In a Q&A with Caroline Escott, investment and defined benefits policy lead at the Pension and Lifetime Savings Association (PLSA), we discuss the ongoing debate on the clearing exemption for pension scheme arrangements—including what a permanent solution may look like, and if the exemption should be extended. Listen to the podcast on this topic.
Q: Do you think that the current CCP clearing exemption for pension fund schemes could possibly be extended again? And if so, why and why not?
Caroline: I think that there is a very good chance the central counterparty (CCP) clearing exemption for pension fund schemes will be extended. We saw the European Commission put this proposal in May 2017, of course in December 2017 we then saw that the European Council adopted this position to extend the exemption of pension schemes. And when we have been talking to European bodies, some of our pension scheme members, and also some of the EU Commission officials, it feels like there is a real will to try to make sure that pension schemes are not affected by the EMIR regulation.
There is a very good reason for pension schemes to be exempted from this regulation. We have recently experienced a tricky financial and economic environment, and for schemes to get the kind of returns that they want for their scheme members, they have had to rely increasingly on a variety of quite sophisticated investment approaches, such as liability driven investment. Many of these approaches mean schemes are more likely to use OTC derivatives as a hedge for some of their liabilities. Pension schemes would be very heavily affected by EMIR if they didn’t have this exemption.
Another good reason for the exemption to be extended is that the initial exemption was given to allow the industry and policy makers to work together to try to find a market-led solution, that would no longer require the exemption be in place, and would provide a way for pension fund schemes to clear using CCPs in a way that didn’t damage their interests. The industry has done a lot of good work on this, however the delay in some of the clearing legislation for the rest of the market has meant that lots of different parts of the industry have been more focused on that. We haven’t had sufficient time to get the kind of pension scheme solution that we might otherwise have wanted to see.
There is industry will to see this, from all different aspects of the industry. I think we are seeing a lot of understanding and acknowledgement of the issues the pension fund schemes face from the EU Commission, and from other part of the European regulatory system. So I think there’s a good chance that we will see the exemption being extended for pension schemes again.
Q: In your view, what is the biggest reason why pension fund schemes should continue to have some type of exemption or alternative solution to CCP clearing?
Caroline: The fundamental reason the exemption is necessary for pension schemes is cost and the potential drag on the rest of the portfolio. Entering the repo markets to get the cash needed to meet margin requirements will obviously entail a cost every time, in order to post this cash collateral, but there is also the opportunity cost of what this cash would have been invested in, the assets that firms have had to repo in order to get the cash, and what that means for returns generally.
It always comes back to the impact on scheme members and the cost to them. Whether it is greater costs, slightly worse asset allocation performance, or a lack of access to the most sophisticated investment techniques used for hedging, these costs will all come at a cost in that it will whittle away the value of scheme members retirement savings.
Q: What type of solution in the industry would be suitable for the pensions fund space? And if so, what are kind of the pros and cons of what is being suggested?
Caroline: We would like to see a variety of different solutions. A permanent exemption gives the industry valuable breathing space to try to come up with the right kind of industry-led solution. However, an exemption might deal with the issue of pension schemes being forced to clear, but pension schemes are also currently facing a problem on the bilateral side of the market. There are various capital and liquidity rules in place with banks since the financial crisis, which prioritize the holding of cash as opposed to other types of collateral, such as high-quality government bonds. Even though pension schemes might be going to the banks for their OTC derivatives contracts, we are now seeing a greater push from the banking side towards insisting upon cash as variation margin. Pension schemes are having problems in both areas of cleared and non-cleared derivatives, and a permanent exemption does not deal with the bilateral-related challenges.
One of the other solutions that is currently being looked at is whether or not you can work with the CCPs to try to overcome some of the operational difficulties that they have, in terms of not wanting or not being able to deal with holding high-quality government bonds or other types of collateral, as opposed to holding cash as variation margin.
There have been a lot of conversations on these kinds of fronts. It’s difficult at the moment to see whether there is a workable solution. But that’s something else that I know is being considered by the people who are looking at this.
Going back to the discussion of the bank capital side, we would be extremely keen to see some kind of alteration of the bank capital rules, so banks become just as willing to hold high-quality government bonds as collateral as they are as cash. This would help deal with the issues on that side of the market.
The other solution that we would be willing to see is that if it turned out to be the case that pension schemes had to clear via CCPs, and then had to provide cash as variation margin, they would need to be able to access the repo markets during all periods (including during stressed periods) in order to be able to repo their gilts into cash. Access to the repo markets is crucial as pension schemes do not hold high proportions of cash, because it doesn’t give the best kind of return for their scheme members.
At the moment, there are concerns that the European repo markets do not have sufficient depth of liquidity to be able to cope with a sudden influx of pension schemes wanting to repo. I know that there is work going on to see whether the central banks could provide a backstop in the form of some kind of liquidity insurance, to ensure that pension schemes would be able to access these repo markets during any kind of circumstance, including stress circumstances.
We are keen to see central banks act as the backstop in terms of liquidity and the repo markets. We think that would be beneficial for pension schemes and their access to hedging techniques.
Is there a potential downside to this solution? I think that there might be a potential fear in terms of public perception, that this is potentially a bailout of pension schemes. But this is certainly not a bailout in the same way that some of the banks were bailed out in the wake of the financial crisis. Rather, what I know some of members and others have been discussing is that the bank would step in, in stress circumstances, to just act at an arm’s length commercial contract kind of way, as the counterparty to the pension schemes when it came to repoing their assets in the market.
Pension schemes are extremely solvent, they are low risk and have a very high-quality credit grade. It is important for the industry to engage with the media and make sure the right messages are getting out. The central banks in the industry would need to work together to do that.
This is about creating a level playing field for the pension funds, but it’s also about minimising any chance for pension funds to pose a systemic risk to the stability of the financial system. We need liquidity in the markets, so that there is no negative impact if all the pension schemes go to the repo markets at the same time.
Q: Are some pension funds moving to CCP clearing already? And if so, is it for risk mitigation or costing reasons?
Caroline: I don’t have any precise statistics on that, but it tends to be the larger funds that are coming to us to talk about this option. The smaller pension schemes are either not aware of what is going on, because they do it through their asset manager, or they have their own small financial account party exemption to EMIR, which in many cases is easier to use, especially given the uncertainty around the pension scheme exemption in EMIR.
There is a view that because of the global shift towards clearing, being a first mover can have some advantages. We have also heard of pension schemes that are avoiding the bilateral markets, due to challenges related to the capital liquidity rules. The problem here is that they might then be implementing hedges that aren’t the most efficient, just because they have decided to go down the standardised route.
Another interesting thing we have heard is that some of the larger pension schemes are being told by the banks, with whom they have long-standing relationships, that although they have accepted high-quality gilts in the past, the banks would prefer to move to cash now. The larger pension schemes are pushing back and asking for flexibility on this—and getting it—but that route is probably not open to some of the smaller pension schemes. Luckily, they have their own exemption that they can use.
Q: The outcome of the exemption for clearing is still uncertain. How is the PLSA dealing with this uncertainty?
Caroline: At the moment, we are working with some of our larger members to plead in their views and the UK perspective to Pensions Europe and some of the other bodies that are working on this kind of issue.
UK pension schemes are in a unique position because they tend to use more derivatives than elsewhere. For instance, the Netherlands has relatively low inflation, so there is less use of derivatives for inflation hedging. Of course, Brexit is the word on everyone’s lips, and that has an impact here as well. In the ESMA Q&A’s on EMIR, there is no exemption for pension schemes that are domiciled in a non-EU country—unless they use an EU clearing house or counterparty, which might not be the case.
Our overarching message to pension schemes would be to monitor developments in this area. As I’ve said before, some of the pension schemes are not aware of the potential impact because their asset manager is dealing with it. Now is a really good time to start having the conversations with managers about what the appropriate hedging technique is for your firm, and what to do should the exemption no longer continue.
From a PLSA perspective, we always want to hear from members what the impact on them is going to be. And in terms of the policy process from here on in, we are now waiting for the MEPs to debate the proposal from the Commission, which was adopted by the Council in April.
It is always important to raise awareness with policy makers as to exactly what the impact of not having the exemption would be, with illustrations, and examples, of the kind of costs that would impact on you, add then ultimately on the value of scheme members’ retirement savings. I would urge pension schemes in the UK and elsewhere who are keen for the exemption to continue to go to their policy maker, to find out who their MEP is, and to work through bodies like the PLSA or Pensions Europe to get the message across to some of the key MEPs, like those on the economic and monetary affairs committee, as to exactly why the exemptions should stay in place.