Schemes to stump up for £300bn LDI reform

The combined cost to schemes of the European Markets & Infrastructure Regulation (EMIR) and Basel III proposals could be more than £315bn, according to analysis from Insight Investment and Royal Bank of Scotland (RBS).

The reforms will force investors using derivatives to put more collateral against the transactions in case counterparties fail, as well as using a safer form of commerce known as ‘cleared’ trades.

Schemes with liability hedges are required to keep allocations of cash or certain low-risk (mostly bond) assets against their swaps.

The value of this collateral will increase under EMIR in its current guise, while the new rules will also make using central, rather than ‘over the counter’ (OTC) clearing mandatory in most cases – although schemes have a three-year exemption from this feature of the reform.

The clearing houses which act as intermediaries in cleared trades will not accept certain types of derivative – including the inflation swaps used in LDI.

UK defined benefit schemes currently have around £700bn of liabilities hedged, holding around £140bn as collateral.

Andrew Giles, chief investment officer at Insight, warns EMIR will dramatically drive up the cost of LDI by between 15%-45%, depending on whether clearing houses increase their ability to take a wider range of derivatives.

The proposed Basel III regulations, meanwhile, require banks doing derivative trades with financial institutions – including pension schemes – to pay larger capital charges against OTC transactions.

RBS head of UK pensions solutions Sinead Leahy admits this capital requirement “is likely to be passed onto clients” and will probably be around two basis points.

She added: “There are plenty of opportunities for pension funds to mitigate this increased capital cost by managing their swap contracts optimally.”

David Bennett, managing director at LDI specialist consultants Redington, added: “Some of the anticipated changes to collateral requirements for derivatives potentially reduce the maximum amount of hedging activity a pension fund can carry out.”