With recent discussion around whether pension schemes should be exempt from EMIR, are we in the pensions business looking at this regulation in a rather one-sided way?
Currently, EMIR is now not due to apply to pension schemes until 2020. Under the rules of the rather snappily named European Markets Infrastructure Regulation (EMIR), key strategic tools, such as Interest Rate Swaps (IRS), are some of the derivative instruments that will need to be cleared via a Central Clearing Party (CCP). The decision to create an obligation to clear derivatives, such as Interest Rate Swaps, intends to promote transparency via standardisation and mitigate direct counterparty risk.
The clearing of derivatives requires two types of margin to be posted as part of this process – initial margin and daily margin. Pension schemes will have fewer problems posting the initial margin as, in general, they hold a large amount of gilts or high quality government bonds. These types of high quality securities are allowed to be used as initial margin. However, the obligation to post cash instead of securities as daily margin could be troubling for pension schemes.
So why does the decision about ATP give me pause for thought? I understand that setting up a derivatives clearing infrastructure costs money. To post daily margin against these derivatives positions would technically require the pension scheme to hold cash which would influence their ability to seek yield across their total asset holding. If schemes don’t want to hold this cash they need to create an additional infrastructure to have access to the Repo market. This would give them the ability to create cash when needed from other investments. However, this additional infrastructure costs money as well.
This cash daily margin component is one of the main reasons many pension schemes in the UK, and across Europe, are concerned by the upcoming obligation under EMIR to clear derivatives. However, we are forgetting one fundamental thing. The counterparty to the pension scheme in these swap transactions is an entity that most likely has no exemption from clearing under EMIR.
Let’s think about how this relationship might impact pension schemes if they don’t start clearing.
If we know that in almost all cases the counter-party in an IRS transaction is a large business bank that has an obligation, under EMIR, to clear derivatives. What happens when their counter-party does not clear? Even when engaging in bilateral derivative transactions, as they would be in this instance, further regulation forces these banks to hold additional capital on their balance sheet to mitigate this bilateral risk.
To compensate this lopsided cost of the transaction for them, we would expect there to be a pricing difference between cleared and non-cleared derivatives transactions. This may well mean that banks will look to their non-clearing counter-parties, such as pension schemes, to cover these additional costs. Basic economic theory of supply and demand would suggest that these banks will quote different prices for a cleared and a non-cleared derivative transaction.
So, while you may alleviate the risks associated with holding lots of cash, pension schemes may find themselves having to pay more anyway to execute these non-EMIR governed derivatives transactions.
The debate about pension scheme’s exemption from clearing under EMIR will no doubt continue. However, I would think that the price discrimination that I describe here could also build a strong case for pension schemes to work out if clearing wouldn’t be more financially effective than not in a post-EMIR world.
Head of Relationship Management - UK Branch
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