Time running short on reprieve for EU derivatives clearing

Pension funds across Europe are yet again facing an obligation to clear derivatives themselves because of the upcoming revision to the European Markets Infrastructure Regulation.

Under rules of the original EMIR, all counterparties trading in the European Union are required to post cash, rather than bonds, as the collateral to clear derivatives' exposures. This means institutional investors will have to liquidate otherwise long-term fixed-income investments if they are to be used as collateral.

An exemption to the clearing rules — the second granted since 2016 in an effort to find a different method for pension funds before EMIR Refit, as it is known, goes into effect in March — expired in August. A source close to European decision-makers said a permanent exemption is not in the cards.

Sacrificing return for short-term liquidity through larger allocations to cash does not sit well with pension funds that have large liabilities, sources said. Instead, pension fund executives wanted to see a market fix that would either help them efficiently transform bonds into cash at favorable rates or simply post bonds as collateral for the variation margin, as they already can do with the initial margin requirement.

Some pension funds, trying to mitigate the impact of the directive's requirements, already have lined their portfolios with higher cash allocations; others are outsourcing collateral-posting to money managers. Either way, asset owners have to hurry.

"We are expecting to get amendment to EMIR (known as EMIR Refit) over the line in the next month or so, but certainly before the end of the year," said Kay Swinburne, member of the European Parliament and vice chairwoman of its economic and monetary affairs committee in Brussels.

"(The market) hasn't found the solution for (pension funds) yet ... but the solution has to be found and acted upon in a very short period of time," she said.

"We envisage (the market) is still looking for a technical solution that will allow pension funds not to have to post cash as variation margin ... they are looking at what that might mean for a central counterparty or central bank involvement to provide liquidity to allow a specialist repo platform. We are negotiating on the basis that there will be a solution — and are now debating how long that solution will take to conclude and then be implemented between three and five years."

Some institutions already have taken steps and are building cash holdings. Among them is the £29.9 billion ($39 billion) Pension Protection Fund, London, the U.K. lifeboat fund for insolvent defined benefit plan sponsors. Barry Kenneth, chief investment officer of the fund, said pension funds need to be able to protect liabilities and use synthetic products, so the use of derivatives will not decrease. "You need some kind of synthetics exposure," he said.

"We used to manage our LDI strategy (including derivatives) externally but we think we can manage it better internally," Mr. Kenneth said, adding that the PPF now runs a strategic cash allocation commensurate with its liquidity needs. "It is not a static cash allocation, but it is at around 6% compared to none a couple of years ago." He would not say what asset class was reduced.

But sources said exchanging bonds for cash is costing pension funds return and could mean an investment opportunity is missed. Depending on exposure, asset owners could lose 40 basis points on the swap transaction because of clearing, and the drag on the return could be 200 basis points on the long end, sources added.

"Depending on a scenario, you need up to 10% in cash to cover your derivatives exposure," said Ido de Geus, Utrecht, Netherlands-based head of fixed income at PGGM, which runs the assets of the €202 billion ($235 billion) Pensioenfonds Zorg en Welzijn in Zeist.

The PPF's Mr. Kenneth said around 25% of the LDI portfolio could be exposed to swaps.

As a result of the clearing rule, more pension funds might find it easier to outsource management of the collateral requirements to money managers. Fonds de Reserve pour les Retraites, the Paris-based €36 billion ($42 billion) French reserve pension fund, hired State Street Corp. and Russell Investments as derivatives overlay managers, said Olivier Rousseau, executive director.

"Operationally, we are not equipped to do derivatives clearing ourselves. As regulation hardens, it doesn't create incentive to (increase) derivatives but rather to avoid (them)," Mr. Rousseau said.

Still, not all executives have given up hope for a third exemption.

Mr. de Geus is confident another exemption will be granted. "Brussels couldn't get the work around (EMIR Refit) in time before the last window has run out. As to the length of (the next exemption), it is yet to be decided."

PGGM has not taken any big steps to prepare for central clearing. But Mr. de Geus added: "We want to do it in-house. It has a big impact on the portfolio and we want to have control over it."

Robert Gall, head of market strategy at Insight Investment in London, agreed. "I believe there will be another exemption … it (just) wasn't (formally) renewed on time." However, he said, meeting central clearing requirements is part of a bigger change. "There also the phasing out of LIBOR, which means utilizing swaps for hedging has decreased in favor of gilts."

The PPF's Mr. Kenneth agreed that cash was initially needed for clearing, but he said “clearing wasn't the only reason we have implemented a cash portfolio.”

“If not central clearing, bilateral trades clearing will require us to post cash for clearing by 2020. You can't get away from the fact that you have to be prepared to post and receive cash if you want to have some form of efficient derivatives exposure,” he said.

“There is another issue, which is there is a lack of price transparency (even where the type of collateral – cash – for margin calls is identical) between bilateral vs. centrally cleared inflation swaps. We have raised it with the regulator,” he said.Mr. Kenneth added.