What is happening?
The Over the Counter (OTC) derivatives market is about to undergo a significant regulatory change, as a result of which almost all commentators forecast a considerable increase in the cost of trading these instruments. Title IV of the Dodd Frank Act (DFA) in the US and the European Market Infrastructure Regulation (EMIR) in the EU will permanently alter the way in which OTC derivatives are settled, collateralised and reported. Despite the 3 year exemption enjoyed by the pension funds, it is of utmost importance that trustees understand the changes and their implications early, so that costs of adjustment can be minimised.
Why is it happening?
In April 2009, faced with concerns about systemic failure of the financial system, G20 countries committed to promote the standardisation and transparency of the OTC derivatives market. This is what both pieces of new regulation (EMIR and DFA) are trying to achieve. Currently, most OTC derivatives transactions are bilateral with margin calls and collateral management arranged between the counterparties and documented in a Credit Support Annex (CSA). A lot of the arrangements are discretionary. However, the new regulation will make it mandatory to use a central clearing house or central counterparty (“CCP”), in order to reduce systemic risk and improve price transparency. This, however, brings a whole range of implications.
What is going to change?
First, initial margin will be mandatory for all cleared trades. This alone brings some complexity (apart from the obvious one that cash will need to be ready at the point of entering the transaction). For example, clients will post gross margin to the clearing broker who will then post the net margin to the central counterparty (CCP). It should be noted, that the difference between the two is not protected by the CCP – only what is held by the CCP is protected. Another, potentially problematic implication of the new regulation is that intraday margin calls are likely to be very frequent (even reportedly as high as seven times per day). This is likely to necessitate some form of a credit line for most end users. Another concern is liquidity. Accepted collateral is very limited and will consist mostly of cash. This will require pension schemes and other users of derivatives to hold more liquid assets. It is also expected that repos (repurchase agreements) will be widely used to convert assets held to ones accepted by the central counterparty. This, however, adds to the complexity and additional problems, e.g. overcollateralization risk, margin calls on the repos, concerns about the ability to enter the repo agreement exactly when it is needed. On top of that, there is also a range of monitoring and reporting requirements. This is all likely to result in significantly increased costs.
Although, most of the focus is understandably on cleared trades, it should also be noted that there will be some uncleared trades as well. Non-financial companies will be exempt from the central clearing (unless they exceed a certain threshold). Also, it is recognised that it will not be possible to clear everything (e.g. some complex exotic instruments). The uncleared trades however will require even more collateral as they will be expected to be dealt with in the same way as centrally cleared trades, meaning the need for initial margin and more frequent margining.
Should pension funds be concerned?
The regulatory changes to the OTC derivatives market are highly relevant to UK and international pension schemes, as widely used LDI strategies usually deploy swaps for interest rate and inflation hedging purposes. Pension schemes that take steps to prepare themselves for the upcoming changes early are likely to incur lower costs than schemes that decide to wait. The reason for this is that just before the changes are implemented, the interest in clearing house arrangements is likely to considerably increase, and it is likely to be extremely difficult (and expensive!) to instruct an appropriate specialist lawyer. Acting early will give pension schemes stronger bargaining power in negotiating CSAs and will give a wider choice of clearing houses to choose from. It is also advisable that pension scheme trustees consider deploying more than one clearing member to protect themselves against the clearing member default. However, obviously it is difficult to fully prepare, as the final shape of the regulation is not yet known. Nevertheless, monitoring the changes and starting to think about the strategy is essential to avoid unnecessary costs.
Further details on collateral agreements are available in my previous blogs.