A Derivative Dilemma

Post-crisis rulebook updates are raising hedging costs on both sides of the Atlantic.

Derivatives: complex, nuanced, full of jargon, decidedly unsexy—but vital to the success of liability-driven investment (LDI) strategies.

Take a deep breath—we’re going in.

Pension funds and asset managers commonly use this massive piece of the global financial sector to implement LDI. But some derivatives instruments—namely swaps linked to government bonds—have become subject to rules rolled out in the wake of the financial crisis. And with new regulation comes new costs.

In the US, money market fund rules have been pushing more investors into the short-term treasury market, says Ronan Cosgrave, managing director at PAAMCO. Money market funds investing in commercial short-term loans now have redemption restrictions and a floating net asset value (NAV) rather than a lower limit of $1 a share. But funds invested in US government bonds are exempt from these rules—resulting in a mass migration of more than $500 billion, according to several reports.

The implications for swaps linked to treasury bonds are “still being worked out,” Cosgrave says—the rules only became effective on October 14 this year. “I can’t imagine that the market won’t stay strong, but the pricing will change relative to cash.”

Already, long-dated swaps are trading at much lower yields than their equivalent physical treasury assets. Cosgrave estimates that a 20-year swap contract is yielding roughly 40 basis points less than a 20-year treasury bond. This might not have sounded like very much a decade ago, but as yields compress across the board, price impacts like these could have a profound effect on portfolios.

And investors were pushed even further towards treasuries in August, when the US Commodity Futures Trading Commission announced that futures brokers and derivatives clearing houses would be “restricted” from investing in money market funds with floating NAVs or redemption barriers.

Meanwhile across the Atlantic, European LDI implementers also face increased costs to using derivatives. In an attempt to address investment bank counterparty risks post-Lehman Brothers, European investors are now required to trade derivatives through central clearing houses and post a minimum level of collateral in case of default.

However, European pensions are exempt from these rules until August next year, and the European Commission (EC)—responsible for designing the new rulebook—has proposed lengthening the exemption.

An extension would be “a positive development, particularly for large pension schemes that might otherwise have been forced to take unnecessary foreign exchange risk,” according to Vanaja Indra, market and regulatory reform director at Insight Investment. In an interview with CIO’s sister publication The Trade Derivatives, Indra said the exemption “recognizes the concern that pension funds have liabilities denominated in local currencies, and therefore should be allowed to post domestic government bonds denominated in the local currency as collateral for over-the-counter [OTC] derivatives.”

Despite the possibility of concessions on collateral, at some point large pension funds trading in derivatives in Europe will have to set up relationships with the new (non-bank) clearing houses, brokers, and counterparties. This would be “far from ideal” for pension funds, claimed Thijs Aaten, managing director for treasury and trading at Dutch pension manager APG, to The Trade Derivatives.

Market value of interest rate derivatives, 2009-2015, $billion

Whichever way you look at them, the rules imply larger cash holdings for institutional investors. “That in itself introduces a performance drag, but also introduces problems in managing short-term cash,” Aaten added. Under current European rules, cash collateral must be posted with the clearing broker or swap dealer as collateral, known as a “variation margin,” for derivatives trades. However, pension funds rarely hold large amounts of cash, preferring instead high-quality government bonds.

At the same time these rules are being debated, investment banks’ capacity to be market makers in the derivatives space has fallen dramatically. Leverage rules imposed on them after the financial crisis mean banks are limited as to the level of debt they can hold. Though pension funds prefer to use government bonds as collateral, if their counterparty is a bank, bond usage will be limited. More cash it is, then.

“Because of the impact of the leverage ratio, some derivatives markets are going to be a lot more expensive,” Aaten said. “[Overall] I do not see a dramatic reduction in interest-rate hedging, but it will be more expensive to trade and maintain a hedge.”

Earlier this year, European investors including APG, fellow Dutch pension manager PGGM, and asset managers MN and Insight wrote to the EC urging it to review the impact leverage ratio rules will have on pension funds when clearing derivatives. The letter warned that pensions could be forced out of the derivatives market if rules requiring them to post cash as collateral were not changed. Pension funds may have to decide whether to accept the new costs of using derivatives or exit the market altogether, the investors said.

“While the leverage ratio only affects banks, there is the knock-on effect because pension funds trade with banks, which as a result do not recognize government bonds as [collateral],” said Insight’s Indra. “That will then put pressure on pension funds.” Those forced to raise cash as collateral would also be forced to liquidate holdings, she added, introducing more risks, adding trading costs, and emphasizing short-termism.

A 2012 paper from consultancies Europe Economics and Bourse Consult estimated that an extra €205 billion to €420 billion ($229 billion to $469 billion) of cash collateral would be needed under the EC’s rules as they were then drafted.

Plus, a move to all-cash collateral would create huge cash buffers at pension funds. The continent-wide trade body PensionsEurope has estimated that a €60 billion pension fund could incur annual costs of as much as €120 million, based on a cash buffer of 4% and an annual average return of 5%.

Cash collateral would also place a greater reliance on repurchase agreements (repo) and securities lending to meet the demand for cash. The cost of running a repo business—buying government bonds with an agreement to sell back at a later date—has increased for banks due to the aforementioned leverage rules.

“Clearing offers some positive advantages but it also offers a fair amount of cost and there is a lot of complication involved with it,” Trevor Welsh, head of LDI at the UK’s Pension Protection Fund (PPF), tells CIO. “Ultimately, it seems to be coming down the pipe so we are preparing ourselves fully for it.” The PPF has an “ongoing project” looking into the rule changes’ operational aspects as the lifeboat fund continues its efforts to bring more LDI capabilities in-house.

But even as more investors follow the PPF in wading into the complex world of derivatives, beware thinking you’ve got it figured out.

“It’s a bit like what Alan Greenspan said about the Federal Reserve,” Welsh concludes. “‘If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.’ Derivatives are a little bit like that.”

—Nick Reeve and Joe Parsons