Central clearing leaves pension funds with hedging dilemma

The increasing costs of using derivatives may force pension funds to re-evaluate their hedging strategies.

Pension funds may be forced to reconsider their use of derivatives for hedging as mandatory central clearing rolls out in Europe, according to a legal expert.

Pension funds are currently exempt from the clearing requirement for interest rate swaps until August 2017. However with volumes increasingly shifting to the cleared world due to pricing differentials and liquidity, schemes may be forced to establish links ahead of schedule.

With schemes relying on the readiness of their asset managers to deal with the regulation, it may encourage them to reconsider their derivatives usage.

“Pension funds have to deal with the impact of regulation across the board, and the cumulative effort of all that means they are going to have to figure out what it means for their hedging strategy,” says Sebastian Reger, a derivatives expert at law firm Sackers & Partners.

“Schemes need to work out what are the costs to entering hedges on a cleared basis, and the result of margin multipliers when they hit certain levels.

“On top of that, they need to consider the business risk. Pension schemes rely on their clearing brokers for their cleared trades, but they can turn around and reduce that volume on notice, forcing them to close out their transactions.”

Earlier this year, a group of European pension funds wrote to the European Commission to review the impact of the leverage ratio rules will have on pension funds when clearing derivatives.

The letter warned European pension funds could be forced out of the derivatives market if rules requiring them to post cash as variation margin are not changed.

Pension funds may have to decide whether to accept the new costs of using derivatives or exit the market.

“Because of the impact of the leverage ratio (NSFR and LCR), some derivatives markets are going to be a lot more expensive. [Overall] I do not see a dramatic reduction in interest rate hedging but it will be more expensive to trade and maintain a hedge,” says Thijs Aaten, managing director for treasury and trading, APG Asset Management.

“For pension funds cleared contracts are far from ideal. It implies that they have to hold large cash buffers. That in itself introduces a performance drag, but also introduces problems in managing short term cash.”

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