By Jamie Gavin
There was an audible sigh of relief in February when the European Commission granted a two year extension to pension funds regarding compulsory clearance of derivatives through central clearing houses.
Of course, this did not come as a surprise to most market practitioners but it was nevertheless a welcome change of heart from the European regulatory authorities governing the activities of pension funds.
And given the palpable lack of readiness across the market for such a move, few would argue against the European Union’s decision to take a regulatory pause for breath.
At the core of regulatory exemption was the regulator’s desire for the market to come up with a plausible and workable solution to the issue of using securities to meet variation margin. There has been a deafening silence on this matter for some time and there is little to suggest that it will be readily resolved anytime soon.
Imposing central clearing on pension funds at this time would be fraught with difficulties. It would have forced pension funds to find new sources of cash to cover new margin requirements linked to their derivatives trades as well as incorporate more liquid assets with the effect of causing a drag on performance. And at a time when many funds face considerable deficits, it would layer on unworkable costs on to the structures of pension fund operations.
Indeed, it would have likely prompted many pension funds to think about ending their use of derivatives, a popular way for many money managers to hedge out risks. Such a move would have resulted in pension funds having to take on greater market risk and left them more susceptible to market fluctuations and swings than before.
But thankfully common sense prevailed and pension funds have another two years or, perhaps three, to formulate workable central clearing strategies. Or do they?
From a purely regulatory perspective, it is correct to assert that pension funds have another few years to get to grips with the central clearing conundrum. In all likelihood the regulatory pause will come to an end in 2018 so one can understand why some pension funds might chose to mothball plans to deal with this issue. There is a continuing groundswell of opinion within the European Parliament that the exemption should be made permanent, but will that help?
The regulator is only one actor in this ongoing play.
Pension funds are likely to find themselves priced into central clearing as the costs of leaving trades bilateral become increasingly expensive when compared to those cleared at a CCP. The view from many participants is that as we approach MiFID II, and we see SEF-like venues called MTFs and OTFs, electronic execution will cause pricing differentials: executing brokers will prefer to quote for cleared rather than bilateral, adding a painful spread for those pension funds who want to, rightly, use their exemption to trade OTC interest rate swaps.
So pension funds have a choice: wait for the regulatory exemption to lapse or begin readying themselves for a world when they are priced into clearing centrally anyhow.
Anecdotally, it is encouraging to hear that some prominent pension funds have chosen to take the second route rather than the former. A number are readying themselves for central clearing and all that it entails, including grappling with the requirements for more high quality liquid assets to be used as collateral and starting their own pricing surveys.
These funds are rightly recognising the actions needed to be part of a centrally cleared world are congruent to the need to develop improved infrastructure and diversify sources of funding and eliminate risk.
Of course, nobody is suggesting that this migration straightforward. It is difficult. But change is necessary in the medium term and there will be a premium reaped for those that crack the clearing conundrum earlier than the refuseniks in the market.
Jamie Gavin is a director, head of institutional OTC clearing, Societe Generale Prime Services
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