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Shockwaves from infrastructure regulation being felt by investors

In May 2017, the European Commission exempted pension funds from the European Market Infrastructure Regulation (EMIR) for a further three years until 2020. Originally this exemption ran out in 2018. 

EMIR has an impact on liability-driven investment (LDI) because clearing houses only accept cash as collateral for over-the-counter (OTC) derivatives like interest rate and inflation swaps. Both of these are fundamental to LDI strategies. However, pension funds can only hold limited cash. 

EMIR is likely to increase the costs of all pension funds with or using LDI. Central clearing for swaps involves extra fees, collateral and administrative costs, even though they give little benefit to pension funds. Because of EMIR, there is less opportunity to invest in non-cleared swaps so pension funds tend to be pushed into using them anyway. 

Trustees should ask investment managers what approach they are going to take with their future and existing transactions as regards EMIR. Many interest rate swap agreements are bilateral and of a long length (they last for decades). The question is should they be kept bilateral or be moved to a central clearing house?

The counterparty to the swap will already be transacting through clearing houses, so they could charge higher fees to enter into new bilateral agreements. Anyway, renegotiating current arrangements could be difficult in terms of cost, the valuation process and how it operates in practice. The valuation of bilateral swaps could be difficult especially when an International Swap and Derivatives Association agreement anticipates the use of non-cash as collateral. There is also a question to what extent banks will want to undo their existing swaps and move to clearing. There are various grades of swaps: dirty (i.e. they allow for cash gilts and investment grade corporate bonds), and clean (that use signed ISDA agreements that allow for cash and gilts and cash-only ones). The less cleaner they are, the harder they are to value. 

Equally although pension funds are not forced to change a contract until 2020, the counterparty may want to unwind the swap and they may be willing to give preferential terms to do so.  

Pension funds could look at reducing the amount of swap element and increasing the amount of physical assets instead but there is regulation on this as well. Basel III affects LDI managers in the repurchase agreements. This is because it increases the cost of capital that banks need to hold against repurchase transactions due to new rules around banks’ leverage ratios, which has in turn increased repurchase rates. For LDI strategies, generating cash to buy long-dated gilts through the repurchase market is more expensive. So long-dated gilt yields have increased compared to swap yields to reflect this extra cost.
The consensus seems to be to apply a diversified approach to LDI strategies, including looking at alternative LDI assets for alternative credit, for de-risking purposes.
Remember, there is no one way of implementing LDI – it is a generic term. 

Published:26 October 2017

Pensions Law Update - October 2017

Key Contact

Penny Cogher