By James Carter
Regulators have been sensitive to the fact that a deluge of new rules has hit pension funds, some of which demand complicated and costly compliance at a time when they are already under pressure from the challenging economic environment.
It comes as little surprise therefore that the European Securities and Markets Authority (ESMA) originally granted a three-year exemption for pension funds from the mandatory clearing of derivative transactions outlined in the European Market Infrastructure Regulation (EMIR), delaying the requirement to do so until August 2015.
Now that this date is nearly upon us, the European Commission is calling for a further two years to give pension funds more time to prepare for the requirements associated with centrally clearing derivatives through central counterparties (CCPs).
Many pension funds will be breathing a sigh of relief at this news. However, while it may appear to be a stay of execution, there are good commercial reasons why pension funds may want to go against the grain and begin voluntary clearing of derivatives, which are an essential part of many funds’ hedging arrangements, before it becomes mandatory.
There is no doubt that compliance will carry costs, which is why some schemes are reluctant to begin voluntary clearing. However, these costs are not going to fall the longer that schemes delay central clearing. In many ways, the sooner it is adopted, the more cost efficient it could be.
Non-cleared transactions – aka bilateral trades – are higher risk so more collateral must be posted against them. In addition, dealing with a CCP can reduce costs for a scheme, as it can net all margin requirements across related to outstanding contracts, and even across Exchange Traded contracts in the portfolio. This means a fund will potentially have to post less initial margin or collateral overall.
Equally, many schemes are finding that there is better liquidity for cleared transactions as there are more market makers, so these contracts may be preferential to their bilaterally traded counterparts. This price differential will not necessarily continue once all participants have come to market.
Beyond cost there are additional compliance benefits for schemes which begin voluntary clearing. Participants who act early will get ahead of the crowd and diminish their project risk, avoiding the last minute rush, which will potentially beset market institutions such as CCPs, which could be overwhelmed as the deadline approaches.
It will also give schemes more time to weed out any operational shortcomings without being under the pressure of an impending regulatory deadline. Central clearing, as outlined in EMIR, carries a notable burden in terms of reporting requirements and collateral management. In many cases, this will create new technological demands, and these could take significant time to implement and solve – not to mention budget too.
These issues will be need to be considered and approached carefully to be effective. Schemes may also find that creating an automated and efficient technology platform that can cope with derivatives requirements creates other cost savings associated with the reduction in manual processes.
In the interim, internal compliance managers are likely to be more amenable to investment managers’ trading activity in derivatives where cleared contracts are used, again due to the lower risks associated with cleared transactions. At a time when schemes are broadening the scope of their investments in an environment of low returns, greater flexibility in the tools that can be used to achieve returns could prove to be extremely valuable.
Ultimately, pension funds stand to gain a significant benefit from acting early. While it is an inevitable fact that complying with EMIR will be costly, there are ways schemes can mitigate these costs and gain advantages by complying now.
James Carter is manager, product management at SimCorp
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