There has been a helpful change by the European Commission (the Commission) affecting the regulatory timescale for clearing certain derivative contracts. Pension scheme trustees with any current or potential exposure to derivative contracts in their investment arrangements (particularly relevant for liability driven investments) should be aware of and plan for this change in their business planning.
The Commission has agreed to extend the mandatory clearing timetable for OTC derivative contracts entered into by pension scheme arrangements. Under the European Market Infrastructure Regulation, pension scheme arrangements must now clear applicable OTC derivative contracts from 16 August 2018. This is an extension of a year. For pension trustees, it means that a material proportion of assets will not need to be divested for cash to meet the margin requirements for central clearing for a longer period of time.
The Commission has stated that this extension should enter into force as soon as possible so that there is no uncertainty as to whether pension scheme arrangements need to begin preparing for upcoming clearing regulations.
This is an important development particularly for pension scheme arrangements that maintain a liability driven investment portfolio.
In an Explanatory Memorandum dated 20 December 2016 the Commission stated that further time was required for central counterparties (CCPs) to develop technical solutions for the transfer of non-cash collateral (such as securities) by pension scheme arrangements in order to meet collateral calls.
Clearing involves CCPs interposing themselves between counterparties to OTC derivative contracts. The credit risk of those counterparties is mitigated through the posting of collateral which is calculated to cover any potential losses upon a default. CCPs only accept highly liquid assets, generally cash, as collateral to meet variation margin calls in order to allow for rapid liquidation in the event of a default.
Pension scheme arrangements generally minimise their cash positions, instead holding higher yielding investments such as securities in order to ensure strong returns for pensioners. Therefore, requiring pension scheme arrangements to clear OTC derivative contracts centrally would lead to a divestment of a significant portion of their assets for cash in order to meet the ongoing margin requirements of CCPs.
Following the outcome of a number of public consultations and calls for evidence, it was confirmed that the necessary effort to develop appropriate technical solutions has not been made by CCPs at this point in time and that the adverse effect of centrally clearing OTC derivative contracts on the retirement benefits of future pensioners remained unchanged.
This central clearing requirement extension only applies to those OTC derivative contracts entered into by pension scheme arrangements that are objectively measurable as reducing the investment risks directly related to the financial solvency of pension scheme arrangements.