Bearing the brunt of margin calls
Earlier this year, the industry cheered as Brussels granted pension funds a temporary exemption from the European Market Infrastructure Regulation (EMIR). Yet concerns over the impact of the regulation on funds persist, reprieve notwithstanding.
The latest issues stems from two main requirements mentioned by the European Securities and Markets Authority (ESMA) in its discussion paper on the draft technical standards for the regulation on OTC derivatives, CCPs and trade repositories. The first has to do with the ‘confidence interval', which refers to the CCP's level of confidence when determining the amount of initial margin it may need to collect for cleared OTC trades. A previous consultation on margin requirements for non-centrally cleared derivatives by the International Organization of Securities Commissions and the Basel Committee on Banking Supervision already called on CCPs to calculate initial margin using a value-at-risk model at a confidence level of 99%. This, they said, would ensure sufficient margin when it was most needed and limit pro-cyclicality. ESMA, however, was required by Brussels to define the "appropriate" percentage above the minimum 99% confidence level set for centrally cleared trades, since it considers OTC derivatives to be less liquid and riskier than contracts traded on exchanges.
Clearly, not everyone agrees with this. For the Dutch Pension Federation, the distinction between cleared and non-cleared derivatives is "not very logical". It adds: "This distinction does not seem to be the appropriate criterion for determining the confidence interval - it is not properly motivated, and, at the very least, it is open to different interpretation."
But it was the level of confidence itself set by ESMA - 99.5% - that really irked some in the industry. Pension funds worry that, if the level is lifted too high, CCPs might increase the volume of collateral they request from clients. The Dutch Pension Federation estimates that a confidence level of 99.5% would increase initial margin for the end user by nearly 23%. "These costs," it says, "will be at the detriment of the pensioners we represent." This, in turn, could reduce the take-up of cleared derivatives by pension schemes for their hedging strategies.
Another concern relates to arbitrage arising from differences between US and European rules. The Investment Management Association points out that such differences in initial-margin calculations between the two areas would create a "disincentive" to clear through European CCPs.
The second possible risk arising from the EMIR relates to ‘rehypothecation'. This enables CCPs to reuse the collateral posted by their clients to back their own trades and borrowings. Some experts have warned that such a strategy could lead to an increase in systemic risk, with pension funds bearing the brunt of any losses. Again, the Pension Federation warns: "If a CCP goes bankrupt, the non-cash collateral - mostly government bonds in our case - could be seen as being part of the bankruptcy estate of the CCP." In the UK, the BT Pension Scheme has called on ESMA to restrict CCPs from reusing non-cash collateral posted with them. Such non-cash collateral, it says, should be held with the custodian in the name of the posting entity, with a security interest provided to the CCP.
However, one could argue that preventing CCPs to rehypothecate the non-cash collaterals would discourage them from covering their own liabilities in further transactions. Additionally, the potential mandatory aspect of segregated accounts held with the custodian would increase the cost of doing business for CCPs. This, in turn, might push CCPs to increase the level of margin requirements posted by pension funds to compensate the losses incurred by the lack of rehypothecation, leading to extra costs for pension funds and, ultimately, their participants.