Controversy has raged over the mandatory central clearing of derivatives by end-users ever since the idea was first mooted last year. Corporates have lobbied hard for an exemption in both the US and Europe - with some success. But the outlook for non-bank financial companies - and in particular, pension funds - looks glum.
In its proposed rules on over-the-counter derivatives published in September, the European Commission included language that will essentially exempt corporates from using central counterparties (CCPs), so long as their derivatives are used to hedge commercial risk. No such exclusion exists for pension funds. For those pursuing liability-driven investment (LDI) strategies, which typically involve long-dated, directional interest rate and inflation swaps, the result could be hundreds of millions of euros in initial and variation margin payments.
Pension funds tend to sign credit support annex agreements on OTC trades and are used to posting variation margin as a result. The main difference in a clearing environment is that variation margin would have to be posted in cash rather than securities, as is the case under most bilateral trades. And this is a major problem for many.
"It will be extremely difficult for pension funds to meet that type of collateral call in cash. These funds don't hold massive cash buffers, but do hold long-dated, high-grade bonds, which they effectively use to meet margin requirements in the bilateral trades. And given the sensitivity of long-dated swaps to changes in interest rates, the collateral calls for pension funds are often huge. How is a pension fund, which holds long-term investments, supposed to find the cash at short notice to meet these obligations?" asks Nicole Grootveld, head of risk control and operations at risk management advisory firm Cardano in Rotterdam.
Clearing houses require margin to close out, hedge or transfer a portfolio in the event of a default. Initial margin covers any adverse price movements following the default of the clearing member but before the closing out of the trades, while variation margin covers any change in price from the previous day. Initial margin can encompass cash or high-quality government bonds, but variation margin has to be paid in cash only.
These requirements could have a dramatic impact on pension fund performance, argue some participants. The Investment Management Association (IMA), a UK trade group, estimates a typical LDI pension mandate with assets of €1 billion and interest rate and inflation swap overlays of €700 million and €800 million, respectively, would incur an investment strategy yield drag of 1.1% in an optimistic scenario if forced to clear through a CCP. In a pessimistic scenario, this would increase to 1.9%.
The biggest component of the estimated cost is a yield loss between cash and government bonds. If pension funds are to meet variation margin payments, they will need to switch a chunk of their portfolio into cash, meaning they will be earning a significantly lower return on that portion. Cardano's Grootveld reckons up to a third of the portfolio will need to be held in cash. "To manage the volatility and sensitivity of swaps portfolios to interest rates, and given the size of positions pension funds have in long-term interest rate swaps, just to meet the variation margin requirements, a pension fund would have to hold up to a third of its portfolio in cash. This is unacceptable when you look at the loss of yield funds incur," she says.
The IMA estimates a variation margin requirement of €300 million would result in a yield loss of around 350 basis points - leading to €10.5 million in investment leakage in a portfolio.
As a result, pension funds and their dealers are looking at ways of reducing the impact. Most investment managers and smaller banks will access clearing through existing members due to the strict membership criteria of CCPs. Essentially, the clearing member will be responsible for posting the appropriate amount of margin to the CCP on behalf of its clients - but what and how much the customer is asked to post to the clearing member is, to some extent, flexible.
One solution could be to repo non-eligible assets via the clearing member or directly with a repo desk - which would enable the pension fund to exchange corporate bonds for cash. This would attract a haircut, meaning the cash amount would be lower than the value of the bonds, but could help solve the immediate problem of a lack of eligible assets for margin, say some participants.
"Pension funds don't have a lot of cash on hand, so conducting a repo is one way of upgrading the collateral. Of course, there will be a charge for doing the repo and the fund will have to pay the repo spread, but the benefits far outweigh having to sell a chunk of the bond portfolio for cash and then suffering the yield loss," says one head of client OTC clearing in London.
This solution doesn't appeal to everyone, though. "The repo solution fails at three levels," says Andrew Giles, chief investment officer at Insight Investment in London. "First, it doesn't remove counterparty risk - it just moves the risk from the OTC to the repo market. Second, many of the swaps cleared are very long-dated, while repo transactions at most will go out to one year, which means there will be significant new rollover risk and roll costs. Third, while repo is well established in the interbank market, it is not widely used by pension funds, so many will have to develop completely new operational and risk management infrastructure, which introduces another new source of risk and cost."
Another concern is the margin surplus pension funds may be required to deliver. Most are not set up internally to meet daily margin calls, so may be asked by their clearing members for a top-up. This is meant to cover the dealer in case there is a delay by the client in transferring margin - after all, the clearing member in most instances would be required to post the collateral to the CCP within an hour, regardless of whether or not the client had delivered that collateral to the dealer.
Pension fund managers who talked to Risk say they accept the rationale behind over-collateralisation, but express concern over what would happen to that margin, particularly in the event of a default of the clearing member.
"We are unhappy at having to over-collateralise positions due to tight margin deadlines because we are unsure how the extra wedge of collateral will be treated," says Mads Gosvig, chief risk officer at pension fund ATP in Copenhagen. "It is possible the cash will be treated as a deposit, so if the clearing member defaults, we lose that money. We are not sure whether the cash will be passed through to the CCP and be segregated. We're not talking about small sums of money - we're potentially talking about hundreds of millions of euros in some cases."
Some dealers say they will pass this margin top-up on to a segregated account at a CCP at the behest of the client. But this comes at a price - one alternative would be to rehypothecate the additional collateral, the returns from which could help reduce overall costs for the customer.
"It comes down to the commercial arrangement you have with the client and the levels of protection they require. There are many options open to clients, which will mainly be driven by their relationship as a whole with their chosen clearing member," says Andrew Sterry, European head of client OTC clearing at Citi in London.
For many pension funds, the best solution would be for the CCP to accept a broader array of assets for variation margin. Alternatively, the CCP itself could repo ineligible collateral, suggest some. Those ideas are rejected by one CCP.
"We have not considered receiving anything else but cash, and we will continue to only accept cash as variation margin for two reasons. First, we do not hold any net variation margin on behalf of clearing members - the margin is washed through from participants who are out-of-the-money to participants who are in-the-money. This process cannot be effectively worked with haircut bonds - many participants may not want to receive bonds as margin. It is also not the business of the clearing house to conduct repos for variation margin. As variation is dynamic (twice per day at least), the burden on existing repo facilities for initial margin could be significant and create unwanted residual collateral risk if the clearing house needs to convert those instruments into cash. Many futures commission merchants (FCMs) already have the ability and infrastructure to provide this service," says Michael Dundon, chief risk officer at the International Derivatives Clearing Group (IDCG) in New York.
Variation margin is the most pressing concern, but the requirement to deliver initial margin is also worrying participants. Pension funds are not typically asked to post independent amount on any OTC trade, so would have to stump up initial margin for the first time. The fact that CCPs accept government debt for initial margin means pension funds have more flexibility than with variation margin, but the potential size is causing some anxiety.
At London-based clearing house LCH.Clearnet, initial margin is based on an estimate of potential future adverse price movements across the portfolio under normal market conditions during a close-out period. The group's SwapClear unit uses a historical simulation model called Pairs - portfolio approach to interest rate scenarios - to calculate margin, based on a data history of five years, an assumed close-out period of seven days for buy-side firms, and no confidence interval (meaning the worst case of 1,250 scenarios is used to calculate initial margin). The calculation is a function of the volatility of the derivatives exposure, so longer-dated swaps tend to have higher initial margin requirements.
The IMA estimates the initial margin for a pension mandate with €1.5 billion notional in swaps would be €175 million (11.7%). Meanwhile, Insight has calculated that up to £15 billion in initial margin would have to be posted if the swaps it manages - totalling £150 billion in notional - had to be cleared.
Margin calculations are so high because the swaps transacted by LDI accounts are typically long-dated and directional, meaning few offsets exist in the portfolio that would reduce the overall amount.
Given the size of the potential obligations, some participants suggest credit risk be taken into account when calculating margin. "To capture the expected costs of default, initial margin should be a function not only of the impact but also the likelihood of a market participant defaulting. If a pension fund, which has a much better credit than a highly leveraged hedge fund, is paying the same level of initial margin as that hedge fund, it feels like cross-subsidisation. The costs are not being borne fairly and proportionately to the risks each brings to the system," says Insight's Giles.
There are two ways this could work. The CCP could look through to the end client and add or deduct a certain amount from the initial margin calculation, depending on the leverage of the counterparty. The alternative is for clearing members themselves to calculate the level of initial margin each of its clients should post. The CCP would still require the full amount, meaning the bank would effectively be making a commercial lending decision.
Only the second option is viable, says Dundon at IDCG. "We have thought about credit risk differentiation, but should we start implementing a process of tiered margining it would complicate everything. CCPs, including IDCG, have credit departments, but these departments concentrate on the credit analysis of the clearing participants. CCPs would need much larger and more specialised credit departments that could analyse the clients of the FCMs. The CCP's job should be to provide a minimum margin amount applicable to all participants, then the responsibility falls on the FCMs to provide credit services to the extent that is regulatorily possible to their own clients. It comes down to a business relationship between FCMs and their clients," he says.
Some dealers see this as a way of differentiating themselves in their client clearing services. Cross-margining across both cleared and uncleared trades could reduce overall margin for the client, while activity in other business lines could also be taken into account. Some have not ruled out lending clients a chunk of the money to meet margin requirements. But not everyone is sold on the idea of determining margin based on the credit risk posed by a client.
"There are a number of issues here. Probability of default is a dynamic measure. Clearing members would not hold those probabilities as static, and would conduct a constant monitoring process across their counterparties. It is even more complicated if the clearing member decides to impose different initial margin requirements on certain classifications of counterparties - it will be extremely hard to get that right," says another head of OTC clearing in London.
Indeed, there's the chance the initial margin posted by clients will not be enough to cover the loss in the event of a default - leaving the clearing member responsible for the deficit. "You would be relying on the CCP estimate of the probability of default. If that is wrong, there exists a mismatch and other clearing members will be on the hook for the shortfall," the head of OTC clearing says.
One further gripe is the cost of posting initial margin to LCH.Clearnet. The clearing house currently charges a 10bp holding fee for bonds posted as initial margin and a 25bp charge on cash - fees many pension funds think are unjustified. This could change, though. Market participants believe LCH.Clearnet is reviewing the 10bp holding charge it levies on posted bonds. However, it refused to comment for this article.
In fact, many pension funds believe compromises will be made that will render central clearing more palatable. Most are in favour of the concept, although stress it should come at an acceptable cost. "The overall cost is huge, but what is the alternative?" asks ATP's Gosvig. "The price of risk reduction is difficult to quantify - it is like calculating the price of fire insurance on your house: is it worth it? Undoubtedly, it's a better world with central clearing and I'm sure there will be some negotiation on the costs to make it more palatable. But one thing is for sure: we are not going to abandon swaps and we don't expect this to drive any change in our hedging strategy."
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