A recent article from Towers Watson, the consulting firm, entitled “Is this the end of OTC derivatives for pension schemes” caught our eye. It is about the impact on financial regulation (and central credit counterparties — CCPs — in particular) on pension investors The article is directed toward UK pension schemes, but the conclusions drawn could apply to the US as well.
The authors note that the credit terms seen by pension managers on ISDA-governed OTC derivatives have become less attractive. Banks are demanding more cash and shorter dated sovereign paper as collateral. Towers Watson expects a convergence between what Banks will take as collateral for OTC derivatives and what CCPs will accept.
We have written about the mismatch between what managers own and what CCPs accept as initial margin for OTC derivatives (see below for links). This mismatch is creating the need for collateral upgrade trades. But collateral upgrade trades don’t always solve the problems and can create risks of their own. It may come down to pension managers simply changing the way they run their portfolios — holding more cash and short-date risk free paper. This will, in turn, impact their returns. The authors also said that for non-cleared OTC derivatives, banks will have to hold additional capital. This is a cost that will inevitably be passed to clients, making the trades less attractive.
Pension fund managers, especially defined benefit plans, have enough problems of their own to earn the returns they need to keep the pensions flowing. Adding CCPs to the mix may be a bridge too far and the result might be swearing off derivatives altogether.
Links from relevant www.secfinancemonitor.com posts are here, here and here. A link to a synopsis of the Finadium research report “Insurance Companies, OTC Derivatives and the Collateral Upgrade Trade” is here. A link to the Finadium research report “Central Credit Counterparties, Margin and the Challenge of Collateral Management” is here.
A link to the Towers Watson article is here.