'Tailor-made' OTC solutions could become commonplace in hedging, says PGGM

EUROPE - Pension funds currently using derivatives for hedging purposes could decide to avoid going through central clearing as required under new US and European rules due to the potential cost burden and instead opt for tailor made OTC solutions, according to PGGM.

Speaking at the TradeTech swaps and derivatives conference in London yesterday, Ido de Geus, head of treasury and client portfolio management at the €120bn PGGM, said that the EU's European Market Infrastructure Regulation (EMIR) - as well as the Volcker rule proposed as part of the Frank-Dodd Act in the US - would inevitably cause pension funds to revise their approach to hedging solutions over the coming years, as the cost imposed by central clearing under both laws would become a burden.

De Geus said he saw a "two speed" market developing as a result of the regulation. "First, the liquid clearable market will grow, whereas the OTC tailored-made OTC market will shrink," he told delegates.

"This means that basic risk will become larger and the business case made internally [by pension funds] to decide between the option of having a cheaper and cleared market or a more expensive OTC tailor-made market will become more important than it currently is."

De Geus was responding to Anthony Belchambers, CEO of the Futures and Options Association, who pointed out that, given the inability to predict precisely the cost difference between the OTC market and the centrally cleared market under EMIR and the Volcker rule, some tailor-made solutions might be put in place for bilateral trades.

"That is precisely the kind of situation where you think that a number of counterparties might get together and decide to make a few changes to the terms of the contracts - with regard to the type of assets to accept as collaterals for instance - signed with end users under bilateral trades", Belchambers said. "This will lead to OTC tailor-made solutions."

De Geus therefore argued that, giving the extra costs introduced with the new set of policy in Europe and the US, pension funds would decide the exact amount of risk they want to hedge.

"If clearing becomes a cost burden to hedge liabilities, financial institutions will opt for tailor-made solutions and hedge exactly what they want to hedge", he said.

According to de Geus, pension funds might also "stay away" from derivatives as those trades will be required to go into central clearing houses under both the European and the US rules and instead use other hedging solutions such as the repo market for instance, for which such conditions do not apply.