(November 8, 2013) — In just over three months’ time, pension funds using any kind of derivatives will be required to have the correct documentation, risk mitigation, and reporting in place to comply with the incoming European Market Infrastructure Regulation (EMIR), it was announced yesterday.
The ruling has been introduced to increase transparency around derivatives trading. It requires two elements: firstly, over-the-counter derivative contracts must be reported and secondly, when those derivatives are entered into by financial counterparties—including pension funds—with other relevant market participants, the contracts must be centrally cleared.
For the moment, pension funds have been given a three-year reprieve on the clearing aspect of the regulation, but the general reporting and risk mitigation requirements will be imposed on them in February.
Derivatives have become commonplace for the most sophisticated investors with more than half of all pensions funds in the UK using some sort of interest rate hedge—which is suspected to be one of the first derivative types to be included under the new rules.
Other types of swaps and hedges associated with liability-driven investment and other risk management tools also come under the EMIR banner. Each derivative counterparty will be required to submit a report to an EMIR authorised trade repository when it enters into, modifies, or terminates a contract. Farming out the processes to third parties does not mean pensions are absolved of responsibility to comply. Trade repositories would then be required to ensure that the trades are reconciled.
“Firms only have a few months to get to grips with this new regulation and there are significant risks to getting it wrong,” said Crispian Lord, regulation partner at PwC. “It may seem fairly straightforward, but the extent of the data required is troubling many in the market and experience shows that it doesn’t take much to get this reporting wrong, with significant consequences.”
These consequences are likely to take the form of a fine.
“Our work in the market over the past few years with clients found that the fines levied for incorrect transaction reporting can be substantial,” said Lord, “but the remediation costs and management time associated with these issues can result in costs that are many multiples of the fine.”
If pension funds and other investors have been keeping up to speed with the regulation, however, they should be well placed.
“Although it has proved challenging so far to roll out across end users, reporting will provide increased transparency for the entire market and hence can only be a positive if it is implemented successfully,” said Tom McCartan, vice-president in manager research at consultants Redington. “To a large extent, reporting should be dealt with by service providers.”
He added that investors should now be aware of margin requirements—which should be held in cash rather than any other asset—that will come into force once central clearing becomes a fact of life.
“As we move towards the clearing obligation date, we think clients should be thinking strategically about the impact of central clearing on asset allocation and risk management.”
Related content: What OTC Rule Changes Might Mean for You & Pension Funds to Drop Derivatives?