Sinead Leahy, head of UK pension solutions group, RBS and Sian Hurrell, head of EMEA sales, RBS
The UK market for long-dated interest rate and inflation swaps has grown significantly since 2005, to stand at around GBP200 billion, as they become popular with pension funds trying to manage the risk resulting from paying inflation-linked pensions to members far into the future. But now, new central clearing and capital rules relating to over-the-counter (OTC) derivatives could increase the cost to pension funds of using these swaps to hedge their liabilities.
While the spectre of central clearing or higher costs will raise concerns for many pension funds, there are some positives. Firstly pension funds have been exempted from central clearing until 2015 and recent developments suggest that pension funds may also be granted some form of exemption from the higher capital charges contained within Basel III. This will be codified into EU law under the Capital Requirements Directive (CRD IV) which was scheduled to take effect from January 2013. Current expectations are that this will be delayed, with January 2014 considered to be the most likely date.
Even if pension funds don't end up being exempt, there are ways in which they can minimise the impact of the new capital regime by working closely with their bank to manage any derivatives positions optimally.
The regulators identified that two-thirds of the losses made by financial institutions in recent years were related to a fall in the creditworthiness of client counterparties, rather than those clients actually defaulting on agreements.
As a result, the European Markets and Infrastructure Regulation (EMIR) states that all standardised OTC derivative contracts must be transacted through an independent central clearing house central counterparty' (CCP) by the end of 2012. This significantly increases the cost of a trade because it requires an initial margin (an upfront cash amount currently not required under standard collateral arrangements) as well as requiring variation margin (additional cash to be posted as the value of the swap moves). The type of collateral that a CCP can accept is limited and is only expected to extend to cash and gilts for the initial margin.
The three year exemption to this rule, achieved by European pension funds, is not the end of the story though as CRDIV rules could still affect them by increasing the cost of swaps. This is because of tougher capital requirements being introduced for banks for their non-cleared, non-standardised transactions.
Once CRD IV comes into effect the amount of capital banks will need to hold to protect against counterparty (client) default is likely to rise under the CRDIV rules. On top of the existing Default Credit Risk Capital Charge (DRC) covering risk of outright counterparty default, there will be a new Credit Valuation Adjustment (CVA) risk charge, introduced to deal with the issue of counterparty credit deterioration.
The impact of this change will be to increase the amount of capital that banks will need to hold against transactions with pension clients that are not cleared. Other counterparties that do not clear trades and which have a lower credit rating, or don't post collateral, will typically be subject to a higher CVA charge. There will also be a higher charge for longer-dated swaps or more illiquid transactions.
It is likely that banks will not be able to absorb the cost of this extra capital without their derivatives business becoming unprofitable, hence the cost is likely to be passed on to clients. Having said that, pension funds are strong counterparties and tend to have tight collateral arrangements; as such the capital charge is much lower for them than other uncollateralised clients. Each transaction will need to be looked at on an individual basis but as an example we estimate, for a 30-year interest rate swap, it
could be around a couple of basis points on the yield, assuming a standard cash and gilts ISDA credit support annex (CSA).
Pension funds should continue to push for an exemption to this capital charge with EU policy makers. The point to make though is that, even if this is ultimately unsuccessful, it shouldn't discourage pension funds from using swaps to manage their liability risks. Putting the additional charge into context, it should be noted that a couple of basis points is small compared to the potential risk arising from pension scheme liabilities, particularly in the volatile market we have experienced recently, which saw long-dated interest rates fall more than 100 basis points.
In addition, there are also plenty of opportunities for pension funds to mitigate this increased capital cost by managing their swap contracts optimally.
Pension funds tend to already have strong collateral arrangements. Despite this, they can look at other options to reduce risk, such as increasing the collateral quality further, or allowing bigger haircuts (percentage of overcollateralisation) on the assets used. Another option is for pension funds to post an initial margin (in cash or other assets), which has the potential to significantly reduce the higher capital charges under CRD IV.
Alternatively, an innovative way to reduce the capital charge could be to reduce the length of any derivatives. Pension funds need to transact long dated swaps (up to 50 years) to match the long-dated nature of their liabilities. Unfortunately, under CRD IV, this attracts a higher capital charge as there is more chance of default or credit deterioration. Adding mandatory breaks, every five years say, should however reduce the capital charge. While this does introduce the risk of a pension fund losing its hedge in the future, this risk can be minimised by working with your bank to structure this appropriately.
Given the extra capital charges for uncleared swaps, central clearing could become more popular, as it has the advantage of not attracting the same level of CVA charges. However central clearing is not a perfect solution; the collateral which is posted is less flexible and funds would need to put up initial margin. In addition it is likely that clearing houses will charge banks additional initial margin for those large positions which are one directional, which is the very nature of pension fund business.
Notwithstanding the above, the likelihood is that the ongoing advantages of using long-dated swaps will more than offset the extra capital cost which can be kept to a minimum via sensible structuring.
The regulation landscape for pension funds should become clearer during 2012 and 2013. This will help pension funds to structure their derivative positions in the most efficient way, which could be by: centrally clearing trades, continuing with current bilateral arrangements or modifying current arrangements to minimise capital impact.
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