Marco Diolosa of Pension Insurance Corporation talks to DerivSource about how the insurance company is preparing for CCP clearing and explains the barriers of entry its pension fund clients face as they consider how to engage with the newly reformed derivatives landscape.
Q. Let’s start by talking about Pension Insurance Corporation and how you currently use OTC derivatives?
A. Pension Insurance Corporation (PIC) is a specialist provider of insurance solutions for defined benefit pension funds, which currently has more than 65,000 policyholders and £7 billion in assets under management.
Since PIC’s business is bulk annuities, whereby we become responsible for paying the pensions of former members of the defined benefit pension schemes we insure, our balance sheet has some very long liabilities, analogous to those of a pension scheme. These liabilities can stretch, in some cases, to longer than 50 years. We typically use a combination of long duration assets and derivatives to manage the interest rate and inflation risks inherent to these liabilities.
Q. How is Pension Insurance Corporation preparing for CCP clearing?
A. We started preparing for the advent of mandatory clearing at the beginning of 2012. We started by conducting a thorough due diligence exercise on clearing brokers and we are currently in the last stages of our selection process. This process had to be managed in a relatively fluid manner in order to allow for the latest regulatory and industry developments.
Towards the end last year we decided to halt the selection process in the absence of industry standard legal agreements. The FOA/ISDA working group has recently published a standard agreement for market participants to use. Although we believe it is likely that some amendments will be made further down the line, we decided to resume our selection process in order move swiftly into implementation and testing.
Q. Are you focusing only on EMIR?
A. As a UK company we are focusing on EMIR. That being said, there is a lot to learn from Dodd-Frank and its implementation in the US. We are keeping track of both.
Q. The mandate for CCP clearing will undoubtedly impact your business and that of your pension fund clients in the long run. How are you adjusting your processes, procedures and business model to accommodate this market change?
A. We believe that the central clearing initiative will increase the cost of managing risks for both pension funds and insurance companies, such as ourselves. This is due to the higher cost of transaction fees for OTC derivatives, and also to the higher liquidity requirements needed to service cash variation margins and initial margins. These will need to be factored into business models and investment strategies. Ultimately, the higher cost of hedging will mean fewer pension funds will remove this risk, with the potential for increased funding requirements from their sponsor, which is legally required to make good any deficit.
Q. What are some of the other barriers to entry should pension funds be aware of?
A. Transacting in OTC derivatives is likely to become more complex and more costly. Pension funds wishing to purchase hedges directly in the market will need more in-house expertise and infrastructure to establish an efficient process. The pension fund exemption will provide them with some time to adjust to the new regime.
The back-office workflow will become more important going forward as collateral is likely to become scarcer due to the increased margin requirements. Pension funds and bulk annuity providers such as PIC are unique in that they transact in both interest rates and inflation swaps. It is unlikely that inflation swaps will be clearable in time for mandatory clearing (i.e. summer 2014). Hence it is essential for those pension funds and insurers who wish to be early adopters to be able to transfer collateral from the bi-lateral world into the cleared world, potentially via the repo market, in order to avoid collateral fragmentation.
Q. What are the advantages for pension funds to clear voluntarily or to continue the bilateral structure until the temporary exemption from mandatory clearing expires?
A. The exemption for pension funds is currently due to expire in 2015, and there is potential for it to be extended by two or even three years thereafter. This exemption is very valuable in our opinion as it gives pension funds more time to prepare for clearing. By the time it expires it is likely that the clearing process will be more mature and better suited to the needs of pension funds, notably around inflation swaps and variation margins.
It may be advantageous to be an early adopter of clearing if cleared interest rate swaps were to become more liquid than their non-cleared counterpart. Also pricing and valuations should become more transparent when dealing cleared swaps as CCPs will be prescribing discount curves. However, we don’t see any incentive to backload books for the time being as existing trades would attract an initial margin.
Q. Given the liquidity squeeze that will result from CCP clearing, where do you see the liquidity coming from?
A. We believe that the amount of high quality liquid assets on balance sheets will increase. We see the repo market as a mean to provide liquidity for cash variation margins. What is less clear at this stage is whether the repo market is the right place for collateral transformation and how this market will behave in times of stress. One of the unintended consequences of the clearing initiative is that it may be transferring systemic risk away from the OTC world into the repo market.
Q. Does the movement of systemic risk away from OTC world and into the repo market an unintended consequence concern you or do you view it as just inevitability?
A. It is an unintended consequence in our view. The OTC market is akin to an ecosystem, it is in a stable equilibrium. A small change in a particular parameter (i.e. central clearing) will be corrected by some negative feedback that will bring the parameter back to its original point of balance. It is extremely difficult to eliminate systemic risk in practice without disrupting the balance of the whole system.
Q. What experience can you share with pension funds trustees reading this who are trying to understand how to respond to clearing and new regulation?
A. Most pension funds will benefit from the clearing exemption and in our view should start on their clearing broker selection process if haven’t already done so. As mentioned above there are some benefits to waiting for the rules to settle and the clearing offering to mature before starting to clear trades. There is, however, no harm in being ready ahead of the exemption expiry. This would mitigate against the risk of a deterioration of liquidity for non-cleared trades. Also the selection, onboarding and legal negotiation processes can be lengthy, and somewhat of a learning curve. It would be advisable to start the preparation process early.
