OTC Swaps Regulation: PGGM: Keeping the faith

All asset managers running liability-driven mandates on behalf of pension funds fear that the European Market Infrastructure

Regulation (EMIR) will drastically affect their hedging strategies, which rely mainly on the derivatives. PGGM is one of them. But unlike most of its European counterparts, the €120bn Dutch asset manager focused on pension fund management for the healthcare and social work sectors, prefers to see the glass as half full rather than half empty.
Ido de Geus, head of treasury and client portfolio management, echoes the concerns of his peers when it comes to the extra costs associated with the new regulation and fears that the requirement to post variation margins in the form of cash for centrally cleared trades will hurt pension funds’ performance.

“The biggest cost relates to the fact that we will need a larger buffer of liquid assets, which are normally low yielding,” he explains. “As a long-only investor, we don’t have any cash to hand.”

He argues that “relatively cheap” liquid derivatives such as interest rate swaps (IRS) are set to become more expensive thanks to EMIR.

And de Geus’ concern about the trading of the most liquid derivatives has to do with the fact that only IRS and credit default swaps (CDS) will go into central clearing when EMIR comes into force. Other trades used by pension funds to hedge their liabilities, such as inflation swaps, will remain in the bilateral system until clearing counterparties (CCPs) offer new solutions for those deals.

According to de Geus, pension schemes and asset managers might therefore reconsider whether they want to use the most liquid products or continue to trade other derivatives over the counter.

“I am seeing a two-speed approach,” he says. “If clearing becomes a cost burden to hedge liabilities, financial institutions will opt for OTC tailor-made solutions. On the other hand, the liquid clearable market might grow, whereas the OTC tailored-made market might shrink. This means that basis risk will become larger and the business case made internally to decide between the option of having a cheaper and cleared market or a more expensive OTC tailored-made market will become more important than it currently is.”

Another option for pension funds looking for leverage in their liability-hedging strategy, according to de Geus, would be bonds purchased with cash generated through the repo market. And since pension funds will increasingly seek to use repo to swap their physical assets into cash to meet margin calls under the central clearing system, the option of using it to purchase more liability-matching bonds would not be unrealistic, de Geus suggests.
As for the potential for this extra demand to push up the cost of bond repo, de Geus remains optimistic. “I do not know what will be the consequences of such pressure on the repo market in terms of liquidity and additional costs,” he conceded. “But I actually think that there will be so many players that it might also become more and more liquid and then cheaper.”

Asked about the cost impact of other European directives such as the Capital Requirement Directive (CRD IV) – the European equivalent of Basel III – on the derivatives market, PGGM’s head of treasury prefers to look on the bright side despite soaring bid-offer spreads.

“We know that banks are reluctant to put extra risk on their books because they are going to be charged by new capital requirements under CRD IV,” he says. “[But] banks will be unlikely to pass on the entire cost of trading derivatives to end users, as the level of competition between banking institutions will strengthen.”

De Geus acknowledges the extra costs but also believes that the exemption granted by Brussels earlier this year aims to lower this same cost burden.

“I do think that all derivatives will become more expensive for all users,” he says. “We are very much in favour of a safer market but the cost must be split equally among
all participants and should not only be borne by end users such as pension funds. That’s why I think the exemption is there – so pension funds together with CCPs can find a more efficient way to trade derivatives, while Brussels can find out what will be the cost incurred by each party, whether it is a bank, an asset manager, a custodian, or whoever.”

Finally, PGGM advocates an international playing field between European and US regulations. According to de Geus, a common agreement between Brussels and Washington would help standardise the market and, therefore, contain the cost.

“I sincerely hope Brussels and Washington will find a way to acknowledge each [other’s] regulation,” de Geus concludes. “The fact is that if you start having different regulations covering different territories it becomes very inefficient and very costly. And such methods usually pushes market players to circumvent the regulation.”


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