EMIR was implemented as a response to the financial crisis in 2008 and the collapse of major financial services firm Lehman Brothers, which was a leading player in the OTC derivatives market.
The regulations came into force in August 2012, but certain requirements were subject to the development of regulatory technical standards, and occupational pension schemes using OTC derivatives to reduce investment risks relating to the financial solvency of the scheme were granted a three year exemption from the requirement to mandatorily clear certain classes of OTC derivatives. The initial exemption ran to August 2015 and has since been extended on two occasions so that it now expires on 16 August 2018. Once this exemption ends, unless it is extended again, it is likely to require pension funds to hold more liquid assets as collateral.
Certain classes of OTC derivatives trades, such as interest rate and credit default swaps, will need to be centrally cleared by pension schemes once the exemption ends. Central clearing involves another entity interposing itself between the two parties to the initial contract. The third entity is known as the central clearing counterparty (CCP). As part of this arrangement the CCP will require the posting of two types of collateral: variation collateral, and upfront or ‘initial’ collateral.
This will cost pension schemes more money for three reasons, said derivatives expert Stephen Woods of Pinsent Masons, the law firm behind Out-Law.com.
"The first is simply that central clearing will require schemes to post more collateral than they do currently. Secondly, outside the world of pensions, many financial institutions will hedge their risks by placing derivatives in both directions – for example some that stand to make money if interest rates go up, and others that pay out if rates go down. So these financial institutions can net off the collateral that is posted for the opposing trades. Pension schemes, by contrast, generally only hedge one way – typically, by protecting themselves only against interest rates falling, and so they cannot net off collateral. This makes the cost of collateral proportionately higher for them than it is for other institutions, meaning that they will suffer a greater cost impact from central clearing."
"Thirdly, CCPs have strict requirements about the kinds of assets that can be used as collateral, and usually require cash. This creates a potential issue for pension schemes which do not typically hold significant amounts of cash, instead having a greater investment focus on conventional and index-linked gilts. This might lead to an increased use of repo transactions by pension schemes, using their gilt portfolios to generate the cash needed to meet CCP collateral requirements" he said.
A Commission official told the Financial Times that Brussels plans to propose "targeted amendments" to the law in March, and is "assessing various options on pension funds". This may include another exemption period, the newspaper said.
Pensions law expert Mark Baker, also of Pinsent Masons said: "An extension would be really welcome for large pension schemes, not least because it would save uncertainty. Schemes already have to cope with the new variation margin requirements this March, so it's good news if Brussels is looking at this problem."
A derivative is a type of financial contract linked to the underlying value of the asset to which it refers, such as the movement of interest rates or currency value, or the possible insolvency of a debtor. OTC derivatives are those not traded on a regulated exchange but instead privately negotiated between two parties.