The European Market Infrastructure Regulation (EMIR) - like most new legislation - has its share of critics. It will hit derivatives players, of course, who have lamented the increased costs the new rules will entail. But it could also have a deep impact on pension funds and their governance.
A number of consultants have recommended that pension funds and their asset managers take their first steps towards central clearing now, instead of waiting for the exemption granted by the European Parliament and the European Council in February to expire. As Ben Gunnee, director at Mercer Sentinel Group, says, central clearing requires “a number of operational changes” in order to interact with the clearing house and minimise the impact of additional collateral requirements.
But exactly what type of “operational changes” can pension funds implement? The answer depends on whether the fund has the resources to build its own in-house team or has put in place a liability-driven investment (LDI) strategy.
For pension funds with LDI strategies, one solution being put forward by asset managers relates to the due diligence process undertaken to select central clearing members. Andrew Giles, co-CIO at Insight Investment, says that his company has gone through a very comprehensive due diligence process with all its potential clearing members. “We have selected a panel of four members,” he says, “and we are now interacting with them to make sure all the infrastructure and paperwork is in place to enable our clients who want to clear their derivatives trades to do so.”
The fact all the documentation prepared by asset managers for current OTC trades must now be replaced by documentation matching central clearing requirements means fund managers will have no option but to streamline their legal frameworks. Gunnee says this exhaustive legal process can take several months.
The role played by clearing members is perhaps an even bigger issue. The Dutch asset manager APG - which manages assets on behalf of the €261bn civil service scheme ABP - points out that, under the current mandatory aspect of central clearing, pension funds do not deal with central clearing parties but, instead, with clearing members. “One of the reasons why we are opposed to the current EMIR requirements,” APG chief legal counsel Guus Warring explains, “is that pension funds run a huge exposure to those clearing members, which are the banks themselves.”
He strongly supports the creation of in-house teams for precisely this reason. “Not only is this advisable, it is also absolutely necessary,” Warring says. “Since the worst risk a pension fund can take is the liquidity squeeze, it should be able to manage its cash itself.” And while some managers argue that the creation of such in-house teams will be too costly for most, Gunnee argues that the cost of derivatives trades will inevitably increase under the new regulations, irrespective of the solutions adopted by counterparties.
Another responsibility asset managers have is to enable their clients access to the appropriate instruments required for central clearing. The repurchase - or repo - market is one of them, where pension funds can swap their physical assets for the cash they need to post variation margins for centrally cleared trades.
According to Laura Brown, head of solutions at Ignis, repo is a tool pension schemes should consider, even before the arrival of central clearing. “Borrowing using repo is cheaper than borrowing using swaps, which is why we have already seen schemes moving to use repo, including our largest pension client,” she says.
Unfortunately, the legal work required to agree master-repurchase agreements with a range of counterparties means pension schemes have been slow to add repo to their LDI arsenal. The task many asset managers now face is making sure their clients get access to the market and, above all, understand it.