OTC derivatives and the law of unintended consequences
The more Brussels tries to reduce risk, the more it seems to grow, says Cecile Sourbes.
The law of unintended consequences has never been truer than in the regulatory sphere, with the latest example coming from the need to post variation margins in cash for over-the-counter (OTC) derivatives trades. Although Brussels has acknowledged the need to exempt pension funds from the European Market Infrastructure Regulation (EMIR) Directive due to liquidity constraints, it seems they are set to incur new costs deriving from the regulated system after all.
Currently, under bilateral trades, pension funds are accustomed to posting gilts as variation margin unless the amounts are trivial. In the initial draft of the EMIR Directive, however, Brussels required all counterparties - including pension funds - to post variation margins in cash only. Of course, institutional investors would have no incentive to hold large cash buffers in their portfolios, since the return on cash would be close to zero. This version of the EMIR Directive could therefore act as a significant drag on pension funds, having no choice but to offload some of their holdings to raise cash for variation margins.
In February, however, the European Parliament and the European Council granted pension funds a temporary exemption from the directive. Brussels agreed to give banks and clearing houses more time to come up with a solution to switch pension funds' holdings into cash.
One option might be to use that portfolio of gilts to generate cash via a repurchase transaction (repo) with a bank. Banks would lend or facilitate variation margins by putting the gilts pension funds would hold in exchange for cash in the repo market. Obviously, this option wouldn't be free of cost. Using the repo market implies a small haircut for the pension funds signing such agreements. The banks would retain a minimal percentage of the total value of the gilt, say 2%, giving back to the pension fund only a portion of this value in cash, say 98%. The haircut, in this case, would be considered a margin posted by the pension fund.
The option for pension funds to pay interest on such instruments is fair. Some pension funds do use gilt repo to generate leverage in their LDI portfolios. But this is about making that portfolio more capital-efficient. And the gilt repo they would do to generate cash for variation margin requirements is a leverage transaction they would not enter into otherwise.
That's precisely what is striking about the EMIR Directive. By looking to reduce systemic risk within the derivatives market, the regulation seems to have created opportunities for banks to set up new businesses. In exchange for fees, lenders would now offer pension funds solutions they otherwise would have no need for. So pension funds - temporary exemption or no - would still incur a significant cost. Worse still, the EMIR Directive could actually increase pension funds' credit exposure to banks through the use of the repo market.
This clearly comes as a paradox giving the fact that the European Securities and Markets Authority (ESMA), which will advise the European Commission on the EMIR Directive, pointed out in one of its consultation papers that it aimed to limit residual counterparty credit risk by implementing new tools such as initial margins for OTC derivatives trades.
Brussels' decision to regulate the derivatives market comes from a good place. The Commission's preoccupation with the topic stems from the need to reduce systemic risk, and the EMIR Directive generally addresses those issues. The repo market is also clearly an option for pension funds to consider in light of the lack of better alternatives for gaining access to large volumes of cash. But, in the end, the semi-permanent usage of the repo market to meet variation margin requirements will make banks the biggest beneficiaries - to the detriment of pension funds.