Pension funds snub swaps over margin demand

Bank of England official says repo market could take the strain, but adds regulators would have to review rules if derivatives markets start to dry up

Some pension funds are turning their backs on swap markets, citing the vast amounts of cash collateral that might be needed to support mandatory central clearing – the "unknown enemy" according to Erik Vynckier, chief investment officer at asset manager AllianceBernstein.

Many funds use long-dated fixed-rate-receiver swaps to hedge their liabilities, which will slide out-of-the-money as interest rates rise. That would produce calls for variation margin running into the billions of dollars – some funds put the margin demand from a 100 basis point run-up in rates at more than 20% of their assets.

Central counterparties insist variation margin is paid in cash, but pension funds typically try to remain fully invested in their target asset class as running with a cash buffer would be a drag on returns. The obvious solution would be to repo out the fund's stock of securities to generate cash as needed, but repo markets have also been caught in a regulatory crossfire – they are penalised by Basel III's leverage ratio, for example, and may be subject to a financial transaction tax in Europe.

"Future variation margin requirements are the unknown enemy. They will have to be in cash and this is very difficult. In order to meet the requirement, [insurance companies and pension funds] need to transform assets into cash using the repo market, and the big question is will the repo market remain liquid enough for us to do that?" said Vynckier, who was speaking during a panel discussion at the Trading and Investment Risk conference in London today.

Vynckier said some clients are now asking the firm to restrict the use of over-the-counter derivatives and instead return to older-fashioned hedges, such as long-dated bonds, property or infrastructure projects.

Future variation margin requirements are the unknown enemy. They will have to be in cash and this is very difficult

"We are working on mandates where we would have turned to swaps for interest rate and inflation risk management, where these clients are asking to do the matching physically. If this trend continues, pension funds and insurers may end up using fewer derivatives," he said.

Edwin Schooling-Latter, head of the payments and infrastructure division at the Bank of England, said repo markets ought to be liquid enough to support demand from buy-side firms looking to transform their assets into cash, but he admitted that if the market's capacity is overwhelmed – and swap market liquidity suffers – the clearing regime might have to be reviewed.

"In principle there should be enough liquidity in the system to deal with the demand, and in principle it is possible to find market solutions to manage that liquidity demand. But I think if we saw evidence that derivatives markets were genuinely drying up then we clearly would want to stop and review whether that had gone further than the regulations had intended. But for the moment, in general, they are alive and well," said Schooling-Latter.

In Europe, pension funds have a temporary exemption from clearing rules. It runs out in 2015 but might be extended for a further three years.