Pensions industry says permanent Emir exemption not enough

European Parliament and UK regulator push for carve-out, but industry unimpressed

European Parliament Brussels
European Parliament: pushing for a permanent exemption

The European Parliament and the UK’s Financial Conduct Authority (FCA) are pressing the European Commission to consider a permanent exemption from requirements to post cash variation margin to central counterparties (CCPs).

Funds have protested loudly about the strain of moving to central clearing, yet some in the industry say an exemption could make matters worse – leaving pension funds still posting cash under bilateral arrangements, but with none of the benefits of clearing through a CCP.

Simon Wilkinson, head of liability-driven investment at Legal & General Investment Management, says: “What you really need to do is find a solution to the cash variation margin problem, rather than abandon central clearing, because otherwise you’re going to push pension schemes into the worst of both worlds – needing to post cash, but not having the benefits of central clearing.

“Ironically, an exemption would push schemes into clearing faster than they would otherwise go, as the costs of bilateral trading would undoubtedly ratchet up very quickly in response.”

Pension funds currently have an exemption until August 2017 from the requirement to centrally clear under the European Market Infrastructure Regulation (Emir), with the possibility of an extension to August 2018.

Regulators decided to give the market time to address worries about how pension schemes would source cash during stressed periods to post as variation margin, particularly in light of reduced liquidity in repo markets. So far, no comprehensive solution has emerged.

Permanent proposition

Now the FCA and the European Parliament are calling for the Commission to consider a permanent exemption.

The FCA wrote in February in a response to the EC’s call for evidence on financial regulation: “In addition to the reduction in the number of clearing members, CCPs currently require variation margin to be posted in cash form, while pension funds seek to maximise returns for pension-holders by being highly invested in shares, bonds and other securities. Even though pension scheme arrangements have been granted a two-year extension to their current Emir exemption from the clearing obligation, which will last until August 2017 (with the potential for a further year’s extension), a longer-term solution is required.”

In a January 19 resolution, the European Parliament also called on the Commission to consider a permanent exemption, citing concerns that CCPs might start accepting non-cash collateral, potentially increasing systemic risk.

Ironically, an exemption would push schemes into clearing faster than they would otherwise go, as the costs of bilateral trading would undoubtedly ratchet up very quickly in response
Simon Wilkinson, Legal & General Investment Management

Pensions industry participants say these calls miss the point. Wilkinson says there would be no problem if the need to source cash for variation margin were confined to central clearing “but what the FCA answer doesn’t recognise is that anything other than cash variation margin for derivatives is dead”.

Ido de Geus, head of treasury and client portfolio management at PGGM, agrees: “As a result of new regulation, banks are becoming reluctant to accept bonds as variation margin under over-the-counter (OTC) derivatives. This effectively means the cash variation margin issue is also becoming an issue for non-cleared derivatives. A permanent exemption does not really help. We have always said a permanent exemption would only help as long as the OTC derivatives market remains open and liquid. This means an exemption should be fully translated into all bank regulation and CVA [credit valuation adjustment] charges.”

Banks are incentivised to move to cash-only credit support annexes because bonds, unlike cash, do not reduce the derivatives exposure calculation that is the basis for the leverage ratio.

“[For non-cleared trades] with cash variation margin you get all the worst of bits of central clearing without any of the good bits,” says Wilkinson. “Out of all the cash variation margin ways of doing things, central clearing is not that bad. You’ve got great liquidity and risk mutualisation benefits, and the initial margin is lower than you will have in the bilateral world at some point.”

Wilkinson worries that a permanent exemption would drastically raise the costs of bilateral trades as well as disincentivising market participants from working on ways to help pension funds source cash: “If the exemption became permanent, all the people quoting lossmaking trades now, with the promise of all this capital-light business going forward, would say to their management: ‘This future flow of business, which is going to be more capital-light and profitable to me, doesn’t look like it’s coming.’ So their management would say: ‘You’d best start smashing pension schemes with full-fat capital charges right now.’

“Asset managers will no longer be able to say ‘bear with us’ until the dynamics are right for a pension fund to clear and shield clients from the additional costs that are coming into bilateral trading.”

Government support

According to de Geus, a better solution would be to enable pension funds to post high-quality government bonds as variation margin at a CCP or to create guaranteed repo lines that are accessible under all market circumstances.

Ursula Bordas, policy adviser at PensionsEurope, says the industry association supported an exemption until a solution to the cash variation margin problem was found. But she adds: “If a review found a satisfactory process was available, then the exemption could fall away at that point – however, not before.”

Some in the industry are more positive about the possibility of an exemption. Max Verheijen, managing director at Cardano based in London, who advises pension funds on risk management and hedging strategies, says: “A permanent exemption is a solution of last resort. CCPs will endeavour to work out the cash variation margin issue because they will want pension funds to start clearing. But I am supportive of the FCA’s suggestion that if these issues are not resolved, pension funds should be granted a permanent exemption.”

James Walsh, senior policy adviser for the Pensions and Lifetime Savings Association, states: “Our position is that the exemption should be maintained until there is a practical and affordable solution for pension funds to clear. It has to be said that we don’t seem any nearer to that. So we would not lose any sleep if the exemption were made permanent.”

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