EUROPE - Denmark's ATP will be ready to comply with European Market Infrastructure Regulation (EMIR) requirements from January 2013 despite Brussels' temporary exemption for pension funds, and said it would continue to use derivatives and repo financing in its hedging portfolio.

While many European pension funds have expressed concerns that costs related to the EMIR's central clearing requirements could disrupt their hedging strategies, the Danish pension fund - which splits its activities between a hedging and an investment portfolio - sees the changes in a more positive light.

Anders Svennesen, co-CIO at ATP, said the EMIR could bring more transparency to a market that could at times be opaque.

He said one of the advantages of a centrally cleared system under the new regulation related to the price of interest rate swaps.

"For instance," he told IPE, "how do you price an interest rate swap when you have a lot of different discount factors used by banks, depending on the collateral you can post? All those questions will be solved by the central clearing system."

Svennesen added that ATP - which currently sits on a large pile of liquid investments - would take all the necessary measures to be operationally prepared for EMIR requirements by January 2013.

With respect to repo financing solutions, Svennesen went on to say that the repo market had shown some appealing characteristics since the 2008 credit crunch.

At that time, the Danish pension fund decided to diversify its hedging portfolio, which has thrived in recent years.

Instead of hedging all of its liabilities by entering into swaps, the fund started to buy AAA-rated government bonds - such as German or Danish debt - on a repo financed basis.

"During the financial crisis, the yields on long-dated government bonds were higher than on interest rate swaps," Svennesen said.

"So, by buying government bonds and repo financing them, we got, say, 25 basis points more than by buying a swap."

At the same time, the swap curve against a Euribor floating leg remained around 1 percentage point higher than the repo rate, according to Svennesen.

Buying government bonds and repo financing them for hedging purposes therefore became common practice, as it enabled a pension fund such as ATP to keep a positive carry of about 130 basis points.

The hedging strategy adopted by ATP proved to be even more effective when, in 2010, the pricing of interest rate swaps started to correlate with collateral agreements.

Prior to the financial crisis, the methodology used by banks to price swaps was based on the assumption that all market participants had similar liquidity and credit risk.

This assumption was no longer taken for granted following the collapse of Lehman Brothers in October 2008.

Banks started to move away from a standard curve - Euribor or Libor - to establish the discounting rate used in the valuation of the fixed leg of the swap to using a credit support annex (CSA) agreement-discounting approach.

Typically, this CSA defines the terms under which collateral is posted between swap counterparties to mitigate the credit risk arising from "in the money" derivative positions.

"What happened in 2010 is that all the net cash flows were priced on a discount curve depending on the CSA of your eligible collateral," Svennesen said.

"The uncertainty about the pricing led us to avoid using interest rate swaps for a period of time back in 2010.

"The fact we were diversified on hedging instruments by also using repo financed government bonds helped us justify this decision."

A number of market players have expressed concerns over the liquidity risk of the current inter-bank repo market.

According to them, banks might be unable to lend the necessary pools of cash required by pension funds in future due to increasing demand from new market players.

Svennesen argued that banking institutions would always have access to central banks to request the large pools of liquidity if need be.

"Of course, there is a risk if central banks put limits on how much cash they will provide the banks, or if regulation tightens up the rules," he added.

"So far, the central banks have provided banks with unlimited liquidity. But, due to these risks, it is prudent not to rely on the repo market only."

ATP did acknowledge that the EMIR could place some restrictions to its investment portfolio, which will now have to focus on more liquid assets.

"The EMIR concretely means we will need to hold more liquid assets, whereas, some years ago, it was easier to hedge liabilities using derivatives and then use the cash to invest in less liquid assets such as private equity or real estate," Svennesen said.

"But, as we already have enough liquid assets, it will have no impact on our investment strategy."

As a result, the Danish pension fund might be required to hold more liquid assets to repo them in future than if EMIR regulation was not implemented.

Topics