Collateral damage

THIS YEAR IN JANAURY, UK and European pension funds were given a three-year exemption from a new regulatory framework on derivatives trading being introduced by the EU under the combined initiatives of EMIR, the European Markets Infrastructure Regulations and MiFID II (the Mark II version of the Markets in Financial Instruments Directive).

The rules are designed to make derivatives trading more transparent and to migrate trading to regulated market operators. However, pensions and advisory industries argued the rules would heap additional costs on pension funds just because they wanted to use swaps to derisk their portfolios.

Pension funds have, in recent years, tended to take every opportunity they get to hedge out unwanted risks such as interest rate risk, inflation risk and longevity risk. Standard practice has been that a fund immediately initiated a swap or a series of swaps, to take more risk off the table, every time it managed to get its assets and liabilities into reasonable shape. The sponsoring companies love this, because it means that finance directors are less likely to be hit with nasty surprises every time the scheme is subjected to an actuarial valuation.

However, engaging in a swap is not cost-free and it always requires a cost-benefit analysis to establish the value and validity of the exercise. Now, as an unlooked-for consequence of the regulatory effort to make derivatives trading more transparent – and hence less of a systemic risk to the financial system – swaps are going to become much more expensive.

The problem, as Mercer principal consultant Ben Gunnee explains, lies with the new drive to make as much as possible of the global trade in derivatives pass through central counter parties (CCPs). The CCP sits between the buyer and the seller and hence records every trade, giving the regulators a clear view of how much is being traded by individual institutions. This sounds innocuous, but it creates a significant layer of additional costs for pension funds. The rules for “collateralising” swaps through CCPs – putting up cash to ensure that each side is good for their part of the bargain – are both more difficult and more expensive for pension funds to meet.

“A large number of pension schemes are presuming, incorrectly, that they are exempt from central clearing – and that therefore they do not need to make any of the operational changes that will be necessary for them to interact with a clearing house. They are also not taking the necessary steps to minimise the impact of the additional collateral they are going to be required to post in order to engage in swaps,” says Gunnee.

Swaps trading

In the traditional bi-lateral world of Over the Counter (OTC) swaps, a fund would deal directly with its chosen (usually local) bank and, between them, they would agree what would count as collateral. The fund would generally want to deposit equities, which it has in spades, as collateral. However, it would not want to post cash collateral, since that would mean foregoing the potential gains it could make by investing the cash. Foregoing the gains would vitiate part of the swap and weaken the point of doing it in the first place.

In the new world of CCP swaps trading, cash is going to be mandatory, with a possible exception for high-grade government bonds (UK, US, Germany). This is going to force many pension funds to swap their equities for acceptable government bonds to post as collateral and there will be a cost associated with doing so. It is also certain to drive a thriving new trade in upgrading collateral (bonds for equities), which will be a nice earner for some insurance companies and banks, which are rich in the appropriate government bonds and will be happy to lend them at a price. However, it was never a part of the regulator’s mandate to enrich the likes of JP Morgan and Citi.

But what of that three-year exemption? Doesn’t that mean that pension funds can get all their swaps out of the way before they get caught by the new CCP rules? No, because a different set of regulations, namely Basel III, imposes very steep penalties on the amount of capital reserves banks have to set aside when they engage in bilateral swaps. So no bank is going to be keen to oblige a pension fund that wants to take advantage of the three-year exemption to continue trading bi-laterally. The three-year exemption is not worth the paper it is written on.

This brings us back to the fact that pension funds still wishing to derisk part of their exposure will find that it is going to be a lot more expensive henceforth. This in turn may well cause funds not to hedge out risk, which means they will be carrying more risk than they need to. But making pension funds more risky was never part of the regulator’s mandate, so once again we are witnessing the law of unintended consequences in full cry.

Will the world’s financial systems be safer after EMIR and MiFID II make it onto the statute books? What is certain is that the new rules will do few favours for pension funds.