Denmark’s Financial Supervisory Authority (FSA) said the country’s pension funds are not facing a sudden liquidity risk surge when their exemption from the obligation to centrally clear derivatives contracts expires next summer – but said the issue still needs close follow-up.
The Copenhagen-based financial watchdog said it scrutinised the pension sector’s liquidity needs in the event of interest-rate increases and the expected effect of the phasing out of the exemption in June 2023 from the requirement for central clearing.
The FSA said of its assessment: “The main conclusions are that, in the short term, there is no immediately significant increased liquidity risk associated with the end of the exception.”
This was partly because only new derivative contracts would be required to be cleared centrally, so there would be a long phasing out of the end of the exception, but also because there had been a trend this year towards decreasing interest-rate sensitivity on the companies’ interest-rate derivative contracts, it said.
“However, the liquidity risk derived from collateral on interest-rate derivatives still requires a lot of attention and close follow-up from the pension companies,” the agency said on Thursday.
The need for close follow-up was partly because pension providers needed to secure enough repo counterparties, it said.
The obligation to clear some classes of OTC derivatives contracts via a central counterparty is part of the European Market Infrastructure Regulation (EMIR) put in place following the global financial crisis and aimed at reducing counterparty risk and systemic risk.
Pension funds have been granted exemptions from this for some time.
The pensions industry has been rattled in the last two months internationally by the UK’s LDI crisis at the end of September, when plummeting bond prices triggered huge collateral calls on derivatives, leaving pension funds scrambling for cash.
The Danish FSA said several pension companies under its supervision, particularly in the long term, had a “not insignificant liquidity risk” in connection with collateral for interest-rate derivative contracts.
“Overall, the long-term liquidity needs in stressed markets can also constitute a systemic risk,” it said.
“It is therefore important that the companies have effective risk management and decision-making ability that can follow and predict the need for liquidity hour-by-hour, and is capable of initiating measures in good time so they can meet margin requirements in the event of large interest-rate rises,” the watchdog said.
Among other things, it said, pension firms should have routines, credit approvals and trade lines in place with banks so they can obtain large amounts of liquidity at short notice.
It also concluded that more pension firms needed to increase the number of repo counterparties they did business with to make sure they could act efficiently and quickly in stressed markets.
Although there had been a gradual transition among Danish pension companies to non-guaranteed market-rate products, the FSA said, the providers still had a number of guaranteed pension products on their balance sheets – which entailed an interest-rate risk for the firms.
They typically covered that risk by investing in fixed-rate bonds or entering into interest-rate derivative contracts – usually swaps, swaptions and interest-rate futures, it said.
Danish pension companies had a long tradition of interest hedging using interest derivatives, the authority said, adding that together with Dutch pension providers, they were among the largest players on the European interest-rate swap market.
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