An extension to the exemption on centrally clearing OTC derivatives would not mean schemes could rest easy, finds Stephanie Baxter.
Pension schemes can breathe a sigh of relief now the European Commission is likely to give in to pressure to extend their exemption from centrally clearing over the counter (OTC) derivatives under the European Markets and Infrastructure Regulation (EMIR).
There had been concern in the industry given that the exemption was due to expire in just 12 months. Although the commission had not published its report on the matter by the time this article went to press, Professional Pensions understands that a private meeting with UK and Dutch schemes and other stakeholders in July resulted in the policymaker agreeing to recommend to the European Council and Parliament that the exemption should be moved to August 2017.
Industry reaction has been positive. Linklaters partner Michael Voisin believes the extension will give schemes muchneeded time. He says: "On-boarding anyone to central clearing is a painful process but on-boarding pension funds is on the more complex side of the spectrum as they have to make arrangements with their managers over the running of clearing operations."
This requires clearing documentation and contracts to be drawn up in addition to setting up arrangements with clearing members.
It is easier for pension funds to wait until the clearing process is "more tried and tested", Voisin adds. There were warnings however about the dangers of schemes further delaying the inevitable. Indeed, there can be benefits in centrally clearing now.
Legal & General Investment Management (LGIM) programme lead on EMIR and central clearing Pankaj Shah, says: "While the further exemption provides pension schemes a bit of breathing space, it's a really good opportunity for them to start getting the infrastructure and legal documentation in place now. We've actually noticed an uptick in pension fund clients wanting to clear."
KAS Bank UK director of sales Brendon Bambury agrees it is helpful to act now. "Preparation is important as it increases the likelihood that you'll mitigate the costs and risks of clearing and be ready to post collateral," he says.
He warns there could be consequences of delaying until the last minute such as being "forced into arrangements that may not be best" and that finding a solution could prove more expensive.
Some of the larger schemes may wish to begin clearing regardless of another exemption but many funds are likely to delay for as long as possible given the heavy regulatory burdens they face.
KAS Bank institutional investors sales manager Carl Giannotta acknowledges that while some pension schemes are on top of their collateral requirements and run very sophisticated securities lending portfolios, others may struggle.
He says: "There is danger in the perception that because of the exemption, EMIR does not apply to them. It does apply to the counterparties and the investment banks these pension funds are dealing with, so schemes need to get their houses in order in any case, otherwise they will face huge costs."
Indeed, the question of whether to clear is not straightforward and ultimately depends on a fund's overall investment portfolio. Some funds may actually be worse off by complying with EMIR now.
Everis capital markets consultant Jonathan Philp says that some large pension funds are "voluntarily testing" centrally clearing derivatives but that several may have been pushed into it by their dealers. The cost of clearing may still be "quite prohibitive" for schemes, he adds.
Whether or not pension schemes decide to take advantage of an extended exemption from EMIR, doing their homework on clearing is a good idea. KAS Bank's Giannotta and Bambury advise schemes to ask about segregation of collateral, which central counterparties (CCPs) are used by the asset manager or investment bank, and what kind of collateral they require. For liability driven investment (LDI) derivative strategies they recommend that schemes ask how much collateral they need now, where they will get it from and how much it will cost.
Cash flow problem
The biggest challenge is the requirement to put up variation margin - usually cash - at CCPs, which is a problem given that most funds do not sit on large piles of readily available cash. Voisin says an extended clearing deadline will allow more time to find a solution. One resolution could be for schemes to post securities as margin, which consultancy Europe Economics has been researching for the European Commission.
Shah adds: "We would like our pension fund clients to be able to post non-cash as variation margin so they can be fully invested. It's a question of whether CCPs can find that acceptable in terms of valuation, practicality and infrastructure." It is unlikely, however, that the CCPs would wish to do this as it would mean having to transform illiquid assets, which would be the "last thing they need in stressed conditions", says Philp.
A solution explored by EU policymakers is for CCPs to have their own repurchase (repo) facilities whereby they could transform securities into cash, but it is uncertain whether this would work in practice. Voisin says CCPs would need to satisfy regulators that having repo facilities would not make them riskier.
Schemes could ask their custodians for large credit lines but this would be difficult as banks face capital constraints. One plausible option is for schemes to go to the repo market, where they could borrow cash, putting up government bonds as collateral. But Philp warns that while the repo market is "very large and liquid" it would bring yet another cost for schemes. He adds that CCPs tend to make big margin calls in stressed market conditions, which is when repo funding becomes expensive.
Europe Economics' analysis, which is yet to be published, will hopefully provide some answers. While it may seem that schemes have won a political argument over EMIR, it's important to remember the road to central clearing will not be easy but that it comes with the good intentions of bringing clarity on derivatives.
As Giannotta says: "As pension funds are main players in this market, the extension of their exemption is just going to delay improving transparency, which can't be good for institutional investors and the market as a whole. Transparency may bring added cost but it's a small price to pay."
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