of hedging liabilities is likely to increase, making it more expensive for pension funds to implement LDI, sources said. In a low bond-yield environment that already has made LDI too expensive for many pension funds, the new rules will further increase the burden.

The directive “isn't going to make LDI any more attractive,” said Julian le Fanu, policy adviser for European regulation at the National Association of Pension Funds, London.

In the U.K. —the largest LDI market in Europe by assets — pension funds' aggregate new asset inflow into LDI strategies has been falling and was nearly flat in 2011, according to a survey published in April by KPMG. Still, historically low yields pushed up bond prices, increasing overall LDI assets by 28% to £312 billion ($501 billion) last year.

“If the cost of hedging is higher, then pension funds may do less hedging than they would otherwise,” said Treeve Coomber, senior investment consultant at Towers Watson & Co, Reigate, England. While those who already have implemented LDI will likely continue to do so, the directive will give investors who are unsure about LDI “another reason not to move forward.”

In the long term, however, investors will choose to adapt because derivatives remain an effective risk management tool, sources said.

“Although it will add complexity, the trade-off is that the overall (portfolio) risk will be more effectively managed. So it's a necessary evil if you like,” said John Dewey, managing director and member of the BlackRock multiasset client solutions group based in London.

The EMIR directive, scheduled to be implemented at the end of the year, includes an initial three-year exemption for pension funds.

Details haven't been finalized, but the new rules broadly push derivatives trading toward central counterparty clearing and away from over-the-counter markets, sources said. In addition, related regulations under Basel III, which increase capital requirements for financial institutions, could further raise the cost of liabilities hedging.

“We're all waiting to see what the final shape (of the directive) will look like,” said Raymond Haines, head of European LDI at State Street Global Advisors, London.

SSgA, BlackRock, Legal & General Investment Management, F&C Asset Management and some other money managers have introduced new pooled strategies and/or are working with clients in separate accounts to mitigate possible negative effects of the new directive.

“Every marketplace participant will have to review their business models,” said Nicole Grootveld, chief operating officer at specialist investment consultant Cardano Risk Management BV, Rotterdam, Netherlands. “How LDI will be impacted is still unknown, but it is clear that certain investment strategies will be impacted. (The new regulations) will force markets to change and evolve, and investors will have to evolve with it.”

Following the 2008-2009 credit crisis, governments from the U.S. to Europe to Asia have been taking steps to reduce risk in the derivatives markets. In the U.S., for example, the Dodd-Frank Act also requires central clearing for derivatives contracts. However, U.S. pension funds normally don't rely on OTC derivatives contracts as much as their European counterparts for LDI implementation. In general, U.S. pension liabilities have shorter durations and funds have a more liquid and broader supply of securities that can be used — instead of derivatives — for liabilities hedging.

“In the current environment, central clearing is a good thing, and reduces counterparty risk in an environment where banks are weaker or perceived to be weaker,” Mr. Coomber said. However, the result is also higher costs, including additional margin requirements, which could put a drag on overall LDI returns for European pension funds.

“One of the details that remain unclear is what pension funds will have to post as variation margins. At the moment, it's mostly cash,” Mr. Coomber said. “Our (pension fund) clients don't hold a lot of cash. They see cash as dead weight.”

Mike Walsh, London-based head of solutions, distribution and management at Legal & General Investment Management Ltd., said the company launched a range of LDI pooled funds in 2011 with the new regulations in mind. For example, the "matching plus' strategy's range has a higher allocation to cash compared with previous generations of LDI pooled funds.

Collateral requirements already have moved toward high-quality government bonds and cash where corporate bonds had previously been used, Mr. Walsh said. “The changes have already started to be reflected in recent transactions,” he added. As of Dec. 31, LGIM managed £111 billion in derivative exposure within LDI strategies for U.K. pension funds.

Another setback for LDI investors is that derivatives contracts available from central clearinghouses are standardized, making them less precise as hedging tools for individual clients. “Clearinghouses like to have things in nice, neat little buckets, compared to OTC (markets), where contracts are infinitely flexible in terms of what you're trying to do,” said Mr. Haines, whose firm has about $4 billion in LDI assets under management in the U.K. “Central clearinghouses are more of a supermarket.”

Estimates of the additional cost to pension funds' LDI strategies are not available. However, a paper published earlier this year by the London-based Investment Management Association estimated a typical pension fund could suffer an average 35-basis-point loss from having to hold more cash for margin requirements. “The performance drag compounded year on year will, in time, be very considerable,” according to the report.

BlackRock, which had £129 billion in LDI assets under management in Europe, the Middle East and Africa region as of Dec. 31, is “looking in detail at what the regulations mean for each individual client,” Mr. Dewey said. “Part of that is to look at the different mechanisms to avoid having to hold a higher proportion in cash.” For example, investors might generate cash from non-cash securities, such as entering a repurchase transaction using U.K. government bonds to synthetically raise cash for margin requirements.

“There are pluses and minuses,” said Alex Soulsby, head of derivatives fund management in the investment solutions team at F&C Asset Management PLC, London. The EMIR directive “does take away the concern in OTC markets of your counterparty going bust; that's the whole reason behind the directive. From that perspective, pension schemes may become more comfortable to implement LDI in the long run.

“We recognize there are difficulties in the short term,” said Mr. Soulsby, whose firm manages about £28 billion in LDI strategies.

Like other managers, F&C has introduced LDI pooled funds that are suitable under a central clearing system. For example, more exchange-traded funds might be used, instead of derivatives, to gain certain types of exposures. Additionally, some strategies are being steered away from credit toward liquid cash equivalents “that are suitable to post margins,” he added.

F&C is looking at “each of the mandates and seeing if it needs to be adjusted and whether it will work under central clearing, which is inevitably where we will end up,” Mr. Soulsby said. “We're well advanced; we've spent a lot of time on this.”

Others are skeptical whether the transition will be smooth for all pension funds.

In at least three papers published in the past year on expected changes in the OTC markets, Cardano's Ms. Grootveld has urged government authorities in Europe to introduce ways to ensure the EMIR directive will not result in a “high amount of additional costs and operational burden.”

According to Ms. Grootveld and the NAPF's Mr. le Fanu, the new regulations could also increase operational risks by restricting the number of counterparties for pension funds.

“More attention should be given on how to promote clearing from a "carrot' perspective that creates liquidity in OTC derivate products without creating disincentives to sound risk management,” Ms. Grootveld wrote in a paper published on April 2. Without such measures, “no amount of "stick' (in the form of higher capital charges) ... will be effective in incentivizing clearing” for all OTC derivatives.