Additional capital charges imposed on banks conducting OTC derivatives trades, particularly those trades outside central clearing, could get passed on to institutional investors, according to Mercer.
In 2009, the Leaders of the G-20 committed to reforms in the OTC derivatives market to improve transparency, mitigate systemic risk, and protect against market abuse. The introduction of the European Market Infrastructure Regulation (EMIR) next year includes new clearing regulations in order to aid counterparty risk management and to improve liquidity in severe market conditions, with all cleared trades to be supported by cash or non-cash collateral.
EMIR recognizes that pension funds are typically fully invested which could make it difficult to provide cash collateral so they have been granted a three year exemption to give them enough time to adjust. This allows pension schemes to continue to trade derivatives on an OTC basis under existing bilateral agreements with counterparties while they prepare for central clearing.
However, with the additional capital charges facing banks under Basel III could make existing bilateral trades highly uneconomic and effectively force pension funds into central clearing.
According to Mercer, preparing for central clearing can take up to six months so the consultancy is advising pension schemes to begin the process sooner rather than later to ensure that trading is not disrupted and that costs are kept down.
“Central clearing requires a number of operational changes in order to interact with the clearing house and to minimise the impact of additional collateral requirements,” said Ben Gunnee, European Director of Mercer’s Sentinel Group. “As most schemes presume they are exempt from central clearing, they have not made preparations to participate.”
“Those schemes that try to undertake hedging strategies using interest rate swaps outside central clearing may find the cost prohibitively expensive under the new regulations,” Gunnee continued. “The additional capital charges levied on counterparties will ultimately result in trading costs increasing for pension funds wishing to hedge liabilities through swaps.”