The EU financial markets watchdog has recommended the European Commission extend until June 2022 the current exemption for pension funds from the obligation to use central clearing for derivatives.

Its stance follows a public consultation to collect more data as well as views from a wide range of stakeholders about issues surrounding potential central clearing solutions for pension schemes.

ESMA said it was convinced of the benefits of a broad adoption of the clearing obligation for pension funds, but that “the additional efforts needed for implementing the solutions (…) and ensuring readiness may still require additional time”. A one-year extension would therefore be beneficial, it said.

For several years pension schemes have been exempt from a central clearing obligation as they could face difficulties providing cash as collateral – known as the variation margin – related to cleared derivative contracts, with the latest extension of this exemption running until June 2021.

Saïf Chaïbi, policy adviser at PensionsEurope, the European association for pension funds, welcomed the extension in an e-mailed comment to IPE as it would give pension funds more time to adjust to the new regime. Chaïbi emphasised the organisation was “not opposed to central clearing by pension schemes”.

ESMA said it received most of the input to its consultation from Dutch pension funds, as these account for 70-80% of the notional amount of derivatives of all EU pension funds.

Max Verheijen, director financial markets at Cardano, said many Dutch pension funds have already been making the transition to central clearing. Cardano manages the derivatives portfolio of a large number of medium- and small-sized Dutch pension funds.

“Central clearing is more transparent and more efficient than bilateral trading as there are more parties available to trade with,” he told IPE. However, pension funds that have not yet made the switch need time to make the necessary arrangements, he added.

“In order to have access to central clearing, you need to have clearing agreements in place with members of a clearing house, for example.,” said Verheijen. “It takes time to arrange this membership, and to set up a treasury function to manage the required cash collateral calls.”

Market stress

While government bonds are often used as collateral for bilateral swap contracts, this is not possible with central clearing where only cash is accepted as collateral.

In this regard, the availability of cash in stressed market conditions is a problem that still needs to be addressed by ESMA, said Chaïbi of PensionsEurope.

“In stressed market conditions, there is no guarantee that a provider of cash will be there when needed,” he said.

Verheijen acknowledged the possibility to borrow cash in the repo market may not always be there in times of stress, but he classifies this as “a right-way risk” as pension funds mostly need to deposit collateral at times when interest rates rise.

“This usually happens in a benign macroeconomic environment when markets function normally.”

In times of market stress, interest rates usually fall. “In such a scenario, pension funds receive collateral and don’t need cash,” said Verheijen.

According to ESMA’s report, the primary concern of pension funds being subject to mandatory clearing is the availability of liquidity in tail risk scenarios of extreme rates moves.

It noted that spikes in rates to almost 1% occured during the COVID-19 market stress earlier this year, with the Euro 20-year swap real rate increasing by circa 0.63% in just one week and the French 20-year govenrment bond yield rising by around 0.90% over two weeks.

“A sell-off of all risk assets (equity and credit) and even high-quality government bonds, and dislocations of currency markets, led to sudden [variation margin] calls across a number of investment portfolios for many market participants,” the watchdog added.

Topics