Having temporarily escaped the costs of the European markets and infrastructure regulation (Emir), pensions funds will be hit, indirectly, by the Capital Requirements Directive 4 (CRD 4). Although Emir is still not finalised – negotiations between the European Commission (EC), European Parliament and the Council of the European Union continue – as it stands, it will impose central clearing for the vast majority of over-the-counter (OTC) derivatives trades.
The regulation supports the Group of 20 (G20) countries’ resolution to centrally clear OTC derivatives to reduce the systemic risk it felt exists in the bilateral trading model.
However, in recognition of the lack of risk that pension funds pose to the market through their use of derivatives purely as hedging against their one-way, long-only investment strategies, the transactions of these funds have been granted an exemption, for three years, from having to be centrally cleared.
“Risk will not become systemic when one is dealing with pension funds,” explains Sharon Bowles MEP, chair of the European Parliament’s Economic and Monetary Affairs Committee. “I made a point in Emir about considering the credit worthiness of a counterparty and we think the pension funds are pretty sound.”
Although Emir represents only one part of the European response to the G20 mandate, various pieces of regulation are being used to impose the other systemic changes that it proposed. Mifid II is being used to migrate bilateral trading onto electronic platforms and CRD 4 is reinforcing the commitment that “Non-centrally cleared contracts should be subject to higher capital requirements.”
There’s the rub
It is not hard to see the problem that the last part of the G20’s statement causes for pension funds, if their trades are not centrally cleared. Although CRD 4 applies to banks and not to pension funds, the banks are in no doubt as to how they will pay for the charges levied on them for non-cleared trades.
“The dealers are lobbying hard to make the point that CRD 4 is so punitive on them, they will have to pass on the costs to their clients,” says Jacqueline Walsh, group derivatives operational officer at F&C.
Bas Zebregs, senior legal counsel for Dutch fund manager APG Asset Management, adds: “All of this regulation was developed from the perspective of systemic risk.
“It appears that the rule makers did not look at the impact on end users and the fact that there are all kinds of end users. They intend to punish the banks, but they end up punishing the man in the street.”
The details of CRD4 are still being finalised, which makes it hard for dealers to predict exactly what the costs for bilateral trading will entail Walsh notes, however Zöhre Tali, responsible for APG Asset Management’s lobby on Emir, says that they are clear the costs of CRD4 will be far higher than for central clearing, making the exemption valueless if the proposal for the European Capital Requirements Regulation is not amended to reflect the outcome of pension funds’ lobby in Emir.
Anthony Kirby, director regulatory reform and risk management, at consultancy Ernst & Young, says, “The standard risk weighting for centrally clearing trades under Emir about 2%; it is likely to be around three to five times that level for non-cleared trades."
“It may be that we won an exemption but from an overall cost perspective, we haven’t won a lot,” notes Zebregs.
Walsh says that in the worst case scenario some smaller houses may not be able to afford to use derivatives.
“We’ve got to make sure that doesn’t happen,” she says, “Hedging is critical. But with bilateral trading more expensive than central clearing, and central clearing more expensive than bilateral trading had been prior to Emir, can everybody afford to hedge?”
Making the case
CRD 4 will go live on 1 January 2013 and there is no current expectation that the date will move, in the way that Dodd-Frank or Emir have done this year, warns Walsh.
“Firms have got a year to lobby, to have their message taken on board and to be written up, into detailed rules,” she says. “Given that we are 16 months into OTC clearing lobbying and discussions and we are half-way to completion... I spoke to a bank today and asked them if they thought CRD 4 would be sorted out before it went live and they said ‘No’. They think it is going to go live with problems in it.”
Although rules have been under discussion for some time, the sheer scale of regulatory change is leaving some firms struggling to keep on top of the cumulative effects. With CRD 4, the Dodd-Frank Act, Emir, the alternative investment fund managers directive (AIFMD), Mifid II, and restrictions on short selling, the financial industry appears to be getting a “regulatory whitewash” Walsh adds.
Tali notes that the European Parliament has already acknowledged the impact of the capital requirements and the problems it will cause.
“We hope that there is still time to lobby for change,” she says. “We have submitted a position paper to the European Parliament and we have talked to officials; we are waiting on the results of the Emir trialogue and we are hopeful it will contain something that allows us to avoid the cost impact of the capital requirements on non-cleared OTC derivatives trades.”
There are still differences between the Parliament’s text and the Council’s text, the former allowing the exemption until it is cancelled, the latter fixing the cut-off date, which must be resolved before Emir is finalised. Bowles has said that she will introduce an amendment to save the pension funds from losing out on the exemption via CRD 4, although that would have to be agreed by both legislative bodies.
The challenge will be to allow the pension funds a reprieve, without granting the same freedom for the banks who are deliberately being targeted by CRD 4.
“You can have one-way exemptions – currently a sovereign is exempt from collateralising but a bank is not,” Bowles explains.
However she acknowledges that having one-sided agreements can be a bad idea, pointing to the collapse of Lehman Brothers as an example.
“The ISDA contracts at the time were asymmetric because they allowed the investment bank to assume it would not fall, but hedge funds would,” she observes. “When the bank collapsed a lot of hedge funds were burnt because they did not have any recourse. So I would agree it’s a bad idea to have asymmetry, and so if it is there we will have to make it clear why it works.”
“It is a shame that the EC didn’t engage with this earlier, because if there is a problem that cannot be resolved with CRD 4 and therefore Emir, we would have addressed it in a different way from the start,” she continues. “It is urgent that we make these things join up.”