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.