As we mark seven years since the bankruptcy of Lehman Brothers this month, the blunt instrument of regulation still hangs over pension funds with respect to European derivatives trading. The G20 summit in Pittsburgh of 2009 heralded the international community’s repair of the financial regulatory architecture, resulting in Frank-Dodd in the US as well as Europe’s Alternative Investment Fund Managers Directive (AIFMD), the second Markets in Financial Instruments Directive (MiFID II) and EMIR, the European market infrastructure regulation.
Given the role they played in exacerbating the global financial crisis of 2008-09, the decision to move derivatives trading to central clearing counterparties (CCPs) was certainly laudable. But EMIR’s unclear intentions towards pension funds with regards to derivatives are still a cause for concern. With no further action from the European Commission, the derivatives trading requirements will apply to pension funds from August 2017, as PensionsEurope points out in a recent paper.
The matter of concern is the higher collateral, in the form of variation margin, that pension funds would have to post if the exemption is not extended or made permanent.
The pension community has repeatedly made the point that centralised derivatives clearing for pension funds does not reduce systemic risk. Pension funds are prudently regulated, long-term investors that use derivatives to hedge interest rate, along with inflation, currency and certain short-term investment risks. The chances of a pension fund failure are close to zero.
It has been calculated, furthermore, that applying the derivatives-trading requirements of EMIR to pension funds could result in a 1.1-2.2% reduction in pension income across Europe, widening to as much as 2% in the UK and 3% in the Netherlands, where interest rate hedging is, in effect, mandated by the regulator.
Hedging of interest rate and other risks by pension funds adds to overall financial stability by reducing the risk of underfunding, which might have to be met by higher sponsor and member contributions. It is certainly unpleasant that pension funds face a penalty for their prudence.
As PensionsEurope also points out, centralised clearing would also help to deter long-term investment by pension funds.
PensionsEurope has called on the Commission effectively to put up or shut up by proving a case for pension funds to be subject to centralised derivatives clearing, or else to withdraw the threat. Pension funds, like all other actors, deserve a degree of regulatory certainty at least.