UK - The proposal to introduce initial margins for centrally cleared OTC derivatives goes against the recent decision to exempt pension funds from the EMIR Directive, a number of pension figures have argued.

The joint consultation paper on the development of regulatory technical standards on capital and collateral levels for counterparties - launched by the European Insurance and Occupational Pensions Authority (EIOPA), the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) last month - has led pension representatives in the UK to voice their concern over the introduction of initial margins for OTC derivatives trades.

Following the comments made by the European Federation for Retirement Provision (EFRP), the National Association of Pension Funds (NAPF) sought to remind European authorities that the reason for pension funds' temporary exemption was to give clearing houses time to work out collateral arrangements to meet pension schemes' needs.

The NAPF said "adequate and properly controlled" variation margin was more than sufficient to provide protection against the risks to individual institutions and to systemic stability, as it fears that initial margins will lead to higher costs for pension funds.

"The Investment Management Association [IMA] has estimated that central clearing under current arrangements would reduce investment returns for a fully immunised liability driven investment portfolio by 1.1 to 1.9 percentage points. 

"Compounded year after year, this drag on performance would hugely increase the cost for companies of providing adequate pensions for their employees and reduce the resources for investment and growth."

According to the association, most of the additional cost will result from the lower return on the margin put up as collateral.

This would particularly result from the initial margin that would have been required for the sort of long-term derivative transactions pension schemes enter to mitigate risk, it said.

The IMA echoed the NAPF's concerns, arguing that the proposals made by the three European authorities could "substantially" increase costs for pension funds, thereby impacting investment returns for unit and policy holders.

In its proposal, ESMA, EIOPA and EBA stressed that there should be at least an exchange of variation margin by both counterparties where the transaction is between financial and/or non-financial counterparties.

In addition, the three authorities said they continued to consider a requirement to "exchange, post or collect" initial margin.

Under a bilaterally cleared transaction, collateral can take the form of variation and/or initial margin.

While variation margin represents collateral exchanged by counterparties to reflect current exposures - which can result in the change of value of the transaction made - initial margin is provided to cover potential future exposures - which can arise between the last exchange of margins and the liquidation of the relevant positions.

The option of posting initial margin on top of variation margin could therefore force pension funds to invest in a narrower group of assets to meet eligible collateral requirements, which generally will provide lower returns, according to the IMA and other pension figures.

In addition, the IMA argued that European authorities had taken the wrong approach to regulate OTC derivatives trades and had failed to "draw out the critical element" of counterparty risk.

Jane Lowe, director of markets, said: "We are concerned the Commission is looking at a rather 'formulaic' approach that would be terribly costly for pension funds when they are not really the ones that represent the risk.

"When you enter into a bilateral relationship, collaterals are not just about the actual assets - in the form of cash, for instance. It is also about the counterparty risk, as you might require over collateralisation or pre-collateralisation from some clients, whereas you don't from some others.

"Unfortunately, this side of the picture has been completely ignored by the EMIR Directive."

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