False comfort from pension scheme clearing exemption
Pension schemes are likely to find their option to continue trading un-cleared swaps will prove uneconomical, according to Derek Steeden from Ignis’ solutions team.
European Market Infrastructure Regulations 648/2012 (EMIR) came into force on 16 August 2012, requiring participants in OTC derivatives to comply with three pillars of reporting, clearing and operational risk management. Implementation dates are still to be announced but reporting requirements, when enforced, will be back dated to 16 August 2012.
Clearing could apply from early 2014 with risk management obligations for non-cleared trades unlikely to be imposed until later in 2014. Steeden expects the clearing and risk management requirements will cover new trades and are unlikely to be applied retrospectively to pre-existing trades.
When the clearing obligation is applied, any new in-scope derivatives traded, including interest rate swaps, will need to be cleared with a central counterparty e.g. London (Clearing House). Currently investors trade swaps bilaterally, where they are not normally required to post an initial margin amount and can post variation margin (collateral) using any agreed assets. Central clearing will require the posting of an initial margin, in the form of cash or gilts, and will require variation margin to be posted as cash. With respect to the new initial margin obligations, the amount of initial margin required will be calculated by the central counterparty and will be based on the volatility and correlation of the client’s trades viewed in aggregate. Although the model is well defined, given the nature of the inputs required, margin amounts will vary in response to changing market conditions and be specific to each portfolio of trades. Despite these caveats, a useful working assumption for estimating likely initial margin requirements is to withstand a 0.5 per cent adverse change in interest rates.
The new requirement for variation margin to be posted as cash is an issue for pension schemes as they do not typically hold sufficient cash to meet the level of potential variation margin calls. In response, there is an exemption available to pension schemes (who apply for it) allowing them to continue to trade derivatives bilaterally for three years from August 2012 (with a possible further two year extension). The intention is that this gives clearing houses time to investigate making gilts eligible for variation margin, although it is not yet certain that this will be delivered. As things stand, we believe it is prudent for schemes to obtain this exemption which may be useful for a period of time. However, once the new risk management obligations are enforced we believe these will render non-centrally cleared trades prohibitively expensive, and pension funds may no longer choose to use their exemption.
The current draft risk management requirements propose initial margins of one per cent to four per cent of notional for interest rate swaps (depending on maturity) for non-centrally cleared trades. Margin posted may not be re-hypothecated and there is no recognition of offsetting risk positions. Cash, gilts and certain corporate bonds and equities are eligible to post within the current draft, although with haircuts of up to 15 per cent. When implemented, both parties entering the trade will need to deposit this margin, and the cost of this capital to the market maker will be factored into the price, to the detriment of the pension scheme. Steeden says it may no longer be in schemes’ best interests to continue to use the exemption provision once the new risk management regulations apply for non-cleared trades.
One major issue is that central clearing houses are currently unable to process inflation swaps and swaptions. Hence, these assets are unable to be cleared and as such will be subject to the new risk management requirements.
Current proposals suggest initial margin requirements will be 15 per cent for inflation swaps and swaptions. Clearly, investors may not wish to enter into new inflation swaps or swaptions if the initial margin required remains at such levels. Steeden believes this is excessive and will either be reduced in the final draft, or the implementation of the risk management (margin) requirements delayed until inflation swaps and swaptions are able to be centrally cleared. Although not all clearing houses are committed to offering clearing for inflation swaps and/or swaptions we understand at least one house is aiming to clear these instruments by the end of 2013.
The pension fund exemption from clearing may appear to give a three to five year period for schemes to consider their options and adapt. However, it is the date on which the new risk management requirements come into force that is far more important. This may not be until 2014 but Steeden believes there is a risk that it will prompt such disadvantageous pricing for non-cleared trades that schemes will want to be in a position to choose to clear. To do this, they will need to be able to cover additional initial margin requirements and make cash available to meet clearing house variation margin requirements. This will involve appointing a clearing broker to enable trades to be cleared, and adding the flexibility to a fund manager’s remit to ensure additional cash is available when required, such as by adding repurchase agreements (“repo”) to the allowed tradable instruments.
- Special Reports