As a result of a new regulatory framework for derivatives, pension funds will need to come up with much more collateral than before. They will face multiple challenges to get the correct collateral in the right place at the right time. In preparation for this changing environment, pension funds need to answer three important questions:
• What demands for collateral can I expect in the future?
• Do I have enough collateral available to fulfill these demands?
• What infrastructure do I need to meet these demands in time?
Only after pension funds have full insight in these questions, can they start to think about optimisation.
To answer the first question we need to take a look at the derivative positions of the average Dutch pension fund. The Dutch regulatory framework (FTK) incentivises pension funds to hedge their interest rate, inflation and currency risks. The use of large derivative overlays is unavoidable. Pension funds already hold buffers to fulfill variation margin requirements in all circumstances. Based on stress scenarios, on average 10% of the asset base must be held available to post as variation margin.
The European Market Infrastructure Regulation (EMIR) requires even more collateral to be posted against these derivatives. The average Dutch pension fund will be required to post about 10-15% of its total assets as initial margin, either bilaterally or with a central counterparty (CCP). In the case of a CCP, this amount can become even higher, because clearing members demand the right to ask for additional collateral at short notice, preferably without any specific trigger. The amount of additional collateral varies per pension fund and per clearing member – but it is at least as high as the already posted initial margin, which means that pension funds need to hold another 10-15% of their total asset base in high quality assets for this contingency.
Adding that all together, pension funds will be required to hold 30-40% of their assets in high quality liquid assets. So the answer to the first question is that roughly one-third of a pension fund’s total asset base must consist of eligible collateral, or assets that can be transformed to eligible collateral quickly. Coincidently, this is roughly equal to the average allocation to fixed income by Dutch pension funds. The conclusion, therefore, is that pension funds will probably have just enough collateral at hand, but are not in a position to provide collateral to the market for collateral transformation purposes – they need it themselves.
Having ‘just enough’ collateral implies a very thin balance for pension funds, with very little room to manoeuvre. Simply enlarging the allocation to fixed income is not feasible. Investment returns have been under pressure and a larger allocation to fixed income will bring them down even further. With pension premiums already at historical highs, and with some funds forced to cut pensions, lower expected returns are not an option.
The first two questions are relatively straightforward to answer as they can be quantified. The third is more complicated but should not be underestimated. This is about the ability to move eligible collateral quickly enough to meet demand. You can have enough eligible collateral, but when you are not able to get it at the right place at the right time you still have a problem – especially with central clearing, where collateral needs to be posted immediately.
Typically, the fixed-income portfolio of a pension fund is spread over multiple mandates and sits with multiple custodians. So the first challenge is to get complete oversight over the entire pool of eligible collateral. Custodians and third party collateral providers will play an important role here. They will need to give full insight into what (potential) collateral sits where. And, more importantly, they will need to provide systems that make the transfer of collateral as quick and automated as possible.
A proper collateral management system is sometimes compared to the cockpit of a plane. When the pilot moves the control stick he expects the plane to react instantaneously; he should not have to wait for two business days before instructions take effect.
After a pension fund has full insight in what collateral sits where and is able to move it, the following question arises: What collateral do I post where? This is the optimisation question.
Optimisation is not just about gaining a few basis points by posting the ‘cheapest-to-deliver’. It is much more than that. Optimisation is, in my opinion, more about risk management. As stated before, in the future pension funds will need to post vast amounts as initial margins. Active management of these posted initial margins will be necessary. For example, when you post your most liquid assets as initial margin, how much liquidity are you left with for regular liquidity needs? On the other hand, if you choose to post illiquid but still eligible assets you will face higher haircuts and tighter concentration limits.
Typical risks that arise from having to post large initial margins and that need to be addressed include:
• Liquidity risk – do I still have enough liquidity at hand to meet all demands?
• Concentration risk – am I overly exposed to one single issuer?
• ‘Wrong-way’ risk – is there a strong correlation between the collateral and counterparty?
• Roll-over risk – from posting short-term T-bills as collateral under 30-year swaps.
To manage these risks, an active collateral management desk must have the right tools to stir the collateral. Apart from the aforementioned insight, collateral transformation will also be a very important tool. I advise pension funds to be connected to some form of collateral transformation mechanism – the repo market and securities lending being the natural candidates. Only then will they be in a better position to optimise their collateral management and to manage the associated risks.
An active repo desk will be very important. Even though pension funds might have enough collateral in absolute terms, they might not have the right type of collateral available. In those circumstances, it is necessary to exchange one type of collateral for the other. Moreover, in stressed markets the repo market can prove to be an indispensible life vest – assuming that it remains open.
In conclusion, pension funds will first need to take a close look at their potential need for collateral and whether they will have enough high quality assets available.
Thirdly, they will need to manage the risks that come with collateral management.
Lastly, they should have access to the repo market, or at least to some form of collateral transformation service. These are the minimum requirements to make sure all margin calls will be met in time, every time.
Ido de Geus is head of treasury and client portfolio management at PGGM Investment
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