Ready or not, EMIR I come: how changing OTC regulation will affect investors

The financial crisis highlighted a perceived lack of risk control across the financial sector, requiring a fresh wave of regulation in response. One of the more contentious targets for regulators has been the

There is one estimate that the amount of extra collateral required by the system is a figure of $2.4trn.

Robert Talbut

OTC derivative deals – which according to EU statistics account for almost 95% of derivatives markets – are traditionally negotiated and executed privately on a bilateral basis between two counterparties, but in 2008 as a result of landmark events such as the default of Lehman Brothers and the bail out of insurance giant AIG, the EU decided that derivatives should be centrally cleared through central counterparties (CCPs). It has been several years in the making but the subsequent European Market Infrastructure Regulation (EMIR) was drawn up in order to increase transparency and reduce counterparty credit risk and operational risk. EMIR is expected to come into force mid 2013 beginning with the clearing of interest rate swaps, followed by credit default swaps and more complicated derivative instruments thereafter. Pension funds have been granted a temporary exemption from central clearing until 2015, but the current draft says they are not exempt from the additional requirements attached to existing bilateral trades. The move is likely to result in increased costs for end investors and affect how much liquidity and risk assets they will be required to hold in portfolios. Elsewhere, industry players are concerned that while EMIR is aiming to reduce risk in the OTC market, it could actually heighten concentration risk, particularly among the CCPs.

Portfolio changes

Under central clearing regulation when clearing a derivative contract through a CCP, counterparties will be required to post higher levels of collateral by way of posting an initial margin, which is the securities an investor keeps in a margin account to be able to borrow from a brokerage; and/or a variation margin, which is paid to the CCP in order to reduce the exposure created by carrying highly risky positions. It is anticipated schemes using derivatives will have to hold more collateral and hence more assets to post as collateral. One of the main areas of concern for pension funds is around what will constitute eligible collateral. Russell Investments senior consultant Tim Cook says: “The only thing that will be certainly accepted is cash and there is debate as to whether gilts will be acceptable for the initial margin. It is likely a lot will be cash so if you have extra collateral and are unable to use some of the assets you were previously, you will have to post more cash-like collateral and thus lose exposure to the assets you had previously.” Axa Investment Managers senior pension solutions manager Lucy Barron has observed a trend over the past two years among pension funds carrying out UK derivative trades for using cash and gilts only as eligible collateral to be better aligned with what will be accepted by clearing houses. “In the past a wide number of clients had wide collateral terms, so including a rage of currencies, government bonds and credit down to single A-rated, but having cash and gilt credit support annexes (CSAs) is much closer to what the margin will be under central clearing. We have therefore seen a significant move into cash and gilt-only CSAs.”

Cash is king

This greater cash holding is likely to come at the expense of other asset classes in the portfolio and even if regulation reduces schemes’ ability to hold growth assets, they could end up allocating to riskier assets regardless thanks to their need for growth. The risk mitigation from holding hedging assets is lost in seeking the greater return to offset that. If pension funds have to centrally clear, one of two things is likely to happen: either the central clearing houses will need to accept gilts as variation margin on an ongoing basis; or if it remains as cash-only schemes will either need to hold a significantly higher proportion of cash than gilts or undergo a collateral transformation process where they invest in gilts but do a sale and repurchase agreement (repo) on those bonds to get cash the same day to post as collateral. “That is one area asset managers have to focus on and work with clients to work out what the solutions will be to convert their gilts into cash to be able to post the margin payments. That is one of the key areas we are focusing on,” says Axa IM’s Barron.

Liquidity issues

In addition, especially with pension funds looking increasingly at illiquid assets with lock-ups, it is advisable to monitor the portfolio’s liquidity on both a day-to-day and crisis management basis, in case the need to raise more collateral arises. “Despite the availability of exemptions, some pension schemes may decide to centrally clear as many of the OTC derivative contracts as possible because of the potentially more onerous risk mitigation techniques and margin requirements for non-centrally cleared derivatives,” says Alexander Culley, a consultant at regulatory consultancy Bovill. “Accordingly, schemes should regularly conduct an analysis of what OTC derivatives they hold/are likely to hold. The less liquid an OTC derivative contract is, the greater the chance that it will not be eligible for central clearing when the obligation enters into force. Either way, a scheme will need to determine whether it has/will have enough liquid collateral to meet the requirements of clearing houses or the regime for non-centrally cleared derivatives.” This comes under consideration if a fund decides that it requires extra cash, say 10%, to meet the new collateral regulations and one bond manager might be holding 5%, another manager is holding 3% and so on. It is therefore important to try to look at the portfolio from the top down. This also relates to if different contracts are held with different CCPs. “Are you going to be able to net across the portfolio the different things you have got in there?” questions Culley. “Because if OTC derivative positions are cleared through more than one CCP and/or clearing member you may not be able to net all of these off. This means that you might have to post more collateral.”