UK - Pension funds could have suffered huge losses on their derivatives positions last week had they not demanded such tough terms on collateralisation and mark-to-market valuations, according to investment consultant Watson Wyatt.

Officials at Watson Wyatt say market conditions over the last year mean many pension funds have taken tactical decisions to delay applying interests rate and inflation rate risk derivatives to their portfolios so the level of trading in derivatives is likely to reach only £10bn among its own clients compared with £15bn in 2007.

That said, the tough stance and terms pension funds now demand when they do pay the high cost for derivatives is shown to have paid off, according to Nick Horsfall, senior investment consultant at Watson Wyatt, as pension funds' exposure to last week's market turbulence was minimal compared with where it could have been.

"We have always been pretty firm in arguing the documentation and collateral have to be robust in conditions surrounding banking defaults. And we have always been pretty insistent on counterparty diversification because if a bank goes down it take much longer to replace a large trade and the longer a replacement period the higher the cost," said Horsfall.

"We had a very small number of clients with Lehmans swap exposure. But we have learned that having tough collateralisation terms and daily mark-to-market did work because if we had not done that our clients would have lost huge amounts of money," he added.

The vast majority of Watson Wyatt's clients demand daily collateralisation on their derivatives, while a handful have weekly and fewer again have monthly collateralisation while credit quality is usually cash and gilts, supranational and AAA-rated debt.

Similarly, many contracts also have a ratings downgrade trigger giving the holder the option to terminate the contract if their credit status is reduced.

While pension funds have been paying a bid offer spread of between 10 and 20bp on inflation rate swaps for the last 18 months, said Horsfall, the interest rate bid offer spread has widened, on the back of last week's rush to replace swaps, from 1.5bp to 3bp.

"It is definitely higher post Lehmans but our expectation is it will get a big easier, even though bid offer spreads have moved from an era of low costs 18 months ago to higher," he added.

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