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Clearer position on derivatives

Powerful forces are pushing both for and against an opt-out for pension funds from central clearing requirements in proposed legislation on market infrastructure, making it anyone's guess as to the final result. However, the European parliamentary rapporteur's softening of position must be reasonable grounds for hope.

Originally, MEP Werner Langen, the rapporteur, co-ordinating progress of the European Market Infrastructure Regulation (EMIR) through Parliament, took a hard-line stance against letting specialised sectors off the hook.

His view was that if all the demands from lobbies for exceptions were granted, "we won't have a regulation that would recognise that the financial crisis ever took place".

He also sought to avoid loopholes. Furthermore, he was - and still is - constrained by the G20 decree to harmonise EU legislation with the relevant section of the Dodd-Frank Act, the US's gargantuan package to rope in Wall Street.

However, in the face of well-backed protests put by the pensions sector, the centre-rightist German MEP's latest position is that Parliament's economic and monetary control committee (ECON) could consider flexibility. "I understand the need to find a solution to this issue", he told.

Now, a drive by the UK's National Association of Pension Funds, and other European groups, has been reinforced by Dutch pension fund interests. Figures from the Netherlands, where pension fund assets total around €800bn, estimate that additional costs likely under EMIR could burden that nation's 7m pension fund members and retirees with extra annual costs of between €1.5-4-5bn.

Sibylle Reichert, Brussels representative of the Dutch Pension Fund Federation, suggests that one way to reduce risk and cost burdens would be to allow collateral to continue to be posted as securities rather than cash.

An elaboration of the pension fund's position comes from APG, the Dutch pension asset manager, with €277bn under management. APG's senior press officer, Harmen Geers, says that pension fund regulations, including the IORP directive, already require pension funds to use derivatives to hedge their liabilities. They use OTC-transactions to buy protection against risks involving changes in interest rates, currency value, and inflation.

However, because Dutch pension funds are solvent, their bilateral OTC derivatives transactions can now be done at low cost. Their solvency makes them trustworthy counterparties, and therefore they should not be required to post high collateral.

Geers adds that inclusion of low risk pension funds within the proposed regulation would result in all transactions being subject to centralised clearing via a CCP. This would put pension funds in the same category as higher-risk hedge funds. Collateral would not be based on the risk level, but, unfairly, on the size of the transaction.

Adding to the burden on pensioners is that ‘netting out' the consolidation of a group of transactions between two counterparties will no longer be possible, further adding to collateral costs. Also, under EMIR, pension funds would be exposed to risk of failure of a clearing member, or of the clearinghouse itself. This may be either a bank or a bank-owned entity.

Overall, says Geers, the proposed system would entail both higher costs and also higher risks. The ideal solution would be to reduce the scope of the regulation to exclude pension funds. Support for the Dutch argument comes from the British centre-right MEP Kay Swinburne. She comments: "The last thing we want would be lower returns and higher costs for prudent saving for the future."

Against the present wrangling, the future progress of EMIR through Brussels could be complex. According to a Parliamentary spokesperson, differences between the positions of the Parliament and the Council of the EU, representing national finance ministers, are great.

Whatever the position of the ECON committee, its decision could easily fail to get through at a plenary session, if only because MEPs are liable to avoid voting on party lines. The comparatively painless procedure of a single reading process in Parliament could break down.

Then the matter could go to COREPER meetings of national representations in Brussels, and to ‘trialogue' meetings involving Parliament, Council and the Commission. This would lead inevitably to delays, and make harder any prediction of the final result.
A parallel debate surrounds the issue of non-financial firms, such as manufacturers, which use OTC derivative deals to mitigate risk arising from their core business activities. This commercial hedging may, for example, be used to protect against exchange rate variations.

According to the Commission, EU member states last summer agreed to conclude all negotiations relating to G20 commitments on financial reform by end of 2011. On this basis, the new rules on derivatives should be operational by the end of 2012. It would surprise no-one if the date slips.
 

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