March 2013


AlchemyPension funds with liability-driven investment strategies may have to consider turning lower quality assets into higher grade stuff as central clearing for OTC derivatives takes hold, writes Nick Fitzpatrick. If investors are smarter about the way they manage collateral compared with when Lehman Brothers collapsed, they should be able to share a few gems of wisdom about it. Here is an example: if given the option, post corporate bonds as collateral and save your cash. This is what Ted Leveroni, executive director of derivatives strategy and external relations at Omgeo, offers. What’s so smart about that? “Almost every collateral call can be satisfied with cash. In fact, there are many that will only use cash. So if a collateral receiver lets you post a corporate bond, use it.” The collapse of Lehman Brothers in 2008 revealed the fragility of counterparty relationships in the over-the-counter (OTC) derivatives market and so national and regional regulators have sought to strengthen the market by introducing a requirement for central clearing. This is expressed through rules like the European Market Infrastructure Regulation (Emir). The centrally cleared regime starts to take hold this year and under it, central counterparties (CCPs) will require high-quality collateral – government bonds and cash – to clear OTC derivatives. Also, investors will now have to provide a buffer. A scarcity of high-quality collateral – particularly cash and government bonds – is expected. Among the numerous market actors to be hit would be pension schemes that operate liability-driven investment (LDI) strategies. OTC swaps are heavily used in these strategies. An LDI mandate can last for 30 to 40 years. Alex Soulsby, head of derivative fund management at London-listed F&C Asset Management, says: “The effect will be big because an LDI mandate tends to be a large position relative to the size of a pension fund and it is directional [it does not net against other derivatives], which requires a meaningful size of collateral.” Collateral is used in LDI mandates to allow for a change in the value of a liability hedge. To use proxy figures, if the hedge is 100 and falls to 90, the scheme only has to cover the loss of ten. But Soulsby says in a centrally cleared world a scheme would also have to put more collateral down as a buffer. For example, ten upfront and then another ten to cover the potential loss. “Liability hedges are marked-to-market. To cover these day-to-day changes, a scheme would need to hold more cash,” says Soulsby. It is cash and highly rated government bonds, such as UK gilts, that the CCPs will draw into themselves in the centrally cleared environment. Lucy Barron, LDI solutions strategist at Axa Investment Managers, says: “[UK] pension funds have a lot of gilts so this is not in itself an issue. However, when combined with ongoing margin requirements to reflect movements in the value of derivatives it means more assets will need to be held in eligible collateral than at present.” Pension funds that hold mostly riskier assets, like equities, are more likely to find the centrally cleared environment difficult. Leveroni says: “Pension funds have a lot of assets that are tied to their own investment strategy and which may not align with a CCP’s collateral requirements.” Fund managers like Axa and F&C have taken measures to prepare. Various asset servicing providers, such as custody banks and Omgeo, which is a post-trade automation provider, have third-party services to offer fund managers that do not have their own facilities. Part of this collateral management process is collateral transformation – essentially turning lower quality assets into higher quality, CCP-eligible collateral. Barron says asset managers that can, will typically offer treasury services or repo to help clients. “Repo is already used extensively in LDI strategies. Pension funds can repo their gilts in return for cash from the counterparty. If they have a lot of corporate bonds, these can also be repoed for gilts or cash.” Repo is a major type of collateral transformation. Barron says Axa has a trading and securities finance team that works on LDI mandates and can help clients meet additional cash and gilt requirements. Soulsby says F&C brought in its liquidity management team to the LDI area last year.  “There is a greater focus on liquidity in the derivatives world now and more focus on derivatives in the liquidity world when we work out what pension schemes can hold.” EARLY CLEARING
Pension funds have an exemption from central clearing under Emir for at least another two and a half years, but Barron thinks some pension funds might see an advantage in initiating central clearing ahead of time. “We believe it is highly likely that a significant number of pension funds may even decide to clear in advance of the deadline,” she says. This is because of the upcoming banking regulations, like Basel III. Banks will have to provide a lot less capital if they clear derivatives centrally rather then execute bilateral trades, which are not cleared. There is expected to be a cost differential between cleared and uncleared instruments that will be passed on to end users. “It is likely to make cleared derivatives cheaper than non-cleared derivatives for investors,” Barron adds. She also adds it is unclear if pension funds in a pooled fund with OTC market involvement qualify for the same exemption. Meanwhile, Leveroni points out pension funds that have high quality sovereign bonds but do not need them can get involved on the other side of a transformation deal and gain revenue. “There is an opportunity in collateral transformation for pension funds that hold sovereign debt.” He also points out that collateral “scarcity is very realistic”, but that regulators are carefully looking at it and are aware of hurting the markets. Leveroni adds some CCPs have extended the list of eligible assets to certain corporate debt, while the derivatives industry is looking at the “futurisation” of swaps – futures with lower collateral requirements than swaps. ©2013 funds europe

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