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Letter from Brussels: Unclear on clearance

The prolongation for 18 months of pension funds’ exemption from posting collateral when trading over-the-counter (OTC) derivatives is leading PensionsEurope to seek clarification. 

At the end of 2016, the European Commission announced it was “further extending transitional relief for Pension Scheme Arrangements (PSAs) from central clearing for OTC derivative transactions until 16 August 2018”. 

It continued: “PSAs are active participants in the OTC derivatives markets in many member states, however, without an extension, they would have to source cash for central clearing. 

“Since PSAs hold neither significant amounts of cash nor highly liquid assets, imposing central clearing requirements would require very far-reaching and costly changes to their business model which could ultimately affect pensioners’ income.”

The Commission concluded that central counterparties (CCPs) need time to find a solution for pension funds. 

In other words, the focus for pension funds has switched to after August 2018. PensionsEurope’s position, is that pension funds should be allowed to post non-cash collateral in both cleared and non-cleared derivative transactions.  

Ursula Bordas, a policy adviser at Pensions Europe states that, for the central clearing of transactions, some funds would prefer to post as collateral high-quality liquid assets, such as government bonds. Others would prefer for regulators to make the present exemption indefinite.

At a meeting with pension experts in December, the Commission discussed five possibilities. The first would be to require PSAs to centrally clear, which would require no policy action.

However, PensionsEurope complains that this would be detrimental. It points to a report by Europe Economics and Bourse Consult, which concluded the “maintenance of cash reserves leads to high opportunity costs for PSA’s because of the low level of interest that is earned on cash collateral”. This report, published in 2015, refers to total annual cost increases without exemption for the EU28 at €3bn. 

Another option was an amendment to Article 46 of EMIR that would oblige CCPs to accept eligible non-cash collateral, such as government bonds. Another option was the feasibility of “direct membership” with a third party acting as agent enabling PSAs to fulfil the clearing obligation. Bordas objects to this as pension funds would still need to post “variation margin” (collateral) in cash.

Option four was further exemption. Finally, there was exempting PSAs permanently from the clearing obligation. 

However, EU policy has to protect European interests from other obligations resulting from the 2009 G20 agreement on central clearance. Further complication results from clearing involves different rules covering the process before and after the trade has been executed. Furthermore, the International Swaps and Derivatives Association (ISDA) recently talked of 2017 being a, “critical year for trading rules”.  

ISDA, which states its role as “working to make the global derivatives markets safer and more efficient” noted that failure to find agreement between the US and EU “could change the nature of the global derivatives market forever, transforming what was a single pool of liquidity into smaller, shallower, more fragmented pools”. 

Edwin Schooling Latter, of the Financial Conduct Authority, the UK regulator, says “the prize to be gained from agreeing mutual equivalence is substantial.”

In principle, PensionsEurope agrees but notes that US pension funds do not need to hedge risk at anything like the rate that pension funds do in the EU. As a result, they escape “huge costs” faced by their European counterparts.

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