Many pension schemes use over-the-counter (OTC) derivatives as part of a liability-driven investment (LDI) strategy. The main types of OTC derivatives that are used by pension schemes are interest rate swaps and inflation swaps, to protect schemes from interest rate and inflation risks.
Although pension schemes use OTC derivatives for risk-management purposes, they can also be used for speculation and the G20 countries saw OTC derivatives as being a key element of the financial crisis in 2008 and agreed to introduce regulation of OTC derivatives transactions. The applicable EU regulation is the European Market Infrastructure Regulation (EMIR), which came into force on 16 August 2012, and will require "financial counterparties" (which includes pension schemes) to clear OTC derivative transaction through a central counterparty. EMIR applies to any entity established in the EU that is a counterparty to a derivatives contract.
What does EMIR require?
Reporting: EMIR requires all counterparties with derivatives contracts outstanding on 16 August 2012 to report details of those contracts and any new contracts they enter into to an authorised or recognised trade repository. This requirement will apply from 1 July 2013 for credit and interest rate derivatives and from 1 January 2014 for all other classes of derivatives.
Risk Management: For OTC derivative contracts that are not cleared through a central counterparty (see below), all counterparties will be required to put in place the following operational risk management measures:-
- processes to ensure timely confirmation of transactions (by electronic means where available);
- robust, resilient and auditable processes to reconcile portfolios, manage risk, identify and resolve disputes and monitor the value of outstanding contracts;
- marking-to-market the value of outstanding contracts on a daily basis (where possible);
- timely, accurate and appropriately segregated exchanges of collateral; and
- holding an appropriate and proportionate amount of capital to manage any risk not covered by collateral.
Clearing: The central clearing requirement is expected to apply from the middle of 2013. However, EMIR contains an exemption from the clearing requirements for OTC derivative contracts which reduce investment risks directly relating to the financial solvency of pension schemes. This exemption will apply until 16 August 2015 (at the earliest) and should apply to all UK registered pension schemes. However, pension schemes may in future opt to clear their OTC derivative trades (even where the exemption would apply) if the attitude of counterparties makes non-cleared transactions economically unattractive, through requirements to post higher initial margin (collateral).
What does this mean for pension schemes?
Schemes which hold OTC derivative contracts should be talking to their investment managers regarding compliance with EMIR requirements. The scheme trustees will be "financial counterparties" for the purposes of the regulation and therefore the ultimate responsibility for EMIR compliance will fall on them. In practice, however trustees would wish to delegate the responsibility to their investment manager, managing the portfolio in which the OTC derivatives are held. Trustees should therefore review their investment management agreements as amendments may be required to give them comfort that the manager will ensure compliance with the EMIR reporting and risk management requirements. It may also be necessary to review and amend ISDA master agreements, in particular credit support annexes (CSAs) governing collateral requirements.