Full Speed Ahead: Pension Funds Take Final Steps Ahead of CCP Deadline

With just months to go until Europe’s pension funds must centrally clear over-the-counter (OTC) derivative transactions, concern and uncertainty continues to plague the industry. Gill Wadsworth reports.

This week the Treasury issued a last minute reprieve exempting UK pension funds from the central clearing obligation, announcing a three-year exemption.

Unlike their European counterparts, UK pension funds will not be forced to comply with European Market Infrastructure Regulation (EMIR) obligations, until 2025 at the earliest.

In the EU meanwhile,

the deadline is set for 19 June this year, and any pension scheme arrangements (PSAs) with derivative positions exceeding €3 billion in OTC interest rate derivatives and/or €1 billion in OTC credit derivatives; €1 billion in OTC equity derivatives, €3 billion in OTC FX derivatives and/or €3 billion in OTC commodity derivatives, must clear those positions using a central clearing counterparty (CCP).

Pension funds have been exempted from the rule since 2019, but after renewing the dispensation for the past two years, ESMA believes there has been enough progress among PSAs for them to meet the regulations.

Jamie Gavin, head of EMEA OTC at Société Générale, says that most of the larger, more sophisticated pension schemes are compliant with EMIR, and some already using CCPs “to make sure that they’re happy with how the setup works”, adding “there are no concerns about anybody meeting the deadline.”

Liquidity drain

While EMIR’s goal is to help manage risk, CCPs impose greater collateralisation requirements than might be expected in bilateral arrangements, and there is a preference for counterparties to post cash.  This raises challenges for some PSAs especially those in Europe that tend to be conservative long-term holders of assets without large cash buffers.

“Looking at Dutch pension funds, a 2020 ESMA study showed their Dollar Value of a Basis Point (DV01) [a risk measure for bonds, swaps, and other fixed income instruments] was €680 million which means for every basis point shift, the whole system has got to find €680 million in cash for variation margin. If we cast our minds back to Lehman when there was a 100-basis point move in five days, if we have a repeat of that scenario, someone has got to find €60-70 billion in cash,” Gavin says.

These concerns played out to some extent when the UK government’s September 2022 ‘mini Budget’ saw a sudden escalation in gilt yields forcing those pension funds following liability-driven investment (LDI) strategies to post huge amounts of margin to their swap counterparties as the value of their positions weakened.

This was particularly problematic for those schemes that had to sell assets to stump up the cash to meet CCP demands.

Paras Shah, head of LDI at fiduciary manager Cardano, says that in response, pension funds have been “locking up cash” as collateral in case such an event occurs again.

“If you look at pension funds in other markets where they didn’t have that crisis, they haven’t necessarily to change their collateral setups or increase the buffers. The demand for cash is having much more of an impact on UK pension schemes,” Shah says.

However, he points out that collateral is a two-way street and the central clearing obligations protect pension schemes should their counterparty collapse which, given the recent issues with Silicon Valley Bank and Credit Suisse this year, may be of comfort.

More tools needed

For PensionsEurope, which represents national associations of pension funds, the move to obligatory central clearing would be more welcome if there were additional liquidity tools in place to help PSAs during times of economic stress.

The association wants European CCPs to provide central bank liquidity to convert high quality government bonds into cash using their cleared repo platforms.

“From a risk management perspective, the European clearinghouses would become then the superior platform to clear derivatives transactions for PSAs. We are not asking for direct liquidity, just mere temporary collateral transformation of European government bonds into cash, which are better match for pension funds liabilities than cash,” the association said.

Gavin says that using repos as an alternative to holding a cash buffer makes sense.

“You want to be able to use repo to convert your bonds into cash rather than keeping a large cash buffer. The same ESMA study shows a 5% holding in cash equates to a 30% drag on returns of the fund, and if repos aren’t available pension funds need somewhere between a five and 10% cash buffer, which is significant,” he says.

There have been advances by European CCPs to allow pension funds to clear using repos, including from Eurex which permits the combination of central clearing of repos and OTC interest rate swaps (IRS). According to Frank Odendall, head of funding & financing product & business development at Eurex, this not only expands the number of repo liquidity providers, but also offers additional operational, liquidity and safety advantages.

Odendall at Eurex says: “Repo clearing is addressing pension funds’ collateral needs and that is where we see the biggest growth.”

Readiness for central clearing

Anastasios Pavlos, senior policy adviser at PensionsEurope sent questionnaires to national pension and insurance associations across the EU, Sweden and the UK to assess their readiness for central clearing. While the Netherlands and Britain are yet to report, DerivSource can share exclusive insight from seven countries across the region.