Derivatives, and credit-default swaps in particular, have become synonymous with Wall Street wrongdoings, and in Europe authorities want to tightly regulate them, even ban speculative derivative trades. President Obama has promised reforms that would fix problems in the derivatives market, starting with trading all derivatives onto transparent exchanges. But large US corporate pension plan sponsors say that not all derivatives are the same - weapons of mass destruction - and not all financial institutions that use them are dangerous speculators. So they are lobbying the US Congress to obtain an exemption from the new rules proposed on swaps.
"Large US pension plans use swaps for risk mitigation, for example to extend their portfolio duration or to manage risk of rebalancing. They have a fiduciary duty and always act in the interest of retirement plans; they do not gamble," says Judy Schub of the Committee on the Investment of Employee Benefit Assets (CIEBA), the ‘voice' of the Association for Financial Professionals (AFP), senior corporate financial officers who individually manage and administer corporate pension plan assets. CIEBA represents around 120 large US pension funds managing $800bn (€589bn) of defined benefit plan assets, and $500bn of defined contribution plan assets.
"Frankly I don't know whether pension funds also use credit default swaps," says Schub. "They might, if they want to protect themselves from interest rate risks. Anyway, they do it according to the Employee Retirement Income Security Act (ERISA) of 1974 and Department of Labor regulations. We don't oppose transparency. Retirement plans are already very transparent."
But they do not want to be defined as Major Swap Participants (MSPs) under the new law. According to the legislation already passed by the House of Representatives, an MSP is "any person who is not a swap dealer, and (i) maintains a substantial net position in outstanding swaps, excluding positions held primarily for hedging, reducing or otherwise mitigating its commercial risk; or (ii) whose outstanding swaps create substantial net counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets". According to the draft by chairman of the Senate Banking Committee, Chris Dodd, an MSP is "any person (a) who is not a swap dealer; and (b) whose outstanding swaps create net counterparty credit exposures (current or potential future exposures) to other market participants that would expose those other market participants to significant credit losses in the event of the person's default."
If pension plans are defined as MSPs, explains the CIEBA, "they would have to comply with bank-style capital and margin rules, registration requirements, and sales practice rules as well as a clearing and exchange-trading mandate. These rules were designed for dealers using swaps for speculation, not entities that use swaps primarily to reduce risk. Accordingly, end-users of swaps that use swaps primarily to reduce commercial risk are exempted from the definition of MSP in the House bill. Plans that use swaps primarily to reduce portfolio risk should be treated in the same way."
The exemption is already under fire from critics who think the financial reform is being watered down. "Private markets lack the rules that prevail in regulated markets... that are essential for regulators and investors to monitor and control risk. That is why it is so essential to move derivative trades onto fully-transparent exchanges," said a New York Times editorial. "The administration originally embraced that idea, with exceptions only for occasional, unique contracts. But when the Treasury proposed legislation in August, it included huge loopholes."
The CIEBA disagrees. "Pension plans may get better terms if the derivative contracts are over-the-counter," says Schub. "Pension plans negotiate the deals very carefully. If all trades must go through exchanges or registered swap depositories, which are run mostly by swap dealers, the terms of the contracts may be changed and the pension plans may be penalised."
To the charge that the exemption opens the door to loopholes in the reform, Schub says: "There are ways of defining what plans do. Congress should understand that pension plans do not represent a systematic risk. I defy anyone to say so. Besides, we are not overexposed to swaps. We are talking with a lot of people in Washington and they seem to understand our point." Currently, it is not clear how and when the legislation will pass the Senate.