Early clearing means savings for pension funds
By James Carter, manager, product management, SimCorp
Since the financial crisis, almost every facet of the
derivatives world has been scrutinised and subjected to new rules by global
regulatory authorities. This has pushed many financial institutions to overhaul
their internal processes, creating ways to efficiently and cost-effectively
accommodate this new environment.
This has been particularly evident for the European Market
Infrastructure Regulation (Emir), which introduced mandatory derivatives
clearing through central counterparties (CCPs). However, the new regulation has
touched on market participants for whom it has not been so straightforward to
adapt systems and processes.
For larger pension schemes, the use of derivatives to hedge
capital and to achieve diversified returns has been essential. But adhering to
these new rules generated a compliance burden that schemes were significantly
less prepared to cope with than their well-capitalised counterparts in the
trading and investment world.
These buy-side institutions, by contrast, had more scope to
invest in upgrading their technology to help them deal with the demands of
reporting and post-trade processing in line with the changed requirements.
In recognition of this, 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 Emir,
delaying the requirement to do so until August 2015. This would give schemes
time to prepare for the changed processes, and more gradually absorb the costs associated
with compliance.
However, now that this date is within sight, 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, giving them further time to adapt internal processes and technology
needed for Emir compliance. Nonetheless, while it may be viewed as a stay of
execution, there is a strong commercial case for pension funds to begin
voluntary clearing of derivatives, which are an essential part of many schemes’
hedging arrangements, before it becomes mandatory.
There is no doubt that compliance will carry costs, which is
why some funds are reluctant to begin voluntary clearing before they are
obligated. However, these costs are not going to fall the longer that schemes
delay central clearing; indeed, the sooner it is adopted, the more cost
efficient it could potentially 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.
What’s more, many schemes are finding there is better
liquidity for cleared transactions as there are more market-makers, so these
contracts may be preferential, from a pricing perspective, to their bilaterally
traded counterparts. This will not necessarily continue once all participants
have come to market.
In addition to this, there are further benefits for schemes
which begin voluntary clearing now. Project risk is a significant factor for
participants who leave clearing implementation to nearer the official deadline.
A last minute rush could potentially beset market institutions such as CCPs,
seeing them overwhelmed as the deadline approaches.
Complying now and engaging with CCPs will also give schemes
more time to weed out any operational shortcomings without the pressure of an
imminent 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. 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.
It is an inevitable fact that complying with Emir will be costly, but there are ways schemes can mitigate these costs and gain advantages by complying now. Ultimately, pension funds stand to gain a significant benefit from acting early, by getting ahead of the curve on compliance.
Found this useful?
Take a complimentary trial of the FOW Marketing Intelligence Platform – the comprehensive source of news and analysis across the buy- and sell- side.
Gain access to:
- A single source of in-depth news, insight and analysis across Asset Management, Securities Finance, Custody, Fund Services and Derivatives
- Our interactive database, optimized to enable you to summarise data and build graphs outlining market activity
- Exclusive whitepapers, supplements and industry analysis curated and published by Futures & Options World
- Breaking news, daily and weekly alerts on the markets most relevant to you