Pension Funds to Drop Derivatives?

(February 10, 2012)  —  High fees and complex counterparty structures may drive institutional investors away from using derivatives new research has suggested, as regulators finally agree the terms on how to legislate practices in Europe.

Reaction to the near-collapse of the banking crisis has meant the way these instruments are used by pension schemes and other large investors has changed, investment consulting firm Towers Watson has said.

In a paper entitled ‘Is this the end of OTC derivatives for pension schemes?’ Towers Watson lays out how changes in regulation and market attitude to these investment tools will make it more costly and complicated for investors to use them.

The paper said that underlying terms in documentation had already become less attractive for investors.

It said: “Flexibility over which assets can be used as eligible collateral has also reduced significantly. It appears that counterparty banks are less willing, or able, to accommodate pension schemes. This stems from a reduction in banks’ risk appetites and changes in their regulation.”

Yesterday, the European Market Infrastructure Regulation (EMIR), a new regulatory framework for over-the-counter derivatives based on criteria set by the G20, was approved by the European Parliament and the Council of the European Union, as reported in aiCIO’s sister publication The Trade. 

The regulation will enable standardised derivatives to be traded on exchange-like trading venues, cleared through central counterparties (CCP) governed by strict organisational, business conduct and prudential requirements, and traded on central reporting repositories.

Some of the most widely used derivative structures used by pension schemes, such as inflation and longevity swaps, do not yet fall under the new regulation but it still may close the door for large investors, the Towers Watson paper said.

“OTC derivatives which will not be subject to mandatory central clearing are likely to require banks to hold more capital than previously has been the case. This will result in higher costs for banks which we would expect to be passed to customers, thus increasing the costs of transaction OTC derivatives that are not centrally cleared.”

The paper concludes that increased costs for investors should be unnecessary, but may still happen.

It also notes that banking counterparties were increasingly only taking short-dated, high quality government bonds as collateral or cash – Towers Watson feared that they would eventually only take cash, which would mean investors would have to hold large sums of this non-return-seeking asset for their derivatives use.

 “In addition, the UK’s Independent Commission on Banking has indicated that the derivative activities of UK banks should largely be in the non-ring fenced part of the bank – that is, the casino.”

However, the paper assets that pension funds, and other liability-driven investors, need to carefully examine the benefits of using derivatives, both OTC and cleared through a CCP, as they were of significant importance to risk management techniques.