EUROPE - European pension funds are largely unaware of the impact regulatory proposals to clear over the counter derivatives (OTCs) through central counterparties (CCPs) could have on them, according to BNP Paribas Investment Partners' head of LDI and fiduciary management, Anton Wouters.
Following a 2009 agreement by the G20 that OTCs should be CCP-cleared by the end of 2012, the adoption of OTC clearing rules in the US Dodd-Frank Act and a series of consultations through 2009 and 2010, the European Commission issued a proposal for a regulation of the European Parliament and of the Council on OTC Derivatives, central counterparties and trade repositories in September.
The proposal would confer new powers on the European Securities and Markets Authority (ESMA) to determine, in collaboration with national authorities, which OTCs should meet the definition of 'standardised' that would require them to be centrally cleared - with a view that the process should "ensure that as many OTC contracts as possible will be cleared".
Following consultation, the proposal describes an exemption for "non-financial (corporate) counterparties" whose derivatives activities are "directly linked to their commercial activity rather than speculation", unless their positions reach "a threshold and are considered to be systemically important".
Examples of non-financial participants given were "energy suppliers that sell future production, agricultural firms fixing the price at which they are going to sell their crops, airlines fixing the price of their future fuel purchases or any commercial companies that must legitimately hedge the risk arising from their specific activity".
It remains unclear whether or not pension funds that use interest rate swaps to hedge their liability risks would be classified as "non-financial" counterparties, or even if they were, how many might breach the regulation's as-yet undefined thresholds.
Wouters, speaking to IPE this week, said there was no doubt a move to centrally cleared OTCs would increase transparency, and he was hopeful that liquidity in long-dated swaps would not be compromised.
"It would not be a real problem for our LDI business, but I'm a little afraid it will increase costs," he said. "One of attractions of OTC derivatives is that they are pretty cost-efficient.
"The problem is with collateral in margin accounts. We have all sorts of mandates in which we provide government bonds as collateral rather than cash. If clearing houses ask for cash in the margin accounts, we will have to free that up from investments and live with very low interest rates on it. These are all hidden costs that would make the use of derivatives much less attractive than it is now."
Wouter's comments echo those of other bodies that have responded to the Commission's proposal.
The UK's National Association of Pension Funds was early to "insist" that the non-financial exemption should be available to pension schemes and warn of the threat of increased costs and reduced risk mitigation options.
It, too, pointed to CCPs' "much increased, and more restrictive, margining requirements", and observed that pension funds could find themselves as substantial contributors to the total margin posted to CCPs and therefore substantial bearers of these costs.
Its response to consultation in July 2010 noted: "This would represent the pension industry funding a central clearing process designed to reduce systemic risk caused by other market participants."
Even the European Economic and Social Committee (EESC), which "warmly welcomed" the Commission's proposal in its February 2011 response, warned against "overstressing the benefits that CCPs can bring" in the short term and the "risk of limiting the array of instruments available and pushing up the transaction costs involved in financial activity".
Furthermore, a recent working paper by Manmohan Singh for the International Monetary Fund questioned whether clearing OTCs through CCPs would mitigate systemic risk rather than simply shifting it - and even raised the possibility that CCPs "may be too-big-to-fail entities in the making".
Wouters commented on the irony that it would be banks setting up these new CCPs.
"The regulation will be sending organisations that had nothing to do with the crisis, that use derivatives mostly for hedging, into the arms of those who caused the whole mess by using derivatives to speculate," he said.
Asked if the pensions industry had been active enough in engaging with the legislative process on OTCs, he said: "To be frank, a lot of pension funds are simply unaware that they are being pinpointed as financial counterparties under this rule.
"As a service provider, we are trying to estimate the potential costs for our clients, but in general they probably are not aware what the impact on them could be."
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