EUROPE - Large pension schemes using derivatives for hedging should prepare for future central-clearing requirements by building in-house teams to manage their collaterals, Mercer Sentinel Group has said.

Talking to IPE, Ben Gunnee, European director at Mercer Sentinel Group, said the "conflicting" regulatory pressures of Basel III and the European Market Infrastructure Regulation (EMIR) could have a significant impact on European pension funds using bilateral derivatives trades, or over-the-counter (OTC) trades.

Mercer Sentinel Group said pension funds should plan ahead for central clearing instead of waiting for the temporary exemption for schemes to end.

Under EMIR, both interest rate and credit default swaps will have to be centrally cleared, while counterparties - such as pension funds - will be required to post variation margins in the form of cash, leading to additional costs once an exemption granted by the European Parliament lapses.

The exemption allows pension schemes to continue trading derivatives on an OTC basis, under existing bilateral agreements with counterparties, while they prepare for central clearing.

But Gunnee advised pension schemes to begin preparing for central clearing "sooner rather than later" to ensure trading was not disrupted and that costs were kept down.

"Central clearing requires a number of operational changes to interact with the clearing house and minimise the impact of additional collateral requirements," he said.

"The problem is that, if central clearing houses come up with a solution to swap pension funds' physical assets into cash before the three-year exemption reaches an end - say [after] two years - pension funds may be required to centrally clear derivatives trades earlier than expected.

"Because most schemes presume they are exempt from central clearing, they have not made preparations to participate."

The consultancy also stressed that Basel III would impose additional capital charges on banks conducting OTC derivative trades.

"Those schemes that try to undertake hedging strategies using interest rate swaps outside central clearing may find the cost prohibitively expensive under the new regulations," Gunnee added.

"The additional capital charges levied on counterparties will ultimately result in trading costs increasing for pension funds wishing to hedge liabilities through swaps."

Mercer Sentinel Group estimated that preparing for central clearing could take six months.

However, when considering possible solutions for pension funds, the Mercer Sentinel team distinguished between schemes with externally managed LDI strategies and those that opted to oversee much of the asset management internally.

"Most pension schemes that hold segregated assets and are running mandates where they need to use a centrally cleared system tend to be pension funds with LDI strategies," Gunnee said.

"Clearly, firms that have been mandated to run such LDI strategies on behalf of pension funds are currently developing solutions to help their clients get ready for the central clearing system."

As for the larger pension funds, the Mercer Sentinel Group recommended they appoint their own direct clearing member - which would interact directly with central clearing houses.

It said they should also appoint collateral managers to manage a central pool of collaterals, instead of having several pools of collaterals managed by different managers.

The consultancy said large pension schemes should also put in place smarter solutions around collateral management to be as efficient as possible when they will be required to move into central clearing.

Gunnee acknowledged pension funds would incur additional costs in building in-house teams, but he argued that the cost of derivatives trades would inevitably increase under the new regulations, irrespective of the solution adopted by counterparties.

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