Risk mitigation for OTC Derivative contracts: Sackers’ response

Background

Sackers’ has responded to the European Securities and Markets Authority (ESMA) on it’s Consultation Paper, Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012.

In our response we have focused solely on the impact of the concentration limits on UK DB pension schemes. These pension schemes are financial counterparties for the purposes of Regulation (EU) No 648/2012 and will therefore be directly affected by the proposed collateral rules. We are a law firm specialising in advising the pension industry. While a significant number of our clients are DB pension schemes, we are not responding on behalf of any particular pension scheme. To give some context to the size of this user group – based on available data, we estimate that at least 83 of the 233 largest schemes (ie schemes with over £1bn of assets) enter directly into derivative transactions. But we know that a considerable number of smaller schemes are also direct users of derivatives.  We can see a general trend towards more pension schemes becoming active users of derivatives as the UK Pensions Regulator encourages pension schemes to de-risk.

Question 5

The consultation paper asked, at Questions 5:

“How would the introduction of concentration limits impact the management of collateral (please provide if possible quantitative information)? Are there arguments for exempting specific securities from concentration limits and how could negative effects be mitigated? What are the pros and cons of exempting securities issued by the governments or central banks of the same jurisdiction? Should proportionality requirements be introduced, if yes, how should these be calibrated to prevent liquidation issued under stressed market conditions?”

De-risking has been a major driver over last years in reshaping pension schemes’ investment strategy. Put simply, most pension schemes are trying to match their respective Stirling pension liabilities with Stirling income yielding assets. It is worth noting that pension liabilities tend to be inflation-linked. This has resulted in substantial gilt holdings by pension schemes. Pension schemes use derivatives to manage the interest and inflation risk between their liabilities and assets.

Over recent years pension schemes and their bank derivative counterparties have put a lot of effort into simplifying their agreed collateral terms for derivative transactions. The general trend has been to reduce the universe of eligible collateral to Sterling cash and gilts only, reflecting the trend towards significant gilt holdings. The impact of the concentration limits will be that 50% of collateral will have to be provided in the form of cash. Widening the eligible collateral terms, and thus requiring pension schemes to hold assets which they would otherwise not hold, would work against matching liabilities with assets.

Pension schemes will therefore either have to increase their general cash holdings or use repos temporarily to access cash in order to manage collateral calls. A general increase in cash holdings will come at a lower investment return to pension schemes. If pension schemes have to resort to repo transactions in order to manage their collateral positions then this will come at a cost and introduce additional counterparty credit risk. Neither consequence is desirable for either the employer sponsoring the pension scheme or the ultimate beneficiaries of the pension schemes, the individual pensioner.