European Pension Funds Face OTC Derivatives Penalties

Terry Flanagan

European pension funds face seeing their derivatives trading costs soar as well as new financial reporting practices adding to their misery as the new rules, aimed at reducing risk, are set to be introduced.

Implementation of the Basel III rules, a set of global regulatory standards aimed at toughening up bank capital adequacy rules, which kick in from the start of next year, will likely conflict with regulatory pressures from the upcoming European Market Infrastructure Regulation (Emir), which will require almost all over-the-counter traded derivatives to be processed through clearing houses from the start of 2013, leaving pension funds stuck in the middle, according to new research from consultant Mercer.

It has been recognized by Emir that pension funds are typically fully invested, which makes it difficult to provide cash collateral, so they have been granted a three-year exemption to give them sufficient time to adjust. This means pension schemes will 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. Mercer says that it takes up to six months for a firm to prepare for central clearing.

“Central clearing requires a number of operational changes in order to interact with the clearing house and to minimize the impact of additional collateral requirements,” said Ben Gunnee, European director of Mercer’s Sentinel Group, a specialist team within its investment business. “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. The additional capital charges levied on counterparties will ultimately result in trading costs increasing for pension funds wishing to hedge liabilities through swaps.”

And new financial reporting rules that could treat pension funds like banks and insurers may also add to the burden for pension funds in Britain, a leading UK trade body has warned.

The National Association of Pension Funds (NAPF), which represents 1,200 pension schemes with assets of around £800 billion, said pension funds would have to disclose in their financial reports unnecessary detail about the financial instruments they use, such as derivatives and hedge funds, under proposals by the UK’s Accounting Standards Board. This would create major costs for large pension schemes with more complex investment and risk mitigation strategies and pension funds would have to comply with the same disclosure requirements as banks and insurers, despite the very different purpose for which their financial statements are prepared, argued the NAPF.

“Pension funds would face tough disclosure requirements starting from the wrong assumption that they are financial institutions like banks and insurers when in fact they are not,” said Darren Philp, policy director for the NAPF. “And, on top of that, they would face further disclosure requirements specific to them, which would raise the bar even higher.

“We support greater transparency, but these new rules will do nothing to help scheme members and their advisers. Instead, they will increase the costs for large pension funds.”

Meanwhile, the European Union’s financial services commissioner, Michel Barnier, this week announced a delay to the timetable of the Solvency II regulations for pension funds.

Barnier said revisions to the directive, aimed at reducing insolvency, would not now happen until the middle of 2013, pushing the revisions back by six months. He said it was important to conduct “first-rate quantitative impact assessments” to take into account the differences between pension systems across Europe.

Critics of the proposed reforms, which are being rolled out across the insurance sector from the beginning of 2014, say they could put an end to defined benefit schemes if the insurance regulations are used as a template for pensions across Europe due to the vastly different set-ups between insurance companies and pension schemes.

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