Legal & General Investment Management has been coaxing pension funds to take advantage of the new swaps trading infrastructure for some time. Where it once drove pension funds to clear swaps, it is now asking them to put down the phone and trade electronically.
“Of the big three [liability-driven investment managers], LGIM saw the opportunities of clearing early on, and was keen to go down that route as soon as possible,” says a pension fund consultant.
LGIM was the first asset manager to clear inflation swaps on behalf of a pension fund in April 2015. In September this year, it was the first asset manager to trade inflation swaps on an electronic platform, rather than by voice.
It has since set up several pension fund clients’ trading on Tradeweb, an electronic trading platform, using request-for-quote protocol, and LGIM says it was instrumental in pushing for retail price inflation (RPI) swaps to be offered on the platform.
The benefits to pension funds, LGIM thinks, are lower costs, better liquidity, price transparency and more counterparties. Liquidity in particular is important for pension funds seeking to unwind swaps if they want to restructure their LDI portfolio or move to buy out.
“Our main concern when trading is knowing where the true market price is at all times… For bilateral inflation swaps you don’t really know where the price is,” says Simon Wilkinson, global head of LDI funds at LGIM.
“For a new swap you can establish this, but for an unwind it is very difficult to get competitive quotes bilaterally, and for RPI only a few will quote sensibly at all. Whereas RPI swaps cleared on a platform are extremely liquid and you get transparency on the way in and out,” he adds.
Eight banks were trading RPI swaps on Tradeweb on the first day of electronic trading in September, after which further banks and dealers have followed.
We take care of cash margin. We have the ability to go out in the repo market and get cash when it’s neededRobert Pace, Legal & General Investment Management
By contrast, when ringing banks to check prices bilaterally for such swaps, there is “no chance” of eight traders quoting prices, Wilkinson thinks – more like two or three. Moreover the risk of moving the market with the two or three bilateral counterparties usually available is high.
Cash margin for inflation swaps would ordinarily be a cause for concern, but LGIM’s pension fund clients are not so highly leveraged that this is a problem. “We take care of cash margin. We have the ability to go out in the repo market and get cash when it’s needed,” says Robert Pace, senior solutions and LDI product specialist.
LGIM has good pricing and availability of repo, given its size and trading volumes, it says. It is continuing to prepare for cleared repo and peer-to-peer repo but “for the primary use of repo it’s going to be banks for the foreseeable future”, says Pace.
Additionally, in the last year, LGIM has focused on getting pension fund clients up-to-date with non-cleared variation margin rules of the European Market Infrastructure Regulation by the March deadline.
LGIM updated all its clients’ credit support annexes (CSAs) to allow them to keep trading over-the-counter derivatives in compliance with Emir’s margin rules, including interest rate and inflation swaps, total return swaps, swaptions, equity options and credit default swaps.
Rather than renegotiate all contracts on an individual basis, LGIM persuaded its clients to adopt one of six template CSAs: cash and cash/government bonds, in euro, sterling and dollar denominations.
In so doing, it could negotiate these bilateral positions en masse with bank counterparties. It pushed for one-day settlement across all counterparties, avoiding a scenario where a European bank would settle one day and a US bank the day after, creating a funding cost. This also avoided splitting CSAs for legacy derivatives, which would have required more collateral for separate European and US contracts.
Internal collateral facility
Pension funds were becoming worried about how they would find collateral for physically settled foreign exchange forwards in particular, a matter LGIM has alleviated by setting up an internal collateral facility for clients.
This allows its pooled equity funds to hedge forex even if they have no cash or gilt collateral, which Emir’s new rules initially required for forex forwards at the start of 2018. These funds are lent gilts so they needn’t hold up to 20% of the currency overlay in eligible collateral and needn’t forced-sell equities to hedge forex.
“It lets clients in on an internal function – otherwise some might have had lost the ability to hedge their currency risk, particularly the smaller ones,” says Wilkinson. On the other side are funds, mostly passive, that earn a premium for lending gilts.
“We’ve got a huge book of passive funds – billions and billions of collateral just sitting there. You’ve got a client on the other side in a pooled equity currency hedge fund with no collateral, they can be lent some of those gilts,” says Wilkinson.
Regulators have indicated they will roll back the variation margin requirement for buy-side firms trading physically settled forex forwards.