(April 9, 2013) — Bond funds and custodians may be the first to change tack as tight rules on over-the-counter (OTC) derivatives become reality later this year.
Changes to how OTC derivatives are held, accounted for, and cleared will come into effect under the European Market Infrastructure Regulation (EMIR). This ruling will the G20 commitment to have all standardised OTC derivatives cleared through a central counterparty (CCP) in the European Union by September 2013.
Investors holding any type of derivatives will be affected, including pension funds and other institutional investors holding interest rate and inflation swaps, options and futures.
Rating agency Moody’s announced this week, however, that managers of bond funds would be affected by the new regulations and were likely to change their strategies as a result.
It said strategy changes were likely as “standardized OTC derivatives would leave residual portfolio credit risks and increase operational costs”.
The rules will affect all major European and North American markets.
“The rule changes could entail the need for extra staff with the expertise to manage the exposures, thereby increasing a fund’s costs, and/or render some hedging arrangements as imperfect, as funds take measures to counteract the extra costs of initial margin requirements,” said Soo Shin-Kobberstad, a Moody’s senior analyst and the author of the report.
Under the rules, CCPs will require users of derivatives, such as bond funds, to deliver collateral through the posting of initial margins, the Moody’s report said. If derivatives are uncleared, the new derivatives regulation will establish more stringent initial margin requirements outright.
In addition, parallel regulatory initiatives – which impose significantly greater capital set-asides for dealers that provide uncleared derivatives – will likely increase the cost of uncleared derivatives transactions.
A threshold margin of $50 million has been announced by Basel Committee on Banking Supervision and International Organization of Securities Commissions, which Moody’s believes will offer relief to some smaller firms.
However, there is still reason to expect change, the ratings agency said. “Despite the threshold, initial margin requirements could lead to a drag on investment returns for many bond funds as initial margins will become standard practice across the market for both cleared and uncleared OTC derivatives. To reduce the cost of using OTC derivatives, some funds may choose to use less costly replacements such as standardised OTC derivatives or exchange-traded bond futures instead of customised derivatives that are tailored to their specific needs. While lowering costs, these shifts could lead to bond funds holding imperfect hedges or additional credit risks in their portfolios,” said Shin-Kobberstad.
Elsewhere, Citi tackled the issue on behalf of their institutional investor clients by announcing segregated collateral custody accounts to help mitigate counterparty risk and improve efficiency.
Tom McCartan, an EMIR specialist in investment consultant Redington’s manager research team, said segregated collateral accounts were a step in the right direction for making the central clearing proposition more appealing to pension funds from a risk reduction perspective.
“The main impacts to pension funds from central clearing will be the requirement to post initial margin and the requirement to meet variation margin calls with cash, rather than gilts or other assets as can currently be posted as collateral under a credit support annex,” McCartan said.
Citi’s new service will offer clients automated substitution control, collateral monitoring, and margin cash reinvestment.
Related content: Pension Funds to Drop Derivatives? & Sovereign Institutions Hit by Derivatives Regulation