EMIR imposes clearing requirements in relation to over-the-counter derivative contracts and reporting requirements in relation to derivative contracts, and sets requirements for non-centrally cleared contracts, including in relation to collateral. Most pension funds have a three-year partial exemption from the central clearing requirement (which may be extended for a further two years after review) but are subject to collateral requirements for non-centrally-cleared derivative contracts. These collateral requirements have been a cause of concern for pension funds:
Initial margin requirements could increase costs: pension funds are not normally required to post initial margin (which protects transacting parties from the risk of counterparty default) by virtue of their low counterparty risk status. High levels of mandatory initial margin would require funds to set aside large reserves, potentially reducing returns and restricting the effectiveness of hedging.
Restrictions on the types of asset required to be posted as either initial or variation margin could have an impact on funds’ investment strategies.
The final framework
The Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO) have published their final framework for margin requirements for non-centrally cleared derivatives under EMIR. The framework is intended to set a framework for the margin requirements for non-centrally cleared derivatives that reduces systemic risk and promotes central clearing. However, the framework introduces phasing, thresholds and other provisions which are designed to mitigate the overall liquidity impact which would be caused by financial market participants needing to provide liquid high-quality collateral. The following elements will tend to reduce the potential increase in costs for pension funds transacting in non-centrally cleared derivatives:
There will be a gradual phase-in period to provide market participants with sufficient time to adjust to the requirements. The requirement to collect and post initial margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015 with the largest, most active and most systemically important derivatives market participants.
The framework allows for a universal initial margin threshold of EUR50 million (applied on a consolidated group basis) below which a firm would have the option of not collecting initial margin. In addition, following the end of the phase-in period, entities will only be subject to initial margin requirements if they pass a threshold of non-centrally cleared OTC derivatives activity, amounting to EUR8 billion in gross notional outstanding amounts.
All margin transfers (including variation margin) between parties may be subject to a minimum transfer amount of up to EUR500,000 (this is an increase from the EUR100,000 threshold proposed in the earlier consultation paper).
A broad range of collateral will be eligible to satisfy initial margin requirements, further reducing the liquidity impact. The potential volatility of some types of asset will be addressed by applying a discount or haircut to their valuation for margin purposes. Cash, bonds, equities and gold will all potentially be eligible collateral, though this could be subject to national variation depending on the conditions of different national markets.
The new framework leaves scope for national supervisors to set specific requirements for their own jurisdictions, within these minimum standards. For example, all financial firms and systemically important non-financial firms are ‘covered entities’ to whom the margin requirements will apply when they enter into a non-centrally cleared derivatives transaction with another covered entity. The precise definition of financial firms, non-financial firms and systemically important non-financial firms will be determined by appropriate national regulation.
The framework sets out a range of initial margin requirements, from 1% of notional exposure for an interest rate swap of up to two years, to 4% for an interest rate swap of five years or more, and 15% for equity-based derivatives and inflation swaps. Other initial margin models may be developed, based on quantitative data, but would have to be approved by national supervisors.
BCBS and IOSCO previously estimated that applying the EUR50 million threshold could reduce total liquidity costs by 56% compared to operating without a threshold for initial margin. This and other elements in the framework are good news for pension funds, but the National Association of Pension Funds has been campaigning for further help in the form of an exemption from initial margin requirements. The argument is that pension funds could still be unduly hard hit by initial margin requirements: for example, their derivatives holdings may be concentrated around long-dated interest rate and inflation swaps, rather than including a mix of contract lengths across a number of different product areas.
The percentage of notional exposure required as initial margin also needs to be considered. The framework sets the initial margin for interest rate swaps at 1-4% of notional exposure, depending on the duration of the contract, but for inflation swaps, the initial margin requirement is set at 15%. This represents a significant additional cost for pension funds considering entering into these contracts, with a consequent impact on overall returns. In addition, contracts carrying such a high percentage of initial margin will be more likely to cross the EUR50 million threshold so that initial margin payments are no longer optional.
The Investment Management Association has estimated that central clearing could impose a yield drag of 1.1 to 1.9% on pension fund investment performance, and funds should now assess the implications of transacting on a non-centrally cleared basis. There may be a choice to be made in the future between transacting on a standardised basis via the central clearing route, and using a customised contract which is a better match for the specific risks being hedged, but which carries higher transaction costs. Trustees may need to review their investment strategy and to update investment parameters in light of the new requirements.
Pension funds investing in derivatives should continue to monitor the position on the margin requirements for non-centrally cleared derivatives as the regulatory technical standards required under EMIR are produced, and should discuss the implications of the new framework with their consultants and investment managers. They will, for example, need to obtain a legal entity identifier and determine with their consultants and asset manager(s) how other EMIR compliance requirements will be met. Some redrafting of current investment management agreements and ISDA contracts may be required; pension funds with multiple managers will have to ensure that the managers take a coordinated approach.
For advice on the impact of EMIR on your pension fund and on your particular pension risk situation, please speak to your usual Allen & Overy contact or to any member of our specialist Pension Risk Group. You can find more information on EMIR and its practical implications for pension funds on our pension risk website.
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