Pension funds face derivatives exodus

Europe's pension funds could be forced to withdraw from the OTC derivatives market if rules on variation margin are not reviewed.

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

In a joint letter to the European Commission’s Jonathan Hill, the heads of Europe’s largest pension funds warned that rules restricting the use of non-cash collateral, such as government bonds, would reduce liquidity in the OTC derivatives market and could result in them being shut out.

The letter was signed by the CEOs and CIOs of Dutch pension funds PGGM, MN and APG Asset Management, and Insight Investment.

Last year, the European Commission provided a temporary exemption for mandatory clearing of derivatives for pension funds. However, the pension funds said: “the temporary pension exemption must remain in place until a robust solution is found for central clearing.”

What is most alarming for Europe’s pension funds though is the leverage ratio and net stable funding ratio rules, which are expected to force pension funds to post variation margin in cash only for their non-cleared derivatives trades.

The letter said banks are refusing to accept high quality government bonds because they are not permitted to offset market-to-market exposures. “As a result, many banks are not restricting OTC derivatives trades to those that are collateralised with cash VM only… We expect this trend to continue and thereby reduce liquidity within the OTC derivatives market,” the letter said.

According to a paper from the Europe Economics and Bourse Consult in 2012, it estimated that an extra €205 billion to €420 billion of cash collateral would be needed if European pension funds were required to post cash variation margin.

“These rules would force pension funds to either divest physical assets (such as bonds and equities) to release the required cash, or avoid using derivatives altogether,” the letter adds.

The rules on variation margin will place greater emphasis on the repo and securities lending markets as the demand for cash increases.

However, as banks continue to feel the bite from the Basel III capital rules, the cost of running a repo business has increased disproportionately. As a result, banks ability to support the repo market is shrinking.

The letter stated: “any negative impact on the repo market would likely have a corresponding negative impact on physical bond market liquidity and derivatives pricing.”

The pension funds have requested the European Commission, as well as other international policymakers, to review the rules and full analysis on the impact of bank regulations to be conducted.