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OTC Swaps Regulation: APG: Collateral damage

“Of course, we may have to consider to hedge less if derivatives solutions become too risky or too expensive.”

Guus Warringa’s statement about the introduction of the European Market Infrastructure Regulation (EMIR) remains beyond dispute.

According to the board member and chief counsel at APG Asset Management, which manages money on behalf of the €261bn Dutch civil pension service scheme ABP, the requirement to centrally clear derivative trades will lead to higher costs and risks for end users. This, in turn, will push pension schemes and teams managing assets on their behalf to look closely at what liabilities really need to be hedged.

Therefore, despite the temporary exemption from EMIR that the European Parliament and the European Council granted to pension schemes in February this year, APG, like many of its counterparts across the continent, remains in a state of high alert over central clearing measures.

Two major issues stand out. The first relates to the posting of variation margin in the form of cash. Probably the largest cost burden under EMIR will come from the yield pension funds would be forced to give up if they have to hold large cash balances to meet margin calls, rather than bonds that are still yielding 2-3%. Instead, pension funds could generate cash using the bond repo market. Some clearing house members have already set up facilities for counterparties to borrow cash at short notice specifically for variation margin, as part of their collateral transformation services. But these alternative solutions could be limited.

“We are sure that due to the central clearing requirements, the repo market will change on liquidity, on volatility and on pricing,” Warringa says. “To what extent, we do not know, but that’s one of the issues we have been lobbying on. We asked Brussels and Washington to make an impact assessment. We all have to realise that this is an attempt to change the largest market in the world and that cannot be done overnight.”

And there are other problems. Under the central clearing system, a pension fund or asset manager on the buy-side deals with the central counterparty (CCP) via its central clearing member, usually a prime broker or a bank. To date, the CCP model has not been required to recognise the risk profile of each separate client. Therefore, pension representatives argue that the buy-side has been pushed to take credit risk on clearing members with a much lower creditworthiness.

“There are huge risks with central clearing, as was proved when the global financial derivatives broker MF Global went bankrupt in October 2011,” Warringa points out. “The worst risk for a pension fund is a liquidity squeeze. We don’t want to lock our money
into an unsafe central clearing system.”

Warringa worries that a mandatory central clearing system will lead pension funds to run an even greater exposure to banking institutions for which the creditworthiness is yet to be proven: “We have all learnt in recent years that banks are not risk-free.”

As for the potential international level playing field Brussels is currently seeking to introduce between the US and Europe to avoid any regulatory arbitrage with the Dodd-Frank Act, Warringa concedes that the extra-territoriality aspect of Dodd-Frank remains an issue. The US regulation stipulates that any pension scheme that enters into an agreement with a US-based organisation or any of its global subsidiaries will be required to use central clearing for derivatives trading. Unlike in Europe, Washington has granted no exemption to pension funds, so far.

“We have been to Washington a couple of times to advocate the same exemption pension funds have been granted under EMIR,” he says. “As the matter stands now, this exemption has not been accepted by US rule makers and I feel that, if the system doesn’t get safer in the US, then parties such as APG will downscale their business with US banks.”

For now, APG will still be able to rely on the European exemption. Until this exemption lapses, the Dutch manager will progressively align its derivatives model to the EMIR rules.

“The temporary exemption to pension funds by Brussels has been granted for a maximum of six years, which gives us the opportunity to carefully study the models,” Warringa says. “In the meantime, we will continue to trade bilaterally using OTC contracts but simultaneously start going into central clearing, as we feel that the market will change drastically over the coming years due to the new regulation.”

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