This briefing considers the key issues that pension schemes should be thinking about (and in certain cases, should have already considered), and the steps they should take, to ensure that they and their investment managers comply with the European Market Infrastructure Regulation (EMIR).
The European Market Infrastructure Regulation (EMIR) was introduced in August 2012 and implementing measures have been coming into force ever since. The regulation has also been subject to extensive review, change and development through delegated legislation. A key recent development occurred on 16 September 2015, when the temporary exemption from the clearing obligation for pension scheme arrangements was extended until 16 August 2017.
Broadly speaking, EMIR is intended to reduce certain systemic risks associated with over the counter (OTC) derivatives (eg the risk of a counterparty defaulting on its obligations and a perceived lack of transparency about derivatives trading). It does this by setting requirements for parties entering into OTC derivatives to take steps to manage their risk, report their trades and clear transactions through central counterparties.
Pension schemes use derivatives to hedge against a range of risks, such as the cost of inflation, interest rates and increases in longevity. As the regulatory framework introduced by EMIR continues to evolve, pension schemes need to respond to these changes in both their investment strategies and the way they manage risk.
This briefing sets out an update (and a recap) on the key issues that pension schemes should be thinking about (and in certain cases, should have already considered), and the steps they should take, to ensure that they (and their investment managers) comply with this regime.
What is EMIR?
EMIR is the European regulation on over-the-counter (OTC) derivatives, central counterparties and trade repositories. EMIR has direct effect on all EU Member States, so does not need to be implemented in individual States through national laws.1 It is part of the global effort to reduce counterparty and operational risk in the OTC derivatives market.2
Does EMIR apply to Pension Schemes?
Yes, most EU pension schemes are ‘institutions for occupational retirement provision’ (IORPs),3 which are treated as financial counterparties (FCs) under EMIR—so are subject to the most onerous requirements under EMIR when they enter into OTC derivatives. Certain pension schemes (such as unfunded schemes) fall outside the IORP definition and will therefore not be financial counterparties. However, EMIR will still apply to such schemes as they will be ‘non-financial counterparties’ under EMIR (known as ‘NFCs’). NFCs are divided into two categories, ‘NFC+’ and ‘NFC-’. The distinction is drawn on the basis of whether or not an entity is above the clearing threshold. An entity will exceed the clearing threshold if it uses derivatives with an aggregate notional amount in excess of the threshold for non-hedging purposes. If an entity is above the clearing threshold, and therefore an NFC+, it is regulated under in a very similar way to a financial counterparty.
Accordingly, certain obligations will apply to pension schemes, whether financial counterparties or not, directly when they enter into OTC derivatives (eg as part of a de-risking or liability management exercise). Pension schemes could also be affected indirectly if they invest in pooled funds or collective investment schemes which use OTC derivatives, due to the increased costs of running those funds.
Pension schemes will also need to consider the impact of EMIR on the counterparties to any OTC derivatives they enter into, who will mainly fall within the following categories:
- a financial counterparty—broadly, an EEA financial institution (eg a bank, non-bank investment firm, insurer, investment fund); and
- a third country firm that would be a financial counterparty or an NFC+ if established in the EEA.
Overview of requirements
EMIR covers all areas of the OTC derivatives market, including equity, credit, interest rates, and most foreign exchange and commodities contracts. EMIR imposes three requirements on those who trade derivatives:
- central clearing: requirements to clear OTC derivatives that have been declared subject to the clearing obligation through a central counterparty;
- risk management: obligations to put in place certain risk management procedures for OTC derivatives transactions that are not cleared (including bilateral margining for non-cleared transactions); and
- reporting: requirements to report derivatives to a trade repository.
Note that clearing and margining apply to entities which are FC and NFC+ under EMIR only. Where the relevant scheme faces a non-EU counterparty, aside from reporting each of the requirements above will in effect apply to the non-EU counterparty, in order to facilitate compliance by the scheme.
The clearing requirement
EMIR requires certain counterparties to OTC derivative contracts that are FCs or NFC+ to clear certain ‘eligible’ contracts through a central clearing counterparty (CCP).
A CCP is an entity, which is authorised by the relevant national regulator (the Bank of England, in the UK), to sit between the counterparties (or clearing members (CM)) to a contract. In effect, a CCP acts as a buyer for every seller, and a seller for every buyer.
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The requirement to clear derivative trades through a CCP is intended to limit the risk that one party will be exposed to losses if another party defaults on its obligations (eg where it becomes insolvent). The reason for this is that a CCP is required to meet its obligations under a contract, even where another counterparty defaults on its obligations to the CCP. One of the ways that CCPs reduce their exposure is by requiring users of OTC derivatives to post an amount of initial margin when they enter into a transaction. Further amounts of variable margin collateral must be posted throughout the duration of the transaction to reflect additional exposure for the other counterparty resulting from changes to the mark-to-market value of the transaction.
Clearing Members will be large banks that will in turn offer clearing services to their clients, ie pension schemes. As a result, schemes will not face the CCP directly themselves. It is expected that the clearing obligation will come into force for mandated interest rate swaps (IRS) in 2016, and thereafter for certain mandated classes of credit default swaps (CDS). Accordingly, once the exemption from the clearing obligation for pension schemes ends, pension schemes subject to the clearing obligation will only be able to enter into these mandated classes of IRS and CDS transactions if they are cleared.
Exemption for pension schemes
The clearing obligation raises certain challenges for pension schemes - in particular, it could force pension schemes to invest a higher proportion of assets in eligible instruments, such as cash or government bonds (depending upon the requirements of the CCP), which can be used to meet a CCP’s margining requirements. This, in turn, could force pension schemes to change their investment strategy in a way which would depress the yields of the fund overall. This would increase the valuation of pension scheme liabilities and the cost of funding the schemes.
In recognition of this, certain ‘pension scheme arrangements’ (including IORPs) were granted an exemption from this central clearing requirement, which applied initially until 16 August 2015 and has been extended recently until 16 August 2017. It could be extended by a further year if the European Commission considers this necessary.
The extension follows a report by the European Commission which determined that CCPs have not yet developed solutions which enable pension schemes to post alternative, non-cash forms of collateral (such as securities) to meet variation margin (VM) calls instead4. The European Commission noted that one CCP has been developing a ‘repo service’ for pension scheme arrangements, to enable them to convert their existing non-cash assets into cash to meet VM calls, whilst retaining ownership (and benefitting from the investment returns) of such assets in the long term. The European Commission also suggested alternative solutions for CCPs, including accepting non-cash assets directly or creating security interests over posted securities in favour of the VM receiver.
In order to qualify for this temporary exemption, the derivative contract must be ‘objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements’.
Certain pension schemes may wish to clear their trades on a voluntary basis, rather than relying on this exemption, for the following reasons:
- collateral requirements: certain non-cleared trades will be subject to additional initial and variable margin requirements, which could increase their cost (see Collateral costs for non-cleared trades, below);
- counterparty risk: pension schemes may want to use a CCP to reduce their counterparty risk; and
- access to market: the market in cleared derivatives may prove to be more efficient than the market for non-cleared trades as the volume of cleared trades increases.
Pension schemes should note that if they want to clear derivative trades using a CCP, they will need to appoint a ‘clearing member’ (such as a bank) to do this on their behalf.
Other risk mitigation measures will still apply to pension schemes even where transactions are cleared (eg trade confirmation requirements, reporting to trade repositories).
Collateral costs for non-cleared trades
Pension schemes are usually viewed as a low risk counterparty, which means that they are not typically asked to post an initial margin under their derivative contracts. Under the EMIR, certain non-cleared trades (for schemes which are FC or NFC+) will be subject to additional initial and variable margin requirements (though the initial and variable margin would need to be posted with the other counterparty rather than a CCP). This would mean that pension schemes would need to increase their reserves of eligible collateral instruments, which could force them to change their investment strategies and increase the cost of using derivatives (eg in hedging). However, in many cases counterparties for non-cleared trades will be able to accept a wider range of collateral than CCPs.
The European Supervisory Authorities (ESAs)5 are required to develop Regulatory Technical Standards (RTS) specifying the levels and type of collateral and segregation arrangements required to comply with these rules. These have not yet been finalised. Until the RTS comes into force, the European Commission has advised that counterparties can apply their own rules on collateral in accordance with the conditions laid down in Article 11(3).6
The ESAs published a joint consultation on draft RTS to be produced under Article 11(15) of EMIR in April 2014.7 This provided further detail on the collateral requirements for uncleared trades, including the criteria for providing both initial margin and variation margin (eg the levels and types of collateral that can be used and concentration limits on posting and receiving collateral) and the frequency of collateral transfers. A second consultation paper on the draft RTS was published by the ESAs in June 2015.8 The exact timing for the introduction of collateral requirements under EMIR is expected to be finalised in the next few months. At this stage, it is clear that there will be a gradual phasing in of at least initial margin requirements over the rest of the decade.
Existing OTC derivatives
Pension schemes will need to take account of the grandfathering provisions in EMIR if they want to enter into new trades before the exemption from clearing expires.
The clearing obligation applies to derivatives that are entered into or novated on or after the date from which the clearing obligation takes effect or an earlier date to be determined by the European Commission. This means that clearing members and clients will have to submit not only new OTC derivatives but also certain of those that exist at the time the clearing obligation takes effect (what’s known as the ‘front-loading’ obligation). This means that certain transactions that exist prior to the commencement of clearing for a particular type of derivative will need to be submitted for clearing, but this depends on the amount of time prior to the introduction of the obligation the relevant trade was entered into and also the remaining maturity of the trade at the time.
Pension schemes must put in place procedures on how they measure, monitor and mitigate certain risks associated with their uncleared OTC derivative contracts (eg operation and credit risk). These include:
- timely confirmation: processes that ensure that they execute confirmations of their derivative contracts in a timely manner (by electronic means wherever possible);
- portfolio reconciliation: pension schemes need to have formalised the processes by which they reconcile portfolios, so that they are robust, resilient and auditable;
- margin: timely, accurately and appropriately segregated exchanges of collateral (for FCs and NFC+);
- monitoring: having robust formal processes in place to monitor risk and the value of outstanding contracts;
- dispute resolution: agreeing processes with counterparties to identify and resolve disputes and report unresolved disputes to their regulator (the relevant UK regulator is the Financial Conduct Authority); and
- capital: (depending upon requirements in local jurisdictions) holding proportionate amounts of capital to manage any risk not covered by collateral exchange.
In the case of portfolio reconciliation and dispute resolution, market standard terms have developed which pension schemes can use in their uncleared OTC derivative contracts.
Recap: reporting requirements
Since February 2014, pension schemes have needed to report certain details of any derivative trades, open positions and associated collateral to a trade repository relating to OTC and exchange traded derivatives no later than the working day following such conclusion, modification or termination of such trade.9
Pension schemes may delegate the reporting of the details of the contract, but must ensure that the details of their derivative contracts are reported without duplication. Ultimate liability for the completion and accuracy of reports remains with the pension scheme.
Where a trade repository is not available to record the details of a contract, the transaction should be reported to the European Securities and Markets Authority (ESMA).
What do pension schemes need to be thinking about?
Pension schemes should respond to these latest developments by:
- keeping their investment strategy under review and responding to the increased cost of clearing and collateral when structuring the fund’s portfolio or investments in pooled funds;
- checking whether their investment management arrangements reflect these obligations (eg by requiring their investment managers to comply with the regime and meet the risk mitigation and reporting standards when entering into OTC derivatives on behalf of pension schemes);
- ensuring they have systems in place to meet any direct reporting and trade confirmation requirements if they are investing directly in OTC derivatives;
- assessing whether they will rely on the exemption from central clearing for pension schemes; and
- considering whether they want to establish infrastructure for voluntary clearing before the exemption ceases to have effect?