By John Wilson
The European Securities and Markets Authority issued its latest update on EMIR – the much-vaunted European Markets Infrastructure Regulation – earlier this month.
While EMIR came into force in August 2012, many market participants are struggling to comply with the regulation’s technical standards. It doesn’t help that these standards are in an almost constant state of flux.
Pension funds, in particular, are still getting to grips with rules that could mean higher costs, a greater operational burden, and liquidity and credit risk – all of which could ultimately damage returns.
The impact upon pension funds is, however, an unintended consequence; they have been caught in the regulatory crossfire. It came as a revelation to those seeking to clamp down on the perceived excesses of the OTC derivatives market in Europe that pensions also make significant use of such derivatives to help manage their liabilities.
Perhaps the biggest issue facing pension funds under EMIR comes in the form of liquidity risk. The reason for this is that Clearing Houses (CCPs) require the mark-to-market movement of portfolios to be settled daily in cash, in the underlying currency of the swaps. However, almost all pensions are fully invested because cash is low yielding, meaning it will be necessary to either hold precautionary cash, or be able to raise it quickly.
Collateral management will also present challenges, as CCPs typically accept a narrow range of assets to cover initial margin requirements, such as G8 government bonds. As a result, pensions may have to exchange their holdings into eligible collateral and absorb any associated costs. The great collateral squeeze has begun.
New costs must also be faced in clearing transactions, including fees levied by CCPs. To the extent that they elect not to clear such trades, their bank counterparties will impose higher swap prices to reflect the higher capital costs on non-cleared trades.
Mandatory clearing will not apply to all derivative transactions, however, since many are incapable of being cleared presently. The creation of two portfolios – one cleared and one uncleared – will also add cost, not least through lost netting benefits and different risk exposures.
Finally, due to the need to have some, or all, collateral lodged with the CPP to cover initial margin requirements, EMIR will also prevent pension funds lending such assets to generate additional income.
Of course, it’s not all doom and gloom for pension funds, with the move to central clearing bringing a number of benefits to bear.
With CCPs acting as the go-between pension funds and their counterparts, the range of counterparties that funds deal with is likely to increase. This may mean keener offer prices, regardless of credit standing, without there being an on-going exposure to those parties or any utilisation of credit limits with such banks.
The introduction of a CCP also means facing a single counterpart with whom trades may be automatically netted, thereby eliminating exposures with the banks that executed the trade.
Similarly, centrally cleared trades are netted with a single CCP rather than with numerous executing counterparties, allowing for simplified margin administration with a single party, namely a clearing firm like Newedge.
So far, most pension funds have been shielded from new requirements due to the delays surrounding EMIR. Hence, it’s encouraging that some pension funds are sensibly using this period of respite to fully understand the vagaries and long-term issues that are likely to emanate from EMIR. They are investing time to getting to grips with what is a genuine gamechanger.
In contrast, some pension funds are still choosing to neglect the challenges that EMIR places on their business; an ignorance that will face a rude awakening.
John Wilson is global head of OTC clearing at Newedge
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