Just as Brussels had seemingly smoothed over its relations with the pension industry by granting a temporary exemption from the EMIR Directive, a new consultation paper has stirred things up. In a joint paper, the European Securities and Markets Authority, the European Insurance and Occupational Pensions Authority and the European Banking Authority (EBA), announced that they are considering a requirement to “exchange, post or collect” initial margins for bilateral over-the-counter (OTC) derivative trades.
Posting initial margins on top of variation margins is already set in the draft version of the EMIR Directive for centrally cleared trades. While variation margin covers any change in price from the previous day, initial margin covers price movements should a clearing member default before trades are closed-out. However, the three European authorities have called for the implementation of similar requirements for bilateral trades, claiming that initial margins are “the most effective risk-reduction tool” against residual counterparty credit risk.
Clearly, not everyone agrees. In the UK, the National Association of Pension Funds (NAPF) argues that UK pension funds are prohibited by law from long-term borrowing and the use of derivatives except for risk mitigation or facilitating portfolio management and do not, as a result, represent a source of credit risk.
Beyond that, pension funds already tend to over-collateralise their current, non-cleared, OTC trades by posting ‘additional amounts’ of collateral over and above the variation margin required for all trades. This additional amount - which usually depends on the creditworthiness of the party paying it - is similar to initial margin in that it provides extra protection for the party receiving it.
Another pensions-industry concern relates to the calculation method adopted for the initial margin. The European Federation for Retirement Provision stresses that, given the fact pension schemes do not have “expedient and low-cost access” to liquidity, their initial margin calculations would be “very high”.
But there are other more serious pressures threatening pension funds. Under the current EMIR Directive, eligible collateral for variation margin in centrally cleared trades is limited to cash. In a previous consultation paper on draft technical standards - published after pension funds were exempted - ESMA asked whether a central counterparty should require a minimum percentage of collateral in cash.
Jane Lowe, director of markets at the UK Investment Management Association, says: “A cash requirement, if passed on to the end client, would require significant investment and pension funds to sell portfolio holdings to raise cash, resulting in lower returns.”
The Dutch Pension Federation argues that, from an operational perspective, using cash instead of securities would be preferable for intraday margin calls that would be “far smaller” than the overall collateral amount required. A spokesman added, however: “This does not interfere with our position that requiring large amounts of cash for margin purposes would lead to a drag on pension investments.”
Conrad Holmboe, consultant at Redington, echoes those concerns but adds that pension schemes can raise the cash without selling assets. “A better alternative would be to repo gilts in the market, but a scheme would still incur a cost for doing so. Separately, some clearing house members are setting up facilities for counterparties to borrow cash specifically for variation margin at short notice, as part of their service offering, which could possibly incur a cost.”
So what prompted the authorities to introduce those measures for bilateral trades? Among the reasons suggested is that Brussels aims to incentivise financial institutions to fulfil their trades at all cost. Another line of reasoning leads to the risk of arbitrage between the Dodd-Frank rules in the US, which come into force in July, and Europe’s EMIR Directive. If the US adopts initial margins for non-cleared trades before Europe has pushed trades into central clearing with initial margin, there could be a rush for European entities to end their OTC derivatives trades with US institutions.