Thought Leadership

Voluntary clearing: the unsung cost saver for pension funds

Since the financial crisis, almost every facet of the derivatives world has been scrutinized and subjected to new rules by global regulatory authorities. This has pushed many financial institutions to overhaul their internal processes, creating ways to efficiently and cost-effectively accommodate this new environment.

This has been particularly evident for the European Market Infrastructure Regulation (EMIR), which introduced mandatory derivatives clearing through central counterparties (CCPs). However, the new regulation has touched on market participants for whom it has not been so straightforward to adapt systems and processes. For larger pension schemes, the use of derivatives to hedge capital and to achieve diversified returns has been essential.

But adhering to these new rules generated a compliance burden that schemes were significantly less prepared to cope with than their well-capitalized counterparts in the trading and investment world. These buy-side institutions, by contrast, had more scope to invest in upgrading their technology to help them deal with the demands of reporting and post-trade processing in line with the changed requirements.

In recognition of this, the European Securities and Markets Authority (ESMA) originally granted a three-year exemption for pension funds from the mandatory clearing of derivative transactions outlined in EMIR, delaying the requirement to do so until August 2015. This would give schemes time to prepare for the changed processes, and more gradually absorb the costs associated with compliance. However, now that this date is within sight, the European Commission is calling for a further two years to give pension funds more time to prepare for the requirements associated with centrally clearing derivatives through central counterparties (CCPs).

Many pension funds will be breathing a sigh of relief at this news, giving them further time to adapt internal processes and technology needed for EMIR compliance. Nonetheless, while it may be viewed as a stay of execution, there is a strong commercial case for pension funds to begin voluntary clearing of derivatives, which are an essential part of many schemes’ hedging arrangements, before it becomes mandatory.

There is no doubt that compliance will carry costs, which is why some funds are reluctant to begin voluntary clearing before they are obligated. However, these costs are not going to fall the longer that schemes delay central clearing; indeed, the sooner it is adopted, the more cost efficient it could potentially be.

Non-cleared transactions – aka bilateral trades – are higher risk so more collateral must be posted against them. In addition, dealing with a CCP can reduce costs for a scheme, as it can net all margin requirements across related to outstanding contracts, and even across Exchange Traded contracts in the portfolio. This means a fund will potentially have to post less initial margin or collateral overall.

What’s more, many schemes are finding that there is better liquidity for cleared transactions as there are more market makers, so these contracts may be preferential, from a pricing perspective, to their bilaterally traded counterparts. This will not necessarily continue once all participants have come to market.

In addition to this, there are further benefits for schemes which begin voluntary clearing now. Project risk is a significant factor for participants who leave clearing implementation to nearer the official deadline. A last minute rush could potentially beset market institutions such as CCPs, seeing them overwhelmed as the deadline approaches.

Complying now and engaging with CCPs will also give schemes more time to weed out any operational shortcomings without the pressure of an imminent regulatory deadline. Central clearing, as outlined in EMIR, carries a notable burden in terms of reporting requirements and collateral management. In many cases, this will create new technological demands, and these could take significant time to implement and solve – not to mention budget too. Schemes may also find that creating an automated and efficient technology platform that can cope with derivatives requirements creates other cost savings associated with the reduction in manual processes.

In the interim, internal compliance managers are likely to be more amenable to investment managers’ trading activity in derivatives where cleared contracts are used, again due to the lower risks associated with cleared transactions. At a time when schemes are broadening the scope of their investments in an environment of low returns, greater flexibility in the tools that can be used to achieve returns could prove to be extremely valuable.

It is an inevitable fact that complying with EMIR will be costly, but there are ways schemes can mitigate these costs and gain advantages by complying now. Ultimately, pension funds stand to gain a significant benefit from acting early, by getting ahead of the curve on compliance.

This article was originally published in Futures and Options World