02 April 2012

EFRP responds to the ESAs' consultation on technical standards for derivatives clearing

The European Federation for Retirement Provision opposes the introduction of Initial Margin requirements for bilateral clearing of derivatives managed by IORPs, as this would be against the rationale for the exemption from central clearing of derivative contracts managed by IORPs, as recently established under EMIR.

The EFRP has submitted its response to the consultation jointly carried out by EBA, EIOPA and ESMA, on the basis of the "Joint Discussion Paper on Draft Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a CCP under the Regulation on OTC derivatives, CCPs and Trade Repositories".

At the moment, IORPs and financial institutions managing assets on their behalf only exchange Variation Margin (VM) with their counterparties, not IM, because they are considered highly creditworthy by their counterparties.

Mandatory initial margin (IM) requirements would necessitate new and costly incremental funding requirements for pension schemes arrangements. As most pension schemes arrangements do not have expedient and low-cost access to liquidity sources, the outcome of IM calculations would be very high, due to the fact that the derivatives transacted by pension schemes arrangements are typically long-dated and one directional, meaning very few offsetting options exist in the portfolio that would reduce the overall amount. Given the large one-sided exposure, IORPs are disadvantaged in management of IM in comparison to derivatives dealers: these generally see more trading flow with offsets and have a broader base of counterparties to allow for lower margin requirements. As a consequence, the impact of IM requirement may be disproportionately high for pension schemes arrangements. Mandatory high levels of IM may oblige pension schemes arrangements to put large cash reserves aside, in order to meet margin rules. These capitals would be diverted from productive investments.

Moreover, mandatory IM requirements would increase the costs of OTC derivatives, making it more expensive for pension schemes arrangements to insulate themselves from risk. Paradoxically, risk-hedging products will come at a greater cost. The envisaged IMs would then dissuade IORPs from hedging against risks. This would be clearly against the purposes of regulatory changes in the financial sector in the European Union. Moreover, the extra costs will be borne by current and future pension beneficiaries, who are saving for their retirement and relying on their complementary, occupational pension, in a time when public pensions are progressively shrinking.

IORPs are generally able to fulfil their obligation as:

• they can increase pension contribution;
• they can decide not to index pensions;
• they can cut pension benefits.

Moreover, IORPs are mostly not-for-profit legal entities: they operate as foundations whose activity is based on an agreement between social partners (employer and employees representatives). They are not part of any company, nor do they have to pay any dividends to shareholder/investors. Therefore, profits, losses and costs only contribute to define the benefits of members. As a consequence, the risk of an IORP not to fulfil its obligations as counterparty in a derivative contract in the short term is almost inexistent, as a shortage in the short term can be recuperated in the long term.

The EFRP would emphasise the need for IM not to lead to additional risk for non-systemic institutions, such as IORPs. In fact, the posting of IM with more systemically relevant institutions could lead to an increase in risk. Failures in segregating assets in an appropriate way have already led to losses for investors, such as in the MF Global case.

In addition, EFRP advocates a clear regulation of re-use of VM. There are different views among EFRP members about the re-use of collateral. Some are in favour of the practice and see liquidity squeeze and systemic crisis as a consequence of its interdiction; others see re-use of VM as incompatible with the segregation of their assets. In fact, VM is the value of an outstanding contract and in case of a default can be offset against outstanding positions. As the (liquidity) risk of re-use of VM lies completely with the VM receiver, VM re-use shall be allowed. As said before, it is already a current market practice for some IORPs and entities managing assets on their behalf to re-use VM collateral. VM needs to be re-used in cases when collateral needs to yield a certain return to be paid to the VM provider. Maintaining such a practice would not increase systemic risk, while restricting it would seriously impede on the pool of available collateral for IORPs which re-use VM.

Finally, the EFRP would like to recall that, contrary to general financial perception, the one-sided exposure, in particular in relation to interest rates, for IORPs is considered as a reduction of the interest risk of the liabilities.

Full paper

© EFRP - European Federation for Retirement Provision