Early clearing means savings for pension funds

By James Carter, manager, product management, SimCorp

Since the financial crisis, almost every facet of thederivatives world has been scrutinised and subjected to new rules by globalregulatory authorities. This has pushed many financial institutions to overhaultheir internal processes, creating ways to efficiently and cost-effectivelyaccommodate this new environment.

This has been particularly evident for the European MarketInfrastructure Regulation (Emir), which introduced mandatory derivativesclearing through central counterparties (CCPs). However, the new regulation hastouched on market participants for whom it has not been so straightforward toadapt systems and processes.

For larger pension schemes, the use of derivatives to hedgecapital and to achieve diversified returns has been essential. But adhering tothese new rules generated a compliance burden that schemes were significantlyless prepared to cope with than their well-capitalised counterparts in thetrading and investment world.

These buy-side institutions, by contrast, had more scope toinvest in upgrading their technology to help them deal with the demands ofreporting and post-trade processing in line with the changed requirements.

In recognition of this, the European Securities and MarketsAuthority (Esma) originally granted a three-year exemption for pension fundsfrom the mandatory clearing of derivative transactions outlined in Emir,delaying the requirement to do so until August 2015. This would give schemestime to prepare for the changed processes, and more gradually absorb the costs associatedwith compliance. 

However, now that this date is within sight, the EuropeanCommission is calling for a further two years to give pension funds more timeto prepare for the requirements associated with centrally clearing derivativesthrough central counterparties (CCPs).

Many pension funds will be breathing a sigh of relief atthis news, giving them further time to adapt internal processes and technologyneeded for Emir compliance. Nonetheless, while it may be viewed as a stay ofexecution, there is a strong commercial case for pension funds to beginvoluntary clearing of derivatives, which are an essential part of many schemes’hedging arrangements, before it becomes mandatory.

There is no doubt that compliance will carry costs, which iswhy some funds are reluctant to begin voluntary clearing before they areobligated. However, these costs are not going to fall the longer that schemesdelay central clearing; indeed, the sooner it is adopted, the more costefficient it could potentially be.

Non-cleared transactions – aka bilateral trades – are higherrisk so more collateral must be posted against them. In addition, dealing witha CCP can reduce costs for a scheme, as it can net all margin requirementsacross related to outstanding contracts, and even across exchange tradedcontracts in the portfolio. This means a fund will potentially have to postless initial margin or collateral overall.

What’s more, many schemes are finding there is betterliquidity for cleared transactions as there are more market-makers, so thesecontracts may be preferential, from a pricing perspective, to their bilaterallytraded counterparts. This will not necessarily continue once all participantshave come to market.

In addition to this, there are further benefits for schemeswhich begin voluntary clearing now. Project risk is a significant factor forparticipants who leave clearing implementation to nearer the official deadline.A last minute rush could potentially beset market institutions such as CCPs,seeing them overwhelmed as the deadline approaches.

Complying now and engaging with CCPs will also give schemesmore time to weed out any operational shortcomings without the pressure of animminent regulatory deadline. Central clearing, as outlined in Emir, carries anotable burden in terms of reporting requirements and collateralmanagement. 

In many cases, this will create new technological demands,and these could take significant time to implement and solve – not to mentionbudget too. Schemes may also find that creating an automated and efficienttechnology platform that can cope with derivatives requirements creates othercost savings associated with the reduction in manual processes.

In the interim, internal compliance managers are likely tobe more amenable to investment managers’ trading activity in derivatives wherecleared contracts are used, again due to the lower risks associated withcleared transactions. At a time when schemes are broadening the scope of theirinvestments in an environment of low returns, greater flexibility in the toolsthat can be used to achieve returns could prove to be extremely valuable.

It is an inevitable fact that complying with Emir will becostly, but there are ways schemes can mitigate these costs and gain advantagesby complying now. Ultimately, pension funds stand to gain a significant benefitfrom acting early, by getting ahead of the curve on compliance.