LCH.Clearnet considering repo lines to pension funds

CCP talking to pension funds about becoming direct repo counterparty

LCH.Clearnet

LCH.Clearnet is working on plans to offer repo lines to pension funds, as a way to help them source cash collateral to post on cleared derivatives trades.

The plans are the most recent step by a central counterparty (CCP) towards helping pension funds and other buy-side firms meet heightened collateral demands under the incoming European Market Infrastructure Regulation (Emir), but raise concerns about the CCP taking on additional risk.

LCH is "offering to have direct repo lines with the CCP for their own balance sheet", according to a head of treasury at a major pension fund. "They collect a lot of cash for initial margin, and they invest that cash through the repo market. The idea is the end-user would post bonds and get cash from the CCP, the cash could then be used for the margin requirements of the end-user."

A senior liability-driven investment (LDI) manager at a leading asset manager confirmed the plans.

Bruce Kellaway, global head of fixed income at LCH.Clearnet in London, says: "We collect cash margin to collateralise the positions we clear, which we must reinvest safely and securely. Within the necessarily tight constraints that govern this process, we are always looking to selectively broaden and deepen our reinvestment options, within regulations. Diversifying our reinvestment portfolio in this way not only reduces our risk, but also increases market capacity for cash borrowers in the face of shrinking supply. This activity does not tackle all the capacity issues as it is limited in scale, so we are separately working with the market to develop cleared repo solutions for the wider end-user community."

Pension funds are currently exempt from Emir's clearing rules for over-the-counter derivatives trading, but the exemption can only be extended until August 2018 at the latest. Counterparties on trades cleared through a CCP are required to post cash variation margin, meaning pension funds would most likely have to repo bonds for cash to meet collateral demands when the exemption ends.

Funds worry they might struggle to meet their collateral transformation needs during times of stress, particularly because of constraints on the repo market.

A consultant with knowledge of CCPs' plans says gilt repo would be a suitable way for clearing houses to earn a return on cash posted as initial martin. Meanwhile, pension funds are unclear about how long the current exemption from Emir will last and face the possibility that uncleared trades could become more expensive as other market participants move to clearing.

"The CCPs are aware of this [lack of cash] and it is in their interest to get trades cleared. If there are things that can be done by the CCPs to make that process easier, that's a win-win for both parties," the consultant says.

The pension fund treasurer says his organisation would consider signing up to a CCP repo line but that LCH's plans are not a "panacea for the variation margin problem".

"It's not the solution for pension funds, because it's highly doubtful whether they [CCPs] will always be open in times of stress and able to absorb the capacity of all end-users at the same time," he says. "Every connection to the repo market is important. But I still think at some point there must be some connection to central bank liquidity that can guarantee liquidity under all circumstances."

This echoes the views of panellists at Risk's Derivatives Clearing Europe conference in London on October 6.

Central bank liquidity need not be provided directly to pension funds, he adds, saying: "I can understand you would put an institution in between, and that institution could be the CCP." In the UK CCPs have access to the Bank of England's Sterling Monetary Framework, giving them access to overnight funding collateralised by high quality liquid government bonds.

Some market participants say the LCH plans raise concerns about heightened risk, however. Nicki Søndergaard Rasmussen, chief analyst, counterparty credit & funding trading at Danske Bank Markets, based in Copenhagen, says: "If [CCPs] think they can absorb a default without triggering a fire sale of the securities then it would be fine. But the CCP should convince itself and everyone else it can absorb the liquidity impact without transmitting the stress to the rest of the market. That might require additional access to liquidity in the stressed time.

"Functionally, it would work," he says. But the clearing house would have to consider whether pension funds could meet their collateral commitments if the CCP withdrew the repo line. "Most likely [pension funds] would no longer be able to perform their commitments," he says.