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Home > Insurance Markets Viewpoints > Derivatives Regulation Threatens to Damage Pension Funds and Pensioners across Europe

Insurance Markets Viewpoints

Derivatives Regulation Threatens to Damage Pension Funds and Pensioners across Europe

by Ben Gunnee


Ben Gunnee is European director of the Mercer Sentinel Group, a specialist group within Mercer’s investments business that advises clients on investment operations and investment execution, including custodian reviews, investment manager operational due diligence, transition manager operations, and transaction cost analysis. Based in London, he is responsible for the group’s overall business strategy within Europe and is part of its global management committee. Before joining Mercer in 2002, Gunnee worked for the Financial Services Authority and a major life assurance company. Holding a master’s degree in accounting and finance and an honors degree in accounting and financial management, he has more than 14 years of experience in the investment and pensions sector. He is a fellow of the Institute of Actuaries.

As a principal consultant for Mercer, you have warned that the new banking regulatory regime set out in Basel III, together with aspects of the US Dodd–Frank Act, is likely to harm pension funds and so, ultimately, pensioners. What are the dangers?

It seems clear that capital charges on banks brought in by the new Basel III banking regulations are going to have a profound impact across Europe on pension funds that use over-the-counter (OTC) derivatives programs. If we break this down step by step, it becomes clear why this should be so. Pension funds that have achieved a degree of balance between their assets and their liabilities are very keen to take further risk off the table. The sponsoring companies behind these final salary pension schemes are also very keen not to expose themselves to continued volatility, so derisking schemes makes sense both from the point of view of the trustees and from that of the scheme sponsors.

Trustees, then, need tools that will enable them to “hedge out” unwanted risk, particularly risk that lies in possible interest rate movements and in inflation, neither of which are within their control and both of which can have a major impact on increasing their liabilities. So pension funds want to hedge out this risk, typically through a series of bilateral swaps with a number of counterparties. So far so good. This kind of swap has been used increasingly by pension funds over the last five to 10 years. There is no argument by any regulator against this, and it is considered to be an important tool for pension funds to have as they seek to meet the obligations they have to their members.

However, swaps are derivatives products and there is no doubt that derivatives—or, more specifically, the lack of transparency in derivatives trading—played a major role in the global financial crash of 2008. Because so much of derivatives trading was conducted away from recognized stock exchanges—taking place on a bilateral basis between two counterparties, with no visibility of how such deals were building up into a systemic risk—regulators and even the banks themselves were taken by surprise by how toxic derivatives turned out to be in the 2008 crash. Naturally enough, once the role that the lack of transparency in derivatives trading had played in the crash came to light, there was massive pressure to bring more transparency to the derivatives market. It seemed to both regulators and politicians that forcing as much as possible of the OTC derivatives market to be traded on recognized exchanges, or move to central clearing, would create transparency. The idea was that regulators should be able to have somewhere where they could go to check on any bank’s global OTC exposure, and since a central clearing counterparty (CCP) acts as a repository of all trades by standing between buyers and sellers this seemed to solve the transparency issue.

What they did not take fully into account is that OTC derivatives constitute a very complex area, and when you try to approach complexity with a rigid rule book the law of unintended consequences tends to run riot.

Can you spell out how the law of unintended consequences has made itself felt so far?

Certainly. Let us go back for a moment to the world of the final salary defined-benefit pension fund, which was already a difficult enough world before the current wave of enthusiasm for reregulation. For schemes that are in deficit, the sponsor company has two basic choices. They can either urge the scheme trustees to take on more risk (note that this decision lies with the trustees, not with the scheme sponsor) or the sponsor can put more cash into the scheme. If a sponsor puts more cash into the scheme, it is going to be very interested in derisking the scheme going forward, so that it will not have to repeat the cash injection at regular intervals. Companies would much rather use surplus cash to invest in new projects or boost the share price by increasing dividend payments to shareholders.

The new regulatory environment for OTC derivatives, which includes swaps, is then layered in on top of the world of the final salary pension scheme, not because the regulators want to regulate pension funds but because they want to regulate derivatives exposures. Under the proposed regulations there is a requirement for cash collateral, an asset class that is not typically held by investors with long-term liabilities such as a pension fund.

So, as the logical way of preventing pension funds from having an unwarranted and quite substantial additional layer of costs imposed on schemes by the new OTC regulation, the European Union has decided to allow pension schemes an exemption for three years. The idea is that they have three years when they can put all the swaps they want or need in place on a bilateral basis just as they have always done, and thus they will not be caught out by the cash collateral requirements once they too are included in the OTC regulations.

However, this exemption is granted to pension funds via the European Union’s proposed European Market Infrastructure Regulation (EMIR). This would be all fine but for the fact that the exemption is eroded by the provisions in a different piece of regulatory legislation, namely the new Basel III regulatory framework for banks. Basel III doesn’t address the needs of pension funds, instead requiring banks that are trading on a bilateral basis (i.e. with pension funds) to hold substantially more capital for these types of trades, which increases the overall cost of execution. It does this by imposing very stringent capital and margin requirements on any bilateral trades that banks do outside a CCP framework. So Basel III provides a disincentive for banks to do bilateral swaps with pension funds, which means that the three-year exemption for pension funds will not be as useful as originally intended.

The problem right now is that a large number of pension schemes are presuming that, as they have an exemption from central clearing, they do not need to make any of the operational changes that will be necessary for them to interact with a clearing house. They are also not taking the necessary steps to minimize the impact of the additional collateral they are going to be required to post in order to engage in swaps.

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