GLOBAL - Pension funds struggling to find returns in the traditional equity and bond markets could find additional returns in liquidity swaps, as institutional investors have been relatively spared from new regulations coming into the market.

Unlike bank swaps, which are closely scrutinised by the Financial Services Authority (FSA) as they grow increasingly popular, deals involving pension funds and other large institutions have been exempted from the same rules so far, according to the Government Actuary's Department (GAD).

As a result, pension schemes should take advantage of the current regulatory framework for institutional investors to find opportunities in the liquidity swap market, the GAD said.

"Other institutions such as insurance companies and pension schemes often have large investments in high-quality liquid assets, which are currently providing relatively low yields," it added.

"Typically, cash requirements for these institutions are more predictable than for banks, and, hence, they are in a position to reduce their available liquidity in search of additional yield.

"Liquidity swaps, therefore, provide banks with access to the liquidity they seek and provide other financial institutions with an additional source of return."

Chris Demarco, principal at Aon Hewitt, added: "Pension funds that hold indexed-linked gilts will be holding them over a long period of time and lend them out to a bank. The bank will then turn them into cash by going to the repo market or the Bank of England.

"In the current context, pension schemes are desperate for returns. If they sit on such securities for a long period of time, they can therefore see their return increase significantly."

According to Demarco, the reason pension schemes in the UK are taking such a position is because these securities match pensioners' liabilities.

In July, the FSA published a report in which it said the level of potential demand for liquidity swaps had raised its concern about increased systemic risk.

The watchdog said: "This will need to be balanced against benefits such as increased lending capacity of banks to the general economy, to the extent that the increased lending is economical.

"In the light of this, we consider it necessary to issue general guidance to mitigate potential threats that liquidity swaps may pose to our objectives of financial stability and consumer protection."

According to the FSA, deals involving insurers providing liquidity to banks could lead to serious damage in financial markets.

The key concern is that allowing liquidity swaps to go ahead unchecked causes significant interconnectedness between the banking and insurance markets.

This could create a mechanism by which systemic risk is transmitted across the financial system, the FSA said.

Demarco added: "The risk is the same for pension funds. Schemes have to be aware of the potential risks arising with transactions where the collateral and the counterparty are correlated."

At the moment, transactions on a bilateral basis are only available for large pension schemes due to the amounts of capital involved.

However, the launch of pooled opportunities in the future might help reduce the cost and therefore encourage smaller pension funds to enter into those deals, Demarco said.