Pension funds should prepare for central clearing of derivatives ahead of the introduction of Basel III to avoid a disruption in trading and added costs, Mercer has said.
The consultant said capital charges on banks brought on by Basel III regulation could cause significant cost and operational impact for European pension funds using over the counter (OTC) derivatives.
The issue is caused by the conflicting regulatory pressures of Basel III and the European Market Infrastructure Regulation (EMIR).
The latter, due to come into effect in 2013, was brought about following the collapse of Lehman Brothers in 2008 after central governments expressed concern about the level of counterparty risk in the OTC derivatives market.
Under EMIR interest rate swaps and credit default swaps will have to be cleared through central exchanges, known as clearing houses.
EMIR has recognised that pension funds are typically fully invested, which could make it difficult to provide cash collateral, so they have been granted a three-year exemption to give them sufficient time to adjust. However, Basel III imposes additional capital charges on banks conducting OTC derivative trades, particularly those trades outside central clearing.
Mercer said banks are likely to pass on these costs to institutional investors so it could be significantly more expensive for pension schemes to trade with banks on a bilateral basis. It has advised pension schemes to begin preparation sooner rather than later as preparing for central clearing can take up to six months.
Mercer Sentinel Group European director Ben Gunnee said: “Central clearing requires a number of operational changes in order to interact with the clearing house and to minimise the impact of additional collateral requirements. As most schemes presume they are exempt from central clearing, they have not made preparations to participate. The additional capital charges levied on counterparties will ultimately result in trading costs increasing for pension funds wishing to hedge liabilities through swaps.”
Last month, State Street Global Advisors warned liabilities are just as volatile as assets, particularly due to the way regulations such as Basel III will change how schemes manage their liability driven investment portfolios.
In April, Royal London Asset Management chief investment officer Robert Talbut (pictured) told portfolio institutional that Solvency II and EMIR had created a “double whammy” to the cost of hedging.
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