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As pension funds are hedging large and one-way liabilities, their positions attract huge amounts of collateral - or variation margin - to cover the daily mark-to-market fluctuation of the value of their swaps. Moreover, central counterparties only accept cash for variation margin, which causes a serious headache for pension funds that hold all of their assets in bonds, equities and other financial instruments. Global pension assets totalled US$21.8 trillion at the end of 2012, according to the OECD, with a fair chunk of these residing in Europe: UK assets were US$2.3 trillion, Dutch US$1.3 trillion and Swiss US$700 billion. Moving this colossal industry – which includes some of the largest users of interest rate and inflation swaps in the shape of Northern European pension funds – into central clearing is no mean task.
Mindful of these issues, European legislators have given pension funds relief from clearing for at least three years, which could be extended by a further three years at their discretion. But far from sitting idly by, some European pension funds are actively engaged in smoothing the transition towards derivatives clearing. "Some pension funds are paving the way and making things work – some are already clearing today", Michael Davie, CEO of LCH.Clearnet, told an audience at the Centre for Economic Policy Studies last week. Davie outlined some of the work being conducted by industry participants behind the scenes. This includes CCPs providing beefed up safeguards for customer collateral, known as full physical segregation in industry parlance.
Perhaps the thorniest project is designing a robust process for pension funds to transform their financial assets (such as large portfolios of government bonds) into cash for collateral purposes. Posting bonds or other securities as variation margin hugely complicates the valuation of swaps portfolios. As a result, CCPs are unwilling to accept non-cash collateral. "We’re not just boneheaded or reluctant", said Davie. "It’s a major structural problem for CCPs taking cash. However, we do think there is a solution, which is to give clients more access to repo markets."
The European Securities and Markets Authority (ESMA) is expected to publish technical standards shortly, which must then be approved by the European Parliament and Council. Market participants believe December is the earliest potential date for mandatory clearing to go live. In the meantime, dealers report that many clients have already begun clearing to avoid the kind of last-minute stampede that occurred in the US last year when buyside clearing came online.