Peter Davy reports on the recent efforts to reform the OTC derivatives market

It’s not hard to fathom the international support for central clearing and the reasons behind moves in the US and EU to reform the over the counter (OTC) derivatives market. But it’s harder to figure out how it can be done.

The clearing houses, which act as middle men between the two sides in a trade, were among the few financial institutions to emerge well from the collapse of Lehman and the subsequent crisis.

“The benefits of clearing to any market are that it reduces counterparty risk and improves the market’s safety, efficiency and stability,” says Rory Cunningham, a director at LCH.Clearnet and chairman of the European Association of CCP Clearing Houses.

“That was borne out in the financial crisis.”

In September 2008, when Lehman Brothers collapsed, LCH. Clearnet, which clears about half of the $348 trillion global interest rate swap market, had a Lehman’s book cleared with it that totalled US$9 trillion. The company hedged it, put off a portfolio and, as Cunningham puts it, “essentially the interest
rate swap market carried on trading the prices”.

Other markets that weren’t cleared seized up. It was a turning point. A year later, G20 leaders agreed to radical reforms for the OTC derivatives market, including pushing as much as possible of the $600 trillion market through central clearing counterparties (CCPs). Provisions in the Dodd-Frank Act in the US have already been enacted, while May saw the European Parliament’s economic and monetary affairs (ECON) committee vote on the European Market Infrastructure Regulation (Emir).

Not the bad guys
Few argue with the principle. National governments, regulators, and the financial services industry are all broadly supportive of the aims. So too is the UK’s National Association of Pension Funds (NAPF), which “strongly supports action to ensure the safety, soundness and efficiency of central counterparty clearing houses and repositories”, according to its position paper in March.

However, it added: “[T]he clearing model must genuinely reduce risks for pension schemes and not increase the cost of pension provision.”

And that’s where the problems begin. First, unlike in the OTC world, pensions will have to post initial margin, the deposit required by the clearing house to protect against default. This is calculated on the member’s net, not gross, positions.

“It’s a model that works nicely for banks and hedge funds, which tend to run reasonably flat books in terms of their outright positions, but pension funds, which are just hedging their risk, are all one sided,” says Alex Soulsby, head
of derivative fund management at F&C. The result is much higher margin requirements for pensions. It is, he says, hardly ideal.

“It would be better if pension funds were not subsidising the investment banks.”
Variation margin, meanwhile, covering the costs of the market moving against their position, has to be posted daily, and – at the moment – in cash. That would have significant implications for pension funds’ liquidity, as they would be forced to keep funds readily available, presenting problems for those that are fully invested.

“Ultimately, it’s going to provide a drag on the scheme’s performance,” notes Jonathan Bowler, BNY Mellon’s business manager for EMEA.

Perhaps the biggest issue, however, is that while interest rate swaps can be centrally cleared, inflation swaps can’t be at the moment. For most pension funds running LDI strategies hedging both, it introduces not just added complexity, but also another drain on the fund’s efficiency. Hedging them both OTC with a single counterparty, movements in the positions can tend to offset each other. Putting interest rates through central clearing and keeping the inflation swaps OTC, both will need to be fully collateralised.

“For pension funds that’s the biggest problem – that not everything can be centrally cleared,” says Ben Clissold deputy investment officer at P-Solve. “It causes more problems than it solves.”

Against all this, it’s also difficult to see the benefit, say critics. Interest rate swaps didn’t cause the financial crisis, after all, they point out. Nor do pension funds post a systemic risk.

“Personally, I can't see the benefit,” says Tony Kirby, director of regulatory and risk management at Ernst & Young. The regulation is supposed to tackle speculators; pension funds, by contrast, are hedging long term liabilities.
“They're not looking to make a quick buck.”

Looking up
There are, however, some reasons for optimism among pensions funds.

First, time is probably on their side.

The ECON committee’s version of the regulations still needs to be finalised and voted on by the Parliament in July, after the rapporteur for the parliament Werner Langen decided there should be a second reading (a relatively rare step). Then it must be reconciled with texts from the European Commission and Council. It could be October before we know its final shape, and many are also betting on a delay in implementation, originally intended for the end of next year, as has happened with Dodd-Franks.

“The politicians have taken one of the largest markets on the face of the planet, one that finds itself in one of the most challenging periods of financial market history, and decided to completely re-write the rule book,” says Will Rhode, analyst at advisory and research firm Tabb Group, which published its research on the changes in the US and EU in May.

“There will undoubtedly be delays, and I wouldn’t be surprised if we saw a consultation introduced for the implementation process, just as we have for the drafting.

“Lo and behold it turns out that financial markets are quite complex.”

That means there’s still time for compromises.

There are already encouraging signs, says Jane Lowe, director of markets for the Investment Management Association. The ECON committee, for example, voted to widen the range of assets that CCPs would be allowed to accept as collateral. In its version, bonds and gilts will also be acceptable.

“They even included gold, although I don’t think many pension funds will be holding it,” notes Lowe.

It also, crucially, included a “transitional” period, giving pensions three years before they would have to comply. Most expect that to remain in any final text.

“My gut is they will get a reprieve. It would be silly to have them do it,” says Conrad Holmboe, an analyst with investment consultants Redington.

Of course, a transition is not the exemption some hoped for. Belgium MEP Guy Verhofstadt, who is also a member of the supervisory board of APG, which administers the Netherlands’ largest pension scheme ABP, is among those who have argued strongly against just delaying application to pensions, pointing out that the case for their inclusion will be just as weak in three years.

Nevertheless, a delay does have real value: first, in terms of costs. As Bowler puts it, “For our pension fund clients any delay is very welcome.”

But second, it provides another opportunity to look at the issue in a cooler atmosphere – and time for the market to sort out some of the challenges for pensions, perhaps even for the clearing houses to begin to develop the ability to clear inflation swaps.
It has to be said, there is no sign yet of that happening, but if it did many concede there would be real benefits to central clearing in terms of the ease of trading, increased transparency, levelling the playing field between counterparties and arguably introducing the potential for greater competition.

“The ideal situation is a good efficient system where everything is centrally cleared,” says Soulsby. “We’ll certainly be moving a lot of our funds towards clearing.”

And finally, of course, it’s important to remember what attracted the G20 to central clearing in the first place – the lower risk of default.

Yes, it will cost more, says Cunningham, and how much will remain the crucial question.

“However, the flipside is if you are a pension fund looking to hedge 30 or 50-year risk having a clearing house as your dealer’s counterparty will bring significant benefits” he says.

Ultimately, perhaps, the question pensions funds should ask is whether, looking that far into the future, they would prefer their hedge ultimately relied on a clearing house or an investment bank. After all, which is more likely to still
be there?

Peter davy is a freelance journalist

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