By James Carter, manager, product
Since the financial crisis, almost every
facet of the derivatives world has been scrutinised and
subjected to new rules by global regulatory authorities. This
has pushed many financial institutions to overhaul their
internal processes, creating ways to efficiently and
cost-effectively accommodate this new environment.
This has been particularly evident for the
European Market Infrastructure Regulation (Emir), which
introduced mandatory derivatives clearing through central
counterparties (CCPs). However, the new regulation has touched
on market participants for whom it has not been so
straightforward to adapt systems and processes.
For larger pension schemes, the use of
derivatives to hedge capital and to achieve diversified returns
has been essential. But adhering to these new rules generated a
compliance burden that schemes were significantly less prepared
to cope with than their well-capitalised counterparts in the
trading and investment world.
These buy-side institutions, by contrast,
had more scope to invest in upgrading their technology to help
them deal with the demands of reporting and post-trade
processing in line with the changed requirements.
In recognition of this, the European
Securities and Markets Authority (Esma) originally granted a
three-year exemption for pension funds from the mandatory
clearing of derivative transactions outlined in Emir, delaying
the requirement to do so until August 2015. This would give
schemes time to prepare for the changed processes, and more
gradually absorb the costs associated with
However, now that this date is within
sight, the European Commission is calling for a further two
years to give pension funds more time to prepare for the
requirements associated with centrally clearing derivatives
through central counterparties (CCPs).
Many pension funds will be breathing a
sigh of relief at this news, giving them further time to adapt
internal processes and technology needed for Emir compliance.
Nonetheless, while it may be viewed as a stay of execution,
there is a strong commercial case for pension funds to begin
voluntary clearing of derivatives, which are an essential part
of many schemes’ hedging arrangements, before it
There is no doubt that compliance will
carry costs, which is why some funds are reluctant to begin
voluntary clearing before they are obligated. However, these
costs are not going to fall the longer that schemes delay
central clearing; indeed, the sooner it is adopted, the more
cost efficient it could potentially be.
Non-cleared transactions – aka
bilateral trades – are higher risk so more collateral
must be posted against them. In addition, dealing with a CCP
can reduce costs for a scheme, as it can net all margin
requirements across related to outstanding contracts, and even
across exchange traded contracts in the portfolio. This means a
fund will potentially have to post less initial margin or
What’s more, many schemes are
finding there is better liquidity for cleared transactions as
there are more market-makers, so these contracts may be
preferential, from a pricing perspective, to their bilaterally
traded counterparts. This will not necessarily continue once
all participants have come to market.
In addition to this, there are further
benefits for schemes which begin voluntary clearing now.
Project risk is a significant factor for participants 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 schemes more time to weed out any operational
shortcomings without the pressure of an imminent regulatory
deadline. Central clearing, as outlined in Emir, carries a
notable burden in terms of reporting requirements and
In many cases, this will create new
technological demands, and these could take significant time to
implement and solve – not to mention budget too.
Schemes may also find that creating an automated and efficient
technology platform that can cope with derivatives requirements
creates other cost savings associated with the reduction in
In the interim, internal compliance
managers are likely to be more amenable to investment
managers’ trading activity in derivatives where
cleared contracts are used, again due to the lower risks
associated with cleared transactions. At a time when schemes
are broadening the scope of their investments in an environment
of low returns, greater flexibility in the tools that can be
used to achieve returns could prove to be extremely
It is an inevitable fact that complying
with Emir will be costly, but there are ways schemes can
mitigate these costs and gain advantages by complying now.
Ultimately, pension funds stand to gain a significant benefit
from acting early, by getting ahead of the curve on