Practical implications of trading derivatives can make pension funds reluctant to implement a derivatives program. Outsourcing has benefits but could be in conflict with upcoming governance rules. An in-house derivative program is cost effective, transparent and not as difficult as it may seem. An attempt to demystify derivative implications.
In the current turmoil of changing pension regulations in the Netherlands, one could take the view it is better to be safe than sorry. Being safe often means returning to traditional values. However in the normally conservative world of pension funds, traditional values are about to be replaced by new market values which will unarguably lead to a revolution in the way pension funds assess the future.
There is one central theme running through the new regulatory change: Pension funds need to reduce the interest rate gap between assets and liabilities. But how is this gap to be reduced? Moving into long-term bonds is a possibility but the offering is limited and involves partial liquidation of the current fixed income portfolio. Interest rate swaps are often mentioned as a flexible and highly liquid alternative, but swaps are derivatives and most pension funds lack experience in dealing with them.

Outsourcing versus In-house handling
Trading derivatives requires different expertise than investing in physical bonds and equity. The barriers for most pension funds lie in the lack of execution knowledge and the lack of in-house back-office systems to value derivatives. Banks in the 1980s, and the more sophisticated corporates and pension funds in the 1990s implemented the necessary systems and hired qualified resources to handle synthetic instruments.
Basically there are two options for pension funds lacking in derivative expertise. One option is to outsource the complete derivatives program to an asset manager or a fiduciary manager. In return for annually recurring management fees, the manager takes care of all practical issues like confirmation, settlements, collateral management, documentation, valuation etc. Subsequently the manager transfers the market risk to a broker. Benefits of outsourcing are that the pension fund does not have to set up internal procedures and in-source the necessary resources and systems. Disadvantages are less practical in nature but nevertheless material. The upcoming governance rules require pension funds to be completely on top of the risks taken within the fund. Employing derivatives, can only be the result of sophisticated risk management tools and by mandating a third party to manage derivatives, risk positions could disappear into a black box.
The second disadvantage is that much like pension funds, fiduciary and asset managers have only recently entered the world of derivatives, and typically choose traditional investment banks to execute the trades for them. This means the annual management fees are not paid for the expertise on derivatives, but more for taking care of the practical implications. It may seem reasonable that taking care of the practical issues has a price. However, an average pricing screen will tell you how narrow swap execution spreads are and no mathematics are needed to calculate that the price for the remaining practical services is fairly high compared to the execution price.
The second option is to execute and manage the derivatives in-house with the support of a third party. The pension fund can outsource all typical back-office tasks to a third party and/or in-source knowledge and systems to handle the positions themselves. Benefits are the potential reduction of costs and the increase of internal transparency and understanding of the risk positions of the fund. Pension funds will need to take some practical hurdles before an in-house solution can be implemented. What would thus be of real value is a total solution package that mitigates the hurdles of dealing with derivatives and makes their use accessible and easy. ABN AMRO is committed to lower the burdens and can assist in setting up a sound and prudent process.

Implications of In-house handling
The process of implementing and managing a derivatives overlay structure is graphically presented in chart 1.2.
There seems to be a lot of mystification on the implications of the different steps. Let us try to demystify the structure.

Product knowledge
There is a wide variety of over–the-counter (OTC) products available that can help pension funds to mitigate the interest rate risk, the most common being interest rate swaps and options on swaps (“swaptions”). Besides the use of swaps to mitigate the interest rate risk, pension funds can lower solvency requirements under the new FTK by using other derivatives to hedge equity risk, currency risk and credit risk. For the purpose of this article the focus will be on interest rate risk. The mechanics of swaps are as follows:
An interest rate swap is an exchange of a fixed for a floating coupon (or vice versa) over a predefined period and notional amount. In case a pension fund decides to receive a long dated fixed coupon and pay a floating coupon with a negligible duration, the net effect will be an extension of the duration. The swaps can be tailored to exactly match the interest rate risk of the assets with the liabilities. Let’s illustrate this with a simplified example.
In case the bond portfolio has a duration of 5 years, the payer leg of the swap will mimic the 5 year duration of the bond portfolio return, and the receiver leg will provide for the fixed high duration component to match the liabilities (See chart 1.3).
This strategy can be implemented on top of an existing portfolio and needs annual re-balancing on the basis of an ALM study.
ABN AMRO offers courses that are tailored to the needs of the clients covering the behaviour of swaps and other derivatives, their effectiveness, and their regulatory consequences (including the possibility of solvency relief for pension funds).

Documentation
The International Swap and Derivative Association (ISDA) agreement is the standard legal framework for trading derivatives. An ISDA agreement consists of two parts. The first part, the Master Agreement, contains a fixed set of standards under which derivatives are traded and is normally governed by English law. The second part is the Schedule to the Master Agreement and contains specific terms between the two parties and is subject to negotiations. The purpose of an ISDA agreement is two-fold: a) once the agreement is signed between two parties all future trades can be done under that agreement without renegotiation and b) the ISDA agreement provides the procedures in case of a credit event on one of the parties.
In addition to an ISDA agreement, banks will require a Credit Support Annex (CSA) for long-term swaps as needed for duration matching. This addendum to the agreement specifically deals with the minimisation of the bilateral credit exposure. The CSA will substantially reduce credit risk for both parties by posting collateral under the swap (see collateral management).

Swap Execution
The actual pricing of swaps will be determined by the prevailing market swap rates at time of trading. In general the market price of the swap will consist of two components:
a) The hedge price. This is the price at which a bank can hedge itself by entering into an exactly offsetting opposite swap transaction with a 3rd party. A bank can also set up a hedge via offsetting position in listed market products e.g. bund futures.
b) Additional spread. This spread will consist of components for credit risk, legal risk and operational risk. The first two risks can be addressed via putting in place an ISDA and a CSA (See documentation). If implemented and negotiated properly the additional spread for these risks in the end user swap price can be minimised.
A way of diversifying the credit risk is to have multiple counterparties to trade with. The downside of trading with multiple banks is that it will take more time and effort to negotiate all the proper documentation before trading takes place. On average, negotiating legal documents like ISDA and CSA takes more than 6 months. Pension funds face price risk during this period and end up with different ISDA and CSA terms and conditions with each bank. A solution to this, is to have a bank to underwrite the initial swap against the market price plus a predetermined credit spread with one ISDA and one CSA attached to the deal. The bank together with the pension fund will line up a syndicate of other banks that can each quote on a part of the initial swap based on the same or a better credit spread and the same ISDA/CSA conditions. The whole syndication process will not take longer than 3 to 6 months. The benefits are that underwriting accommodates quick, smooth implementation and fully transparent pricing, that market and timing risks are hedged, and that uniform collateral conditions can be negotiated.
ABN AMRO provides full implementation service to underwrite and syndicate the swap portfolio.

Confirmations and Settlements
A swap overlay program means dealing with confirmations and settlements. A confirmation usually consists of four pages describing every detail of the transaction e.g. amounts, rates, settlement dates, business day conventions etc. Every time a pension fund enters into a swap transaction or changes the existing deal the confirmation needs to be checked in detail.
Settlement is the actual exchange of the pre-agreed fixed versus floating legs. Settlements take place as follows: the floating leg usually settles over Libor every 6 months while coupon settlements of the fixed leg take place on an annual basis.
A pension fund can outsource processing of both the confirmations and settlements to a 3rd party like ABN AMRO. Alternatively procedures can be set up for pension funds in order to handle confirmations and settlements themselves. Before real trading takes place a testing phase is implemented with dummy trades covering settlements, confirmations and collateral calls.

Swap Position Valuation
During the life of the trade, valuations need to be done in order to calculate the overall swap position of the portfolio for collateral management and to re-balance the position in line with a new ALM study.
Depending on changes in the swap yield curve, there will be a positive or negative marked-to-market (MtM) value on the swap position. In essence the MtM represents the cost incurred in closing out the swap position by entering into an offsetting swap position.
If collateral agreements are in place, normally the bank will be the calculating agent in providing periodic MtM valuations to the end user. Cases of disputes on valuation can be covered in an upfront agreement by a number of different methods: valuation boundary (+/- 2.5%); independent valuation agent (third party bank); or the average of 5 independent quotes by market makers disregarding the highest and the lowest quote. If a pension fund wishes to do in-house valuation, ABN AMRO provides education on valuation methods along with the implementation of the necessary pricing tools.

Collateral management
To mitigate the credit risk long-term trades will be performed on a collateralised basis on the terms described in the CSA. The mechanics of posting collateral are that on a predefined frequency, the portfolio of trades are valued and the net present value (NPV) of all fixed and floating legs is calculated. The total sum of these NPVs is the MtM of a transaction. If there are multiple trades outstanding the sum of all the MtMs is taken to calculate the value of the entire portfolio. This sum equals the risk one party bears against the other party. The CSA will legally bind two parties to post an equal amount of collateral e.g. bonds, cash or equity on a given period before maturity of the trade. A certain threshold amount will trigger the CSA and in order to settle only material amounts, a minimum transfer amount is included.
ABN AMRO can provide collateral management support, which is an independent service completely segregated from front-office activities. This support takes care of valuation, collateral margining calls and settlements for all trades including those with third parties. If a pension fund wishes to do in-house collateral management, ABN AMRO can implement the necessary procedures along with the necessary valuation tools.

Derivative Management Services
ABN AMRO has bundled the existing knowledge and capabilities on derivatives into Derivative Management Services (DMS). DMS produces tailor-made solutions for pension funds regarding all issues mentioned above. In addition, DMS offers periodic research, P&L, accounting and PVK/DNB reports to provide clients and other stakeholders with insight into the risk positions of the pension fund. Although all services can be tailored as one package, ABN AMRO guarantees strict rules on segregating execution and back office activities.

For more information on DMS or any issues related to pensions please contact:

ABN AMRO Dutch Pension Team
wouter.tol@nl.abnamro.com +31-20-6282800
sander.de.greeff@nl.abnamro.com +31-20-3836565
hilko.de.brouwer@nl.abnamro.com +31-20-3836566
kostas.konstantis@nl.abnamro.com +31-20-3836567
mark.van.binsbergen@nl.abnamro.com +31-20-3836155

ABN AMRO Holding NV
Gustav Mahlerlaan 10
1082 PP Amsterdam
The Netherlands

Telephone: +31 20-629 8000
Fax:+31 20-620 5486

Topics