Schemes win extended reprieve from European OTC clearing rules

Such derivatives are commonly used by by schemes following liability-driven investment strategies and the EC estimates that the UK occupational pensions industry alone accounts for around €2.3tn (£1.7tn) of trades, representing 43 per cent of activity among the commission's 28 nations.

Under the European Market Infrastructure Regulation, from 2012 all financial institutions apart from pension schemes have had to provide collateral in over-the-counter transactions to protect against losses if a counterparty defaults.

However, the structure of pension schemes and their tendency not to hold significant amounts of cash runs counter to this framework and schemes have been granted a temporary exemption while a solution is sought, but that exemption is set to expire in August this year.

The EC said in a release: “Given that pension scheme arrangements hold neither significant amounts of cash nor highly liquid assets, imposing such a requirement on them would require very far-reaching and costly changes to their business model which could ultimately affect pensioners’ incomes.”

Any solution is likely to result in higher transaction costs for schemes entering into OTC derivatives

Faye Jarvis, Hogan Lovells

It has recommended seven possible technical solutions for central counterparties to explore including ‘collateral transformation’, where a scheme would reverse repo securities to receive cash.

Faye Jarvis, of counsel at law firm Hogan Lovells, said if no solution has been found by the end of the two-year period, the commission can extend the exemption for another year.

“The fact that only one CCP has made any real effort to develop a solution for the posting of non-cash assets makes it clear that this disconnect is not going to be resolved easily,” she said.

“Based on the findings of the report, I expect that a further extension to August 2018 will be required."

Higher transaction costs

Jarvis added: “What I think is clear is that any solution is likely to result in higher transaction costs for schemes entering into OTC derivatives.”

She said if no solution is found and schemes are still required to comply with Emir to hold larger cash reserves, trustees would have to decide whether this outweighs the overall advantages of OTC derivatives.

“I expect employers to also be interested in this debate given that any reduction in investment returns would impose increased funding costs on the employer,” Jarvis said.

Kenny Nicoll, director in the manager research team at consultancy Redington, said LDI managers had expected the EC’s recommended two-year extension.

The hit that central clearing could have on schemes depends on how much has already been hedged, and is therefore exempt; how much swaps the scheme uses; and who their LDI manager is, as each will have different financial terms.

Nicoll said: “The costs are varied but in short these are three categories: direct costs, risk-based costs and the cost of holding cash as collateral.”

However, Richard Batchelor, principal associate at law firm Eversheds, said the driving force in any change is most likely to come from the investment managers to which pension funds delegate their investment activities, who will be clearing derivatives for their non-pension fund client base.

He said: “In that context, the investment managers are likely to take a general decision to clear contracts for all clients before the end of the extended transitional period.”

Batchelor added: “Pensions schemes who do not clear their derivatives contracts might find their derivatives become more expensive as the increased capital costs for banks come online.”

In its conclusion to the seven technical solutions on the table, the EC said: “No one solution stands out as the obvious candidate and there is currently little hard evidence that the industry is investing in innovative solutions to the core problem.”