Groups call on BCBS and IOSCO to protect pension funds from initial margin rule


Michael Glenister

Consultation on initial margin for non-cleared swaps sees pensions focus on preventing re-hypothecation, bringing inflation under same regime as interest rate swaps and raising threshold above €8bn
Pension funds, assets managers and lobby groups have joined forces to demand that IOSCO (International Organisation of Securities Commissions) and BCBS (Basel Committee on Banking Supervision) review their existing proposals for initial margin requirements applied to non-cleared derivatives.

On February 16 this year IOSCO and BCBS issued new draft proposals, which introduced 'element 8'. That new section proposes that an €8bn threshold be applied to the regulations when they are phased in fully in 2019. That threshold would give an exemption to those trading less than €8bn notional in OTC derivatives at year end. It would mean many pension funds being outside the rules but would leave some of the larger funds subjected to the margin requirements.

Respondents called for all pension funds to be exempt in full.

'We agree that the exclusion from the initial margin requirement which applies to corporates that use derivatives for hedging purposes should equally apply to the hedging transactions of pension funds,' wrote BT Pension Scheme (BTPS), the £39bn UK defined benefit plan.

It aligned its views with that of the Federation of Dutch Pension Funds, which called for a similar exemption for pension funds.

Others argued that raising the €8bn threshold should be considered as a means of alleviating the regulatory burden on pension funds and other smaller firms that pose minimal systemic risk.

'We believe that for pension plans, the final phase in (I.e. for 2019 and beyond) of the threshold for the notional amount of uncleared swaps in which a counterparty was engaged in as of the month end of the last three months of the year should be €350 billion exclusive of hedging positions' commented the Global Pension Coalition, which included Pensions Europe, the American Benefits Council and the Pension Investment Association of Canada.

The Coalition of lobby groups also raised concerns about swap dealers failing to comply with the regulations. The group said that 'dealers should be required to disclose the methodologies, inputs and key assumption underlying such calculations.'

It said that information should be obtainable by end-users like pension funds, citing the LIBOR scandal as an example of a need for greater transparency in the calculations made by large multinational banks.

The current IOSCO-BCBS proposals indicate that those caught by the regulations will be expected to exchange initial margin on or before the date on which a swap is executed.

The Coalition suggested this would be operationally complex and would tie up pension fund assets where they would be required to source and set aside the initial margin in advance of the swap contract coming into effect. The body called for a four working day timeframe to be applied, which it argued would allow pension funds to put in place appropriate arrangements via their custodian without disruption.

Respondents also opposed the re-hypothecation of assets posted as initial margin. It would 'unnecessarily elevate counterparty risks and thereby elevate systemic risks,' the Coalition argued,

Asset management firm Cardano said that re-hypothecation of asset should not be permitted for initial margin.

'Re- hypothecation is acceptable for variation margin as there is a legal right of set-off against the market value of derivative transactions,' read Cardano's response.

'The posting of initial margin is by definition over-collateralisation which results in additional credit exposure. From a credit risk management perspective re-hypothecation of initial margin should never be acceptable and we support the principles of the consultation paper of ensuring initial margin is sufficiently protected in the event of bankruptcy.’

Banks unsurprisingly fought for their right to re-hypothecate clients assets, however.

‘Re-hypothecation should be allowed for both VM (variation margin) and IM (initial margin). Without the possibility of re-hypothecation, liquidity will be strongly impacted and raise transaction costs and potentially funding levels for end users,’ read the response of the European Banking Federation.

Other complaints from pension funds and asset managers focussed on the treatment of inflation swaps in relation to interest rate swaps. Currently the proposed regulation puts the two derivative contracts types under different initial margin regimes.

Insight Investment, the asset management firm which is part of Bank of New York Mellon (BNY Mellon), explained that ‘users will not be able to net any margin calculation across the two types of instruments. This could therefore incentivise the creation of less liquid derivatives such as real rate swaps, which we believe is not the intention of the policymakers.’

Insight recommended that the regulators reclassify inflation swaps since they are typically used alongside rate swaps as part of an overall hedging strategy. That would allow margin offsets across both instruments.

Those complaints mirrored those of others respondents including BTPS that said inflation and interest rate swaps should be classified together.

BTPS also raised concerns about pension funds being forced out of illiquid, long-term investments in an effort to source eligible collateral to post as margin. ‘The unintended consequences of pension fund inclusion in these regulations by far exceeds the potential for risk mitigation,’ read their response to the consultation

‘Unintended consequences include impacts on asset allocation such as shifts from illiquid long term investments towards short term more liquid instruments to facilitate meeting increased margin calls in times of market stress. Physical equities may also be sold in scale to facilitate increased physical holdings of inflation sensitive bonds if the cost of hedging inflation swaps remains prohibitive. Pension schemes are likely to increase their utilisation of the repo market which is a source of liquidity that is not guaranteed in times of financial market stress. This may result in pension schemes becoming hostage to systemic risk and in some conditions may exasperate it.’

Those concerns over collateral reflect similar issues which have been raised by pension funds concerned about the margin requirements which could be imposed on them under EMIR (European Markets Infrastructure Regulation) rules, which are part of the broader regulatory shift to push OTC derivative markets toward central clearing. 

Tags: inflationBCBSIOSCOSwapsinterest ratespension fundsBT Pension SchemeEBFInsightBNY MellonCardano