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New rules may disrupt pension scheme trading programmes and adversely affect investment performance unless appropriate preparation is undertaken
Capital charges on banks brought on by new banking regulations (known as Basel III) could cause significant cost and operational impact for European pension funds that use over the counter (OTC) derivatives programmes, according to Mercer. The issue is caused by the conflicting regulatory pressures of Basel III and the European Market Infrastructure Regulation (EMIR).
Following the collapse of Lehman Brothers in 2008, central governments, concerned about the level of counterparty risk in the OTC derivatives market, introduced new regulations (EMIR) due to come into effect in 2013. The regulations require interest rate swaps and credit default swaps to be cleared through central exchanges, known as clearing houses. One intention is to improve transparency such that the extent of derivative positions is known, which should aid counterparty risk management. There is also a drive to improve liquidity in severe market conditions, so all cleared trades will be required to be supported by cash or near-cash collateral. It was recognised by EMIR that pension funds are typically fully invested which could make it difficult to provide cash collateral - so they have been granted a three-year exemption to give them sufficient time to adjust. This allows pension schemes to continue to trade derivatives on an OTC basis under existing bilateral agreements with counterparties while they prepare for central clearing.
However, Basel III imposes additional capital charges on banks conducting OTC derivative trades, particularly those trades outside central clearing. Mercer believes that banks are likely to pass on these costs to institutional investors so it could be significantly more expensive for pension schemes to trade with banks on a bilateral basis. This could make existing bilateral trades highly uneconomic and effectively force pension funds into central clearing.
“Central clearing requires a number of operational changes in order to interact with the clearing house and to minimise the impact of additional collateral requirements,” said Ben Gunnee, European Director of Mercer’s Sentinel Group. “As most schemes presume they are exempt from central clearing, they have not made preparations to participate.
“Those schemes that try to undertake hedging strategies using interest rate swaps outside central clearing may find the cost prohibitively expensive under the new regulations,” Mr Gunnee continued. “The additional capital charges levied on counterparties will ultimately result in trading costs increasing for pension funds wishing to hedge liabilities through swaps.”
According to Mercer, preparing for central clearing can take up to six months so the consultancy is advising pension schemes to begin the process sooner rather than later to ensure that trading is not disrupted and that costs are kept down.
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