Asset owners, managers are sort of ready for new swaps rules

Institutional investors and money managers say they are ready — more or less — for regulations on over-the-counter derivatives that become effective Sept. 9.

Officials at pension funds, for example, use swaps for several reasons, including to hedge against drops in interest rates that can increase pension liabilities and harm cash flow.

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, interest-rate and credit default swaps are cleared through registered derivatives clearing organizations.

Those clearing rules came with three deadlines: March for swap dealers and active private funds; June for other swaps customers like third-party investment managers; and Sept. 9 for all users, including institutional investors.

The new regulations also require asset owners to have liquid collateral to meet two types of margin requirements: initial margin to cover the fluctuation in a contract's value over a fixed period; and variation margin to offset the daily fluctuations in the swaps contract's market value.

For initial margin, calculated by the clearing counterparties, swaps users can post high-quality liquid assets such as U.S. Treasuries or corporate bonds. Variation margin is pledged in cash, which means that pension funds using long-duration swaps have to keep enough cash on hand to cover the margin.

“It's a new world,” said Bella Sanevich, general counsel of NISA Investment Advisors LLC in St. Louis, which manages $60 billion for defined benefit plans. “I think the vast majority of our clients will be ready.”

Ms. Sanevich said “some people may have an allergic reaction” to the increased regulation, and stop using swaps due to a perceived burden and clearing cost.

Charles Van Vleet, assistant treasurer and chief investment officer of Textron Inc., which has $5.6 billion in U.S. defined benefit plan assets, is one who already has switched to futures from swaps as a hedging mechanism “until the dust settles” on the new swaps regulations. With the new margin requirements, “the benefit of swaps over futures is diminished,” he said.

But Ms. Sanevich thinks that among clients for whom interest-rate swaps are a component of their liability-driven investing strategy, “anyone who values LDI as a strategy will likely not be swayed” as a result of the new regulatory environment. In fact, she and others expect to see more hedging activity with derivatives as interest rates rise and more pension executives consider swaps to manage their liabilities.

Pension executives using swaps can thank money managers for test-driving the new regulatory regime.

Michael O'Brien, vice president and director of global trading for Eaton Vance Management in Boston, was concerned that money managers were unprepared for their June deadline, “but it was a smooth transition. The big asset managers were prepared.”

“We tested the ropes in March with large hedge funds (and) the June deadline was very telling,” agreed Charley Cooper, New York-based head of exchange-traded derivatives and OTC clearing, Americas, for State Street Global Exchange, a group within State Street Corp. that provides proprietary data, insights, analytics and trading solutions. “There were no major bumps. I am hoping there is light at the end of the tunnel.”

Said Jack Callahan, executive director and OTC product specialist with the CME Group, Chicago: “Much of the swap activity from (pension funds) occurs through external asset managers, who have been clearing for quite some time.”

Mr. Callahan said the CME has worked closely with executives at pension funds that trade swaps through internally managed accounts to help ensure “a seamless transition to clearing.”

BlackRock Inc. has spent the past three years preparing for clearing through clearinghouses, and has operated under the new rules voluntarily for over a year “because it was such a big change in the way we trade, and clearing did offer a counterparty risk management tool,” said Supurna VedBrat, co-head of the market structure and electronic trading team in BlackRock's trading and liquidity strategies group in New York.

“It was an interesting exercise because there is so much interoperability,” with as many as seven parties involved for a single trade. While the clearing process added operational risk, “we understand that regulators wanted a lot more transparency that will ultimately help in managing systemic risk,” said Ms. VedBrat.

NISA's Ms. Sanevich and others expect to see increased administrative costs from the margin requirements and clearing demands, but “if there are substantial extra costs built in, that's going to be a different conversation” involving negotiations to lower the costs, she said.

In addition to fees for the new swaps clearing and margin demands, Ms. VedBrat is concerned about liquidity becoming more fragmented as more clearinghouses enter the market. There is also the question posed by many swaps market participants about whether swap execution facilities will be ready by their October general compliance deadline to allow for quality testing and review of rule books and participation agreements by clients.

“We are working with a lot of pieces,” said Ms. VedBrat, “but at the end of the day, everybody has to be ready.”

Judson Baker is product manager for derivatives and collateral management at Northern Trust Co., Chicago, a global custodian that provides swaps custody and collateral management for clients. He said concern over pension funds' ability to post collateral “is a non-event. If they continue to do what they have been doing, they can absorb that. In the pension fund space, there is no shortage” of collateral, said Mr. Baker.

To get a sense of the impact, Northern Trust identified the initial margin requirements of more than 200 pension fund clients holding eligible interest-rates swaps products and found that those with margin requirements above $1 million had ample eligible collateral in the form of high-grade government or corporate bonds. The average initial margin requirement was $5.3 million, which represented only 1.5% of the average pension fund's assets.

So far, the margin requirements require some effort to figure out which assets to post and when, “but conceptually it's very workable,” said NISA's Ms. Sanevich, who anticipates NISA will work with several clearinghouses for a while to see how it goes. “We're going to keep recalibrating and re-evaluating the process, because that's what we do.”

Another unknown is how new rules for swap execution facilities will affect pricing of swaps, transaction risk and market practices. And the rules out so far don't make swaps trading foolproof, say some pension fund executives and asset managers concerned about the safety of their collateral.

On both collateral management and valuation, “there's a lot of work going on behind the scenes,” said Northern Trust's Mr. Baker. “People will continue trading swaps; they will just have to change their behavior a bit.” One change could be more outsourcing all or part of swaps activity. But with outsourcing, “you have to make a bet on who is going to be around in two years,” said Mr. O'Brien of Eaton Vance.

As the true costs of clearing become better known through practice — along with the final costs of building the infrastructure to handle the new swaps rules — the OTC market might lose market share to futures and custom swap products that don't have to clear, “but I don't think it is going away,” said Mr. Baker. “There are too many specific needs that it fills.”