Credit default swaps: Pension funds make last stand to avert clearing

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By:
Louise Bowman
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April deadline for regulation; Margin requirements could be prohibitive

On April 20 the Economic Affairs Committee of the European Parliament (ECON) is due to vote on amendments tabled on OTC derivative legislation. The vote could spell trouble for the pension fund industry, which has found itself ensnared in the wider drive to push the OTC derivatives market on to central clearing.

In September 2010 it was announced that pension funds were to be treated as financial counterparties in swap transactions – which means they are required to clear certain OTC derivative transactions and report all such deals to a trade repository (similar proposals have been made in the Dodd-Frank reforms in the US).

"It came as something of a shock when pension funds were wrapped into these regulations – September 15 was the first time it was mentioned that they would be," says Ed Parker, global co-head of Mayer Brown’s derivatives and structured products practice. "The pension fund industry was caught out by this."

Cost considerations

The move is of concern to pension funds for cost reasons. If they are classified as financial counterparties they will have to post initial margin against all derivative trades. For large pension funds running liability-driven investment strategies and using long-dated interest rate and inflation swaps this will have big implications.

"Pension funds generally have not posted initial margin before; for some the expected future margin requirements might run to billions. If all that margin was required to be posted in cash, it would be a massive drag on their earnings"

Jeff Gooch, MarkitServe

Jeff Gooch, chief executive at MarkitServe
"Pension funds have large, one-way and long-dated liabilities. Derivatives markets give them the ability to offset the interest-rate or inflation exposure contained in their obligations," says Jeff Gooch, chief executive at MarkitServe. "These transactions can add up to an enormous one-way number. Pension funds generally have not posted initial margin before; for some the expected future margin requirements might run to billions. If all that margin was required to be posted in cash, it would be a massive drag on their earnings."

Having been wrong-footed by the proposals the industry is now engaged in a last-ditch lobbying effort to try to block them.

"We are getting clear messages from all part of the European Commission that they realize there is an issue for pension funds and insurance funds," says Jane Lowe, director, markets at the Investment Management Association (IMA). "We have made a lot of progress – people have understood that if the proposals are not changed pension and insurance funds will not be able to use swaps in the way that they have been using them, which eliminates the kind of trades that the market is there for."

The problem that pension funds face is that their one-way derivatives positions will in many cases result in them being required to post more initial margin than dealers that are able to net their positions off. This could give rise to extraordinary changes in market behaviour – with some funds opting to use repo to meet margin requirements. Opponents of the proposed rules argue that this will result in less-risky institutions effectively subsidizing riskier ones in the amount of margin they are required to post.

"This is systemic risk logic turned on its head," says Jonathan Slater, joint chief executive at TradeRisks. "Those that represent less systemic risk post more margin. It will force the pension funds to change the way they act and reduce the amount of hedging that they do – and therefore increase the amount of interest rate and inflation risk they are exposed to."

TradeRisks has developed an end-user-to-end-user platform through which pension funds will be able to offset their exposure with non-financial counterparties such as infrastructure investors and residential property companies with rental income linked to inflation. They argue that the reasoning behind the regulations is wrong.

"There is confusion about how a party introduces systemic risk into the system," says Alex Pilato, TradeRisks’ founder and chief executive. "The regulators assume that size is the determinant but this is not right. A much better measure would be the ratio of gross to net derivatives exposure. For corporates or pension funds this ratio would be close to one as all the swaps are going the same way; but for a dealer the ratio could be very large or even infinite. A ratio much greater than one therefore should determine that an entity represents systemic risk."

Pilato says that "there is acceptance in the pension fund sector that they will be classified as financial counterparties" but elsewhere optimism remains that the legislation could still be changed. The deadline for amendments was March 16.

Still hope for pension funds

"It would not surprise me to see pension funds taken out of the legislation," says Parker. "It has been very rushed. A lot of pension transactions such as longevity trades and long-dated transactions are not natural trades for clearing anyway. Pension funds already have restrictions on what they can buy and they are not market-making or proprietary trading institutions."

He points to the fact that if there were a clearing house insolvency the clearing house could end up drawing on pension fund assets if it had worked its way through its margin, capital and default fund. "This is very harsh," he says.

Lowe agrees that the way in which clients such as pension funds and dealers use the market is different and argues that the two should be separated in implementing the regulation. "Dealers represent systemic risk but many clients don’t," she says. But time is running out.

"The aim is to reach a general agreement in mid-April and have the text agreed by June or July. It seems a bit ambitious to me," says Danka Starovic, head of capital markets policy at the IMA.