The costs for pension schemes using over-the-counter (OTC) derivatives are set to rise. New European Commission regulations will affect banks' pricing of derivatives and the ease with which derivatives can be used by pension schemes. Certain details are still to be decided, such as which types of derivative contracts will have to be cleared under the new 'clearing requirement'. The G20 has set a provisional date of the end of 2012 for full implementation.
The main reform will require financial counterparties, currently defined in the draft legislation to include occupational pension funds (Schemes), to 'clear' certain types of derivative contracts. Details of all OTC contracts will also need to be reported to a trade repository, although Schemes will be able to delegate this obligation to the banks.
Similar reforms will affect the US (covered there by the Dodd-Frank Act). This update focuses on the EU Regulations (the Regulations) on OTC derivatives, first proposed in draft form on 15 September 2009.
The Clearing Requirement
Currently, Schemes that hedge their risks with financial institutions through contracts such as interest rate, currency or inflation swaps (and more recently, longevity swaps) deal only with the bank providing the swap. As part of a global push to reduce risk in this market, financial counterparties will be required to clear certain types of contracts (see below).
The new clearing of OTC contracts regime will introduce an extra party between the bank and the Scheme - the clearing house. Each EU member state is to have its own clearing house which will:
- take the credit risk of all market participants by entering the contract itself, reducing the risk of default;
- clear eligible contracts;
- establish settlement positions on the contracts; and
- check that sufficient collateral is available to be posted by the parties.
This arrangement only works if the clearing house itself does not default on the contracts. To minimise the risk of the clearing house defaulting, measures such as capital requirements will be introduced and each member state may be responsible for the solvency of clearing houses.
Which contracts must be cleared?
The list of contracts subject to clearing will be produced by the European Securities and Markets Authority (ESMA) by summer 2012 and will include most standardised OTC contracts. This list is expected to grow over time. The aim is for this list to cover all standardised forms of derivative contracts. ESMA will be able to include new types of derivative contracts on this list if they become more popular in the future.
The main types of derivative contracts used by Schemes are inflation and interest rate swaps, which are almost certain to be on the list of contracts which require clearing.
Whether longevity swaps will be on the list of contracts requiring clearing remains uncertain. Although longevity swaps tend to be bespoke, rather than standardised, recent developments such as the creation of the Life & Longevity Markets Association could bring longevity swaps within the list of standardised contracts requiring clearing.
Liability driven investments (LDI) involve bespoke contracts and it may be difficult to standardise these contracts so that the clearing requirement can be met. Schemes could find themselves being required to comply with other onerous obligations which apply to non-cleared contracts (see below).
What about contracts outside the clearing requirement?
For bespoke derivative contracts (such as those involved in a LDI arrangement) Schemes will have to implement 'risk mitigation techniques' as these contracts will not be cleared. This includes processes to ensure timely confirmation of transactions (preferably by electronic means) and to implement the exchange and holding of segregated collateral. For many Schemes this will not be a realistic option.
Banks will also have to comply with these requirements if they are a party to any bespoke derivative contracts, so the costs are likely to be passed on to customers, resulting in derivatives becoming a more expensive investment option for Schemes.
What does this mean for Schemes?
Occupational pension funds are categorised as 'financial counterparties'. That means that they are subject to the same onerous requirements as banks and hedge funds. Efforts have been made to move pension funds within the definition of 'non-financial counterparties', where clearing is only required should the value of each derivative contract exceed a certain threshold (yet to be determined). If Schemes remain within the financial counterparties definition this will mean:
- Increased costs: Clearing houses generally require more collateral to be posted than banks, so Schemes will have fewer assets under management earning a return. Clearing houses pool counterparty funds for certain collateral purposes, meaning they can satisfy obligations using the pooled fund assets. If they are required to segregate assets to protect clients, the cost of finding extra assets will likely be passed on to Schemes. Banks earn a return by investing the collateral posted by Schemes. This return will be lost as the collateral will be posted to the clearing house, so the banks will probably look to mitigate this through higher fees.
- Posting highly liquid assets: Both 'initial' and 'variation' collateral will be required. It is expected the initial collateral could be posted in bonds or cash with the variation margin being posted in cash only. This requirement is not in line with the investment make-up of many Schemes and will require Schemes to source assets from elsewhere at a cost (for example the repo market to raise cash or exchanging collateral through a clearing broker).
- Greater risk exposure for scheme assets: The collateral posted to the clearing house will be exposed to the creditworthiness of the clearing house. Schemes will be exposed to two entities for the purposes of the same transaction (the bank and the clearing house).
What should trustees be doing now?
The proposed changes could potentially affect decisions to invest in derivatives. There is still some uncertainty as to the changes because the relevant law has not yet been finalised. Wragge & Co will monitor the position and provide updates as and when the position becomes more certain.
For the time being, trustees already using derivatives should:
- ensure that their investment consultants are monitoring the position and seek comfort that the consultant will take a proactive approach to advising the trustees when the position becomes more certain; and
- review existing derivative agreements to identify whether a material change in the law or regulation relating to derivatives trading constitutes an event of default which might prompt banks to unwind their positions once the law actually changes; and
- ask their investment consultant or fund manager to seek confirmation of the counterparty's position ahead of time so they have a clear view of the position.