Insight Investment: The need for non-cash variation margin

Of all the firms that will be required to clear over-the-counter derivatives, pension funds are the group for which it looks most problematic – hence a three-year exemption in Europe’s clearing legislation. But that grace period started last August, and there are a lot of issues to resolve by the time it expires in 2015. In the meantime, relatively few funds are deciding to start clearing voluntarily – and that’s the right call, says Vanaja Indra, market and regulatory reform director in the financial solutions group at UK-based pension fund specialist Insight Investment.

“There are still key concerns for some of our pension fund clients we would like to see resolved before we recommend clearing. We’re not anti-clearing, but most of the clearing models out there have been built for the dealer community, not the buy side. Client clearing offerings at the clearing houses are still evolving, and we want to make sure we help shape those offerings to benefit our clients,” she says.

The top concern is the funding burden associated with intra-day margining, says James Parsons, Insight’s central counterparty (CCP) programme manager. Pension funds have big, long-dated exposures to hedge – Insight collectively manages notional sums in excess of £300 billion ($460 billion) – which could generate similarly large variation margin calls. Unfortunately, as things stand, CCPs only accept cash as variation margin, and pension funds tend not to have a lot of it.

Parsons says Insight is talking to all the major European CCPs about accepting non-cash assets as variation margin, but that it is unlikely any clearing house will have a solution in place in the near term. That leaves funds with two options: hold higher levels of cash, or convert their bond holdings to cash as required.

Typically, Insight would be able to offer this kind of collateral transformation to clients through the repo market, says Parsons. But in stressed market conditions, where the need for cash margin is likely to be highest, that may become difficult, as banks move to constrain their balance sheets, he says. In those circumstances, other providers must come forward – and Parsons says the industry should clarify this mechanism ahead of time, or risk unmet margin calls triggering a liquidity crisis.

“Collateral transformation could take place at several levels of the market: it could take place at the client level, or it could be at a centralised utility. The industry as a whole needs to develop solutions to provide layers of liquidity to the market. We’re talking to all the CCPs, clearing members and market utilities to develop and promote an industry-wide dialogue. It’s a key issue for our clients that we need to resolve. We could be in danger of entering an environment where we reduce counterparty risk, but actually create significant liquidity risk for our clients – and that could precipitate the next crash,” Parsons says.

These problems could be magnified for liability-driven investment (LDI) funds that hedge inflation alongside interest rate exposure. Currently, interest rate swaps can be cleared, while inflation products cannot – meaning any offsets between the two books will be lost and each will become subject to a separate margin regime (Risk December 2012, pages 42–43). Rules on margin requirements for uncleared trades are being finalised by a group run jointly by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

“Another major issue for our clients is the lack of support for centrally cleared inflation products. If inflation swaps cannot be cleared, then the hedge for our LDI clients will be split between cleared and non-cleared trades, potentially requiring a larger collateral pool. A number of CCPs are now looking at supporting inflation swaps, but there are a number of significant barriers – for example, defining the default management process in a market where liquidity is concentrated at a small number of counterparties,” says Parsons.