EUROPE - The European Commission's proposals on derivatives could increase costs and risk for pension funds and lead to lower retirement benefits for plan members, the European Federation for Retirement Provision (EFRP) has warned.

The federation, whose 26 member associations represent more than €3.5trn of assets, acknowledged the Commission's consultation was an "important step" toward enhancing transparency and controlling systemic risk.

But it said it was "very concerned" about a number of the Commission's proposals.

Specifically, the EFRP objected to mandatory participation in a central counterparty (CCP), which, it said, posed a "real danger" of increasing counterparty risk.

It pointed out that pension funds, to diversify risk, manage derivative positions by "carefully selecting a wide range of counterparties with outstanding ratings".

The EFRP suggested CCPs would only have a limited number of clearing members, which would result in higher risk concentration.

It also argued that market participants with "suboptimal credit ratings might act as clearing members", increasing risk for pension funds even further.

The federation said clearing through a CCP should therefore be optional for pension funds.

It said: "Such a step would not affect systemic risk, as [pension funds] are prohibited from using derivatives for speculative purposes.

"It would allow pension funds to select a solution that is most favourable for their plan members in terms of counterparty risk and, hence, would qualify as a Pareto improvement."

The EFRP argued that clearing through a CCP was likely to increase costs for pension funds.

"The Commission's proposal would impose uniform margin requirements to cover losses resulting from at least 99% of price movements," it said.

"Clearly, such a crude method would be very disadvantageous for [pension funds], since the probability of them defaulting is negligible.

"In fact, it would result in pension funds - ie the plan members - cross-subsidising speculative activities of hedge funds and banks' proprietary trading desks."

To prevent such an "undesirable situation", the EFRP said CCPs should be required to take into account the creditworthiness of market participants in setting margin requirements.

Lower-risk participants, for example, would have to post lower levels of collateral, and vice versa, it said.

Further, CCPs should be required to accept government bonds to cover initial and variation margin requirements, while returns on bonds "should be forwarded to the participant without deduction of charges by the CCP or clearing member".

Lastly, the federation called for the establishment of CCPs as utilities under a revenue-sharing model, rather than profit-seeking institutions.