But this seemingly technical change to the over-the-counter derivatives market means the likes of pension and mutual funds will need to post collateral to back their trades – collateral they do not always have, at least not in the form the central counterparties are willing to accept. The tighter regulations are a result of the financial crisis, when the leverage and opacity associated with the OTC market was seen as having contributed to the transmission and amplification of credit losses through the financial system.
These fears prompted a unified regulatory response, with the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US, the EU’s European Market Infrastructure Regulation.
First on the list are interest rate swaps – integral to liability-driven investment programmes – followed by credit default swaps. Around 50 per cent of interest rate swaps are already centrally cleared, but this is mainly dealer-to-dealer business. These traders will tend to have offsetting two-way positions, allowing them to net off the collateral they need to post, reducing it substantially. For those positioned one-way, such as pension and mutual funds, trading will become substantially more capital intensive. Europe’s EMIR requirements could also force pension and insurance funds to hold 10-20 per cent of their assets in cash and near-cash to meet potential variation margin calls, resulting in an annualised yield drag of 2 percentage points for the former and 2.5 for the latter
In Europe, pension funds have been given a three-year exemption from central clearing, but there is a widespread view that banks will pressure pension funds to switch away from uncleared deals before then, while many schemes themselves may want to get ahead of the curve.
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