Industry experts have warned that schemes using LDI strategies may face higher costs and additional risks when the European Market Infrastructure Regulation’s collateral diversity requirements come into force.
From February, Emir has required schemes to report the creation, change or termination of a derivatives contract to a central repository the day after it takes place. Further requirements, including the diversification rule, will kick in over the next eight years.
Under the new regulation, scheme investors entering into over-the-counter derivatives contracts that are not centrally cleared will need to post collateral to mitigate the risk of default that counterparties are exposed to.
It could push people to hedge now or hedge sooner rather than later to avoid the costs that are only going to come further down the line
Tom McCarten, Redington
However, a consultation paper on risk-mitigation techniques for OTC derivatives issued last month by European supervisory authorities, stated other factors should be considered by counterparties accepting non-cash collateral.
“In particular, counterparties should ensure that the collateral collected is reasonably diversified in terms of an individual issuer, issuer type and asset type," said the paper. "For that reason concentration limits are established.”
The collateral requirements will mean many schemes will not be able to run LDI portfolios in their current form since they usually consist of gilts, cash, interest rate swaps and inflation swaps, said Sebastian Reger, associate director at law firm Sackers.
Schemes have also considered using non-UK government bonds, he said, but added: “I’m not aware of any that have gone down that route because of the complexities and the other risks that are created, [currency] risk for example. The only available sources of collateral are hence gilts and cash.”
Collateral posted for the purposes of initial and variation margin requirements must be of sufficiently high liquidity and credit quality to allow a counterparty to liquidate the positions in the case of default, without facing significant price changes.
These collateral requirements could lead to schemes having to hold more cash. “Lots of cash isn’t really in the interest of members because you don’t really generate a return on it,” said Faye Jarvis, of counsel at law firm Hogan Lovells.
The regulatory technical standards stipulate that financial institutions cannot transfer more than 50 per cent of the required collateral to a single counterparty in the form of government debt issued by a single country.
Given the asset mix in the LDI portfolio, you would have to provide collateral comprised of 50 per cent gilts and 50 per cent cash, said Reger.
“This means that depending on the derivative exposures, you may have to have access to a lot of cash,” he said. “That may be possible either by selling gilts outright or using repos to temporarily sell gilts, but again, this just creates new risks and may not be economical.”
The effect would be that schemes could no longer use OTC swaps, only those which are cleared, he added.
The collateral requirements could lead to schemes altering their investment strategy to avoid additional costs, said Tom McCarten, vice-president in the manager research team at consultancy Redington.
“It could push people towards certain [investments] like more gilt repo; it could push people to hedge now or hedge sooner rather than later to avoid the costs that are only going to come further down the line,” said McCarten.
