Constraints on banks' capacity in the repo market are threatening to cut off a key source of the cash that pension funds require for variation margin under incoming central clearing rules. In response, central counterparties and brokers are putting forward ways to assist.
Several central counterparties (CCPs), for example, are working on plans to enable the buy side to clear repo directly. One CCP has plans to act directly as a counterparty with pension funds. And interdealer broker Tradition is launching a peer-to-peer repo platform.
Meanwhile, some advisers are suggesting pension funds extend their use of derivatives as a means to free up cash (see box: More of the same). But many in the pensions sector think only access to central banks as a fail-safe source of liquidity will be enough.
"Industry initiatives are only likely to work under normal market conditions," wrote eight funds and service providers in a letter to regulators in the summer. "In their currently anticipated form, they cannot be relied upon as a solution for the cash variation margin issue in stressed market conditions, which is precisely when clearing must work." Among the pensions industry professionals Risk.net spoke to, there has been little change in view since.
The race to find workable solutions is well underway. Though pension funds have an exemption from central clearing under the European Market Infrastructure Regulation until – probably – 2018, a move by banks to cash-only CSAs for over-the-counter derivatives trades is already increasing concerns about sourcing collateral. Also, as the rest of the market moves to central clearing, pension funds might expect uncleared swaps to become more expensive, forcing them to clear some trades before the exemption runs out.
If the industry finds no way out of its predicament, pension funds are stuck with the cost of holding sizeable cash buffers to meet collateral needs. "Generally, where cash is needed we'd look to hold a buffer of around 40 to 50 basis points (bp) times the interest-rate sensitivity of the contract as a starting point. So, for a £100 million DV01 cleared swap trade you'd be looking to holding a £40 million cash buffer," says Robert Pace, senior product specialist at Legal & General Investment Management in London.
That equates to holding roughly a third of assets as cash in a three-times leveraged fund, according to Nicola Thorpe, liability-driven investments (LDI) portfolio manager at BMO Asset Management in London. It is an unwelcome prospect for schemes suffering with low yields, especially those with funding deficits. Right now, funds forced to sell equity to pay for such a cash buffer would be giving up about 5% in lost return, points out Max Verheijen, Rotterdam-based managing director at Cardano, a fiduciary management and risk management firm for pension funds.
Their fall-back option is to repo high-quality bonds for cash, but a report by consultancy firms Europe Economics and Bourse Consult for the European Commission estimates a 100bp rise in interest rates would be enough to trigger a collateral call that would overwhelm the daily capacity of the UK gilt repo market (see box: Shrinking repo).
Pace says clients are already making sure they have better access to repo as awareness of the problem grows. Funds now typically have four or five repo counterparties where before they often relied on gilt total return swaps, he says.
But better access to the market will be little use if the repo market just keeps shrinking. In response CME, the Depository Trust & Clearing Corporation (DTCC), Eurex and LCH.Clearnet have all announced plans within the past year to create buy-side repo clearing.
Cleared repo trades put less strain on bank balance sheets because the CCP is treated as the only counterparty, which allows the netting of offsetting trades when calculating their Basel III leverage ratio. However, none of the CCPs is yet ready to implement its plans.
The buy side, though, is uncomfortable with the ramifications of some models. BMO's Thorpe says: "One of the main stumbling blocks is that to participate in a cleared repo solution we would have to be a [CCP] direct member and post a contribution to the default fund. That opens up mutualisation risk.
"Pension funds are not the type of parties that have capital available to put into a default fund. As a direct member you're also obligated to participate in any default auctions, and a pension fund is not going want to be a forced buyer of any positions of a defaulted member."
Eurex has a put forward a model that would allow buy-side firms to access the clearing house directly, with a sponsoring bank providing the default fund contribution, offering a potential solution to this problem. According to one industry source, Eurex's model was initially rejected by its risk committee but has now been accepted conditional on Bafin approval and further revision to the waterfall process.
But the buy side is sceptical about how long it will take for a workable cleared repo solution to emerge. Alan Kerneis, a managing director at BlackRock Client Solutions in London, which provides advice and portfolio management to pension funds, says: "In time this might be a useful way for our clients to access repo trades… At the moment however we don't see it as a solution that alone will help solve the reduction in repo capacity, certainly in the near term."
One CCP, meanwhile, has plans to step into the repo market directly. LCH.Clearnet wants to provide direct, although not guaranteed, repo lines to pension funds using cash it gathers from its clearing members as initial margin.
The LCH plans have the potential to provide extra liquidity, but speaking to Risk.net in November, a pension fund treasurer cautioned they were not a "panacea" for the variation margin problem. "It's not the solution for pension funds, because it's highly doubtful whether they [CCPs] will always be open in times of stress and able to absorb the capacity of all end-users at the same time," he said.
Elsewhere, interdealer broker Tradition is looking to play a role – launching DBVX in the first quarter of 2016, a multilateral repo trading facility that aims to match up institutions such as pension funds with cash-rich corporate treasuries. DBVX will enable counterparties to trade anonymously with each other, having specified in advance who they are willing to trade with and how much.
The platform plans to offer both cleared and tri-party repo, with Euroclear acting as the tri-party repo agent. According to David Millar, London-based business development manager at Tradition, more than 10 asset managers have already signed letters of intent and are currently reviewing DBVX's drafted legal documentation.
Mark Higgins, managing director at BNY Mellon Markets Group in London, says: "They could be the perfect institutions to work directly with each other, because a pension fund is typically long government securities and may increasingly need short-term cash to meet margin obligations, while a corporate is typically long cash, looking to invest against collateral. At the same time some banks are finding it hard to make the classic repo trade work."
Half a dozen pension fund and asset managers that Risk.net spoke to said they would be interested in using the platform when it comes live. According to BlackRock's Kerneis: "We've been looking at them with some interest to see whether they can diversify our sources of financing – something we're very keen to do.
"The challenge from an asset manager's perspective is that when we're facing an entity in that platform we've done sufficient due diligence on who we're facing, so there are some operational challenges that need to be resolved before we're comfortable using it in scale. But once that's resolved we think it's a very interesting concept and something we'll use."
However, others have raised concerns about the viability of pension funds relying on corporates for repo in times of strain. "Where we find ourselves at a point of stress, those cash-rich corporates might have other issues that concern them," said David Cobbald, portfolio manager at the UK's Pension Protection Fund, speaking at the Risk Clearing Conference in London in early October.
Meanwhile, the Europe Economics and Bourse Consult report cautions: "The cash is on balance sheets because of a lack of suitably attractive investment opportunities and has not been returned to investors due to a mix of faith in future opportunities and perhaps also the associated tax effects of returning cash to investors. These motivations may not be maintained indefinitely."
Some pension funds think the initiatives described, even together, fail to remove the risk of a repo crunch. The eight pension funds and service providers that wrote to the European Securities and Markets Authority (Esma), including APG, Insight Investment and PGGM, argued the only viable solution for the industry would be access to central bank liquidity, either directly or indirectly.
This view was echoed by a panel of industry practitioners at the Risk Clearing Conference in London in October.
While the idea of CCPs providing pension funds with indirect access to central bank liquidity has been talked about – CCPs have access to some Bank of England facilities in the UK, Eurex has a banking licence in Germany and LCH a licence in France – none of the CCPs has said anything publicly about doing so.
As for direct access for pension funds to central bank liquidity, there has been no official movement from central banks in this direction, although there are reports that some are aware of the issue and listening to the arguments being made.
Meanwhile, the Basel Committee on Banking Supervision announced recently it will consult next year on how it calculates the leverage ratio, with the aim of adopting a more risk-sensitive approach. The pensions industry will be hoping for changes that mean pressure on the repo market turns out to be less severe than feared.
More of the same
One counterintuitive option for funds facing pressure to source collateral is to sell cash assets and use more rather than fewer derivatives. Tom Carr, head of active liability-driven investments (LDI) at LGIM in London and Alan Kerneis, a managing director at BlackRock Client Solutions in London, say larger, more sophisticated pension funds are doing this now.
"We are encouraging our clients to diversify their sources of financing in their portfolios," says Kerneis. "Rather than relying just on the repo market, [they are] adopting other strategies to allow them to free up cash if they need to. Instead of having an equity exposure that is fully funded with physical equities, for example, you can use some element of derivatives. The leverage you have is not just concentrated in fixed-income LDI. You can have a bit of leverage in both LDI and equities."
Though this strategy has been gaining momentum, it is far from mainstream among pension funds, and makes up only a small portion of the portfolios of those using it.
Kerneis says: "You need to look at the cost of financing: whether it's going to be equities or gilts. There might be differences either way, and you also need to take into account liquidity and how often you need to roll those positions."
At the same time, derivatives are also affected by restrictions in the repo market. Bank counterparties often use the repo market to hedge their side of trades. So stress in the repo market could filter into the equity derivatives market in the form of higher pricing.
According to a senior LDI manager at an asset manager: "There would be a risk that the cost of using the unfunded exposure would increase over time. At the moment we've seen the costs of equity futures decrease. But we have seen times over the past few years where that cost has been relatively high. It's not a static."
The European Market Infrastructure Regulation (Emir) means funds will have to clear over-the-counter derivatives from 2018 at the latest, posting variation margin in cash on those trades. As the rest of the market moves to central clearing, pension funds might find a price gap opening between cleared and uncleared swaps that forces them to clear some trades even earlier.
At the same time, banks are pushing the buy side towards using cash-only credit support annexes (CSAs), which are less onerous for the banks under the Basel III leverage ratio.
Pension funds might expect to rely on repo to source cash to meet collateral calls. But repo is also under pressure because of Basel III, with banks unable to net offsetting repo transactions when calculating the ratio. This has led to a shrinking market. Between 2012 and 2014 market participants cut their repo exposure by 40%.
Meanwhile, the pensions sector alongside insurers holds high volumes of out-of-the-money fixed receiver swaps, used to extend the duration of liabilities. The implication, according to a report by Europe Economics and Bourse Consult for the European Commission is that a 100 basis point (bp) rise in interest rates might trigger a collateral call that would overwhelm the daily capacity of the UK gilt repo market.
Some buy-side participants still think the market is working well, according to David Hiscock, senior director of market practice and regulatory policy at the International Capital Market Association in London. But repo is becoming a cost centre for banks.
"Repo generally needs to be thought of as a service you're providing to a client and therefore you need to look at your relationship with that client and say, how much is this client bringing to me and therefore can I afford to provide them with this service which is costing me money. At the moment the cost frequently outweighs the returns from putting on transactions."
However, some think the scenario imagined by Europe Economics and Bourse Consult might be overly pessimistic. Nicola Thorpe at BMO Global Asset Management points out a 100 basis point (bp) move in rates in a single day would be abnormal. "We think a €25 billion call is overstated for a typical one-day move," she says.
"Second, we assume that not 100% of cash will be sourced via the repo market for variation margin calls. We expect pension funds typically to hold about 60–80% of their cash requirement in physical cash and money-market instruments with repo making up the balance. It is not necessarily the case that every pension will need to enter the market on a daily basis to raise cash, as some might run down the cash buffer before topping up via repo."
Nevertheless, concerns about access to cash in a stressed environment are high on the industry's agenda.
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