The use of credit support annexe (CSA) agreements, defining the collateral that can be posted in bilateral over-the-counter derivative (OTC) trades, has increased significantly over recent years as pension funds have made increasing use of derivatives.
Yet, the current financial environment has changed the game. Banks have now started to turn their nose up at some collateral such as corporate bonds, pushing pension funds to restructure their CSA agreements. One burning question arises: what type of collateral will investors be permitted to post?
Looking back at the collapse of Lehman Brothers in 2008, pension funds had feared the consequences of a crash in the derivatives market because of the bank’s important role in the sector. But there was not the effect on collateral that some had expected. In fact, pension funds that had liability driven investment (LDI) strategies came out of the collapse relatively untouched, using CSA agreements to their advantage to undertake modelling and set aside sufficient appropriate collateral.
Three years later, however, the spectre of the sovereign debt crisis in Europe is clearly haunting pension funds for many reasons. Solely from the perspective of derivatives, the fact that banks no longer accept corporate bonds as collateral has led to a change in the valuation of derivatives, which now depends on the type of collateral pension funds include in their CSA agreements.
According to Robert Gardner, co-founder and chief executive officer at London-based consultancy firm Redington Partners, banks want to know what is included in a CSA before making any trades.
Traditionally, CSA agreements included cash, government bonds - restricted to G7 countries - and corporate bonds. Nowadays, the range is tightened around cash and G3 government bonds. Again, the fact that collateral has been restricted to G3 issuers only can be explained by the credit downgrade of some countries such as Japan or Italy, from which government bonds were previously used as collateral in CSAs.
The choices are therefore decreasing but this does not mean that pension funds cannot turn the situation to their advantage.
“There is now an opportunity for pension schemes to restructure those CSAs and actually get paid for removing the corporate bonds,” Gardner concedes. “It also makes sense for the pension schemes because it means that any future derivatives will likely be executed at a better dealing spread if it’s a clean CSA with cash and G3 than it would be with cash, G3 and corporate bonds.”
However, the new European Market Infrastructure Regulation (EMIR) directive on OTCs, could add further restrictions. The first draft of the regulation previously required pension funds to comply with the same capital requirements as for banks and hedge funds. This meant that these investors needed to own a large portion of their assets in cash or government bonds.
According to Niels Kortleve, innovation manager at the €105bn Dutch pensions provider PGGM, the EMIR directive means that more collateral will be required in the future and will add an extra cost for pension funds in both payment of fees and posted margin.
“The directive could give us the opportunity to export our experience on derivatives, as well as show the relevance and the impact of such instruments on the pension sector,” Kortleve said at the World Pension Forum in Amsterdam last month. “But, at the moment, it seems like the threat caused by the new regulation on OTCs will be greater than the potential pipeline of opportunities.”
Pension funds will not have to comply with these rules for at least the next three to four years. Nonetheless, even though the European Commission agreed to exempt pension funds from this regulation for now, it goes without saying that, sooner or later, European pension funds will also be asked to meet the same requirements.