New collateral rule for OTC derivatives with potentially far reaching consequences for pension schemes

Introduction

The European Regulators, ESMA, EBA, and EIOPA, are consulting on the draft Regulatory Technical Standards (RTS) on risk mitigation techniques for over the counter derivative contracts (OTCs) not cleared by central counterparties (CCPs) for the purposes of the European Markets Infrastructure Regulation (EMIR) – see the consultation paper published by ESMA, EBA and EIOPA on 14 April 2014.

Key issue

The RTS propose that OTC derivatives will have to be margined with diversified collateral pools. This could have an impact on pension schemes which typically have collateralised OTC derivatives using cash and/or gilts. The new rules will add to the challenge of managing collateral in the context of LDIportfolios, finding collateral pools to back longevity swaps and manage exposures on other OTC derivatives typically used by pension schemes such as “Total Return Swaps”. The Regulators have identified this as an area of potential concern and are looking for industry feedback by 14 July 2014.

Background

EMIR is a European Union regulation which aims to strengthen the market for OTC Derivatives. You can find more information on EMIR here.
Under Article 11(3) of EMIR, which deals with non-cleared OTC derivatives, financial counterparties (which includes pension schemes) must have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts
Regulators were required to develop technical standards which set out in more detail how these obligations are to be complied with in practice. This is what the RTS do.
In particular, the RTS sets out:
- the criteria for having to provide “Initial Margin” (an amount of collateral provided at the outset of a derivative transaction which is intended to provide an additional buffer for changes in value after a default before a transaction can be terminated. Under an ISDA Credit Support Annex (CSA) this would be the Independent Amount)
- the criteria for having to provide “Variation Margin” (an amount of collateral reflecting the exposure of one party to the other as result of changes in the mark-to-market value of a derivative transaction)
- the frequency of collateral transfers
- the valuation methodologies for Initial Margin
- the list of eligible collateral
- operational and technical capabilities which parties need to demonstrate as part of their risk management procedures and ability to exchange collateral
- requirements for receivers of collateral to assess the credit quality of the collateral
- eligibility criteria for collateral
- concentration limits for initial and variation margin

Issues for pension schemes

We expect the obligations to come into force in early 2015.

Concentration Limits

In our view, this is probably the most important (and potentially detrimental) provision. Pension schemes would have to observe concentration limits when posting (and receiving) collateral. We have summarised the list of eligible collateral and the applicable concentration limits here.

An obvious example is that, if these limits apply, pension schemes could only collateralise up to 50% of a counterparty’s OTC exposure to the pension scheme with gilts. The rest would have to be made up of, for example, cash or some other form of eligible collateral. This can make managing collateral for LDI portfolios more complex when combined with the margin rules for cleared derivatives (which normally require (a) Initial Margin in the form of cash or gilts and (b) Variation Margin in the form of cash). LDI portfolios tend to comprise cash and gilts. As a result, access to cash for collateral purposes will need to be managed for both OTC and cleared derivatives.

Longevity Swaps which typically are backed by a specific pool of assets (often cash and gilts) would also be impacted by these rules were large exposures to arise. The Regulators are alert to this issue.

No Initial Margin

Pension schemes are unlikely to have to provide Initial Margin (only some of the biggest schemes could potentially be affected). This obligation to provide Initial Margin will be phased in between December 2015 and December 2019. The obligation will ultimately only extend to entities with an aggregate month-end average notional amount of non-centrally cleared derivatives exceeding EUR 8bn.

Variation Margin

Pension schemes will have to provide daily variation margin for non-cleared OTC derivatives. Most pension schemes using OTC derivatives will already be doing this under the terms of their ISDA Master Agreements. The obligation to provide variation margin would also extend to Foreign Exchange swaps.

Eligible Collateral

The list of eligible collateral includes (amongst others): cash, government bonds (issued by EU and non-EU governments), bonds issued by credit institutions and investment firms, corporate bonds and the most senior securitisation tranche (which is not a re-securitisation), convertible bonds, equities included in certain indexes and shares or units in UCIT.

Processes

Pension schemes will have to show that various operational and policy processes are in place, some of which will have to be reflected in the relevant ISDAs. Our initial view is that current CSAs will deal with a number of these requirements. In practice these processes will have to be provided by managers. We are considering this further.

Next Steps

The Regulators have asked for feedback on a number of questions. One question concerns the Concentration Limits:

“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 issues under stressed market conditions?“

We intend to make a submission to the Regulators on this point. We would be keen to hear your views on this question so that we can reflect these.