Pension funds bite nails over Dodd Frank margin demands
15 August 2013 New York
Image: Shutterstock
Northern Trust has released a paper on capital requirements for pension funds in the wake of the US Dodd Frank Act that encourages collateral management as a solution to demanding margin requirements.
In an effort to reduce risk and increase transparency, the US Dodd Frank act imposes mandatory clearing and trade execution of certain derivative products. To help ease the migration of swaps to a central clearinghouse, the Commodity Futures Trading Commission (CFTC) and the 麻豆传媒 and Exchange Commission (SEC) have approved a phase-in approach for market participants.
For pension plans subject to the Employee Retirement Income Security Act (ERISA), the mandatory clearing of certain interest rate and credit default swaps begins on 9 September 2013. By mandating interest rate products first, which account for $489 trillion or 77 percent of outstanding notional, the CFTC has encompassed a majority of the swap activity in the OTC market.
鈥淢any pension funds use interest rate swaps to synthetically increase their portfolios鈥� duration while conserving plan capital.
These instruments are widely used in liability-driven investment strategies to hedge long- term pension liabilities,鈥� said the report.
But Dodd-Frank鈥檚 central clearing of swap contracts adds new capital requirements of initial margin and variation margin.
The initial margin is intended to cover the fluctuation in a contract鈥檚 value over a fixed period. The variation margin functions as a mitigation to credit exposure arising from daily fluctuations of a contract鈥檚 market value.
Northern Trust has expressed concern over these new requirements, saying that they can be seen as imposing to plan managers. The amount of initial margin required is as yet unknown; with estimates ranging from $800 billion to $10 trillion dollars.
A recent report published by the Bank of International Settlements estimated a growth of $4 trillion in initial margin demand.2 These figures have begun causing concern that there could be a shortfall in available high quality assets to meet the requirements for plans.
To determine the impact of Dodd-Frank鈥檚 initial margin requirements on pension funds, the custodian identified the initial margin requirements across hundreds of pension fund accounts, all of which held eligible interest-rate swap products.
Among the accounts in its sample, the average initial margin requirement was $5.3 million, which is only 1.53 percent of gross notional. Only 18 percent had initial margin requirements larger than $10 million.
鈥淥ur analysis shows that most funds in our sample group with margin requirements of more than $1 million have ample eligible collateral, in the form of high-grade government or corporate bonds, to meet their initial margin requirements,鈥� said the report.
While the clients have sufficient collateral to cover the initial margin required for interest rate swaps, pension funds use other OTC products as well, it added.
Across the sample set of data, 57.4 percent of the trades in the pension accounts were interest rate products. The next most prevalent swap type was credit products, which consisted of 34.5 percent of all trades, leaving 7.9 percent to be distributed across remaining swap categories.
The Dodd-Frank Act imposes initial and variation margin for uncleared swaps as well.
鈥淒ue to the phasing in of product categories under the Dodd-Frank regulations, pension funds may discover they eventually will be required to post collateral to multiple sources for these non-interest- rate products,鈥� said Northern Trust, adding that distributing collateral to counterparties on noncleared derivatives will require sophisticated collateral management to track and ensure proper collateral is available to cover all margin requirements.
鈥淔or the accounts sampled in our data set supplying initial margin should prove no immediate challenge. However, pension plans must also be mindful that margin will also be required for uncleared swaps. Having cash on hand to meet variation margin needs may pose a challenge for some plan managers, especially those with longer duration swaps, which can have large market value swings. The real test will be ensuring that plans are engaging in the more efficient use of their collateral.鈥�
In an effort to reduce risk and increase transparency, the US Dodd Frank act imposes mandatory clearing and trade execution of certain derivative products. To help ease the migration of swaps to a central clearinghouse, the Commodity Futures Trading Commission (CFTC) and the 麻豆传媒 and Exchange Commission (SEC) have approved a phase-in approach for market participants.
For pension plans subject to the Employee Retirement Income Security Act (ERISA), the mandatory clearing of certain interest rate and credit default swaps begins on 9 September 2013. By mandating interest rate products first, which account for $489 trillion or 77 percent of outstanding notional, the CFTC has encompassed a majority of the swap activity in the OTC market.
鈥淢any pension funds use interest rate swaps to synthetically increase their portfolios鈥� duration while conserving plan capital.
These instruments are widely used in liability-driven investment strategies to hedge long- term pension liabilities,鈥� said the report.
But Dodd-Frank鈥檚 central clearing of swap contracts adds new capital requirements of initial margin and variation margin.
The initial margin is intended to cover the fluctuation in a contract鈥檚 value over a fixed period. The variation margin functions as a mitigation to credit exposure arising from daily fluctuations of a contract鈥檚 market value.
Northern Trust has expressed concern over these new requirements, saying that they can be seen as imposing to plan managers. The amount of initial margin required is as yet unknown; with estimates ranging from $800 billion to $10 trillion dollars.
A recent report published by the Bank of International Settlements estimated a growth of $4 trillion in initial margin demand.2 These figures have begun causing concern that there could be a shortfall in available high quality assets to meet the requirements for plans.
To determine the impact of Dodd-Frank鈥檚 initial margin requirements on pension funds, the custodian identified the initial margin requirements across hundreds of pension fund accounts, all of which held eligible interest-rate swap products.
Among the accounts in its sample, the average initial margin requirement was $5.3 million, which is only 1.53 percent of gross notional. Only 18 percent had initial margin requirements larger than $10 million.
鈥淥ur analysis shows that most funds in our sample group with margin requirements of more than $1 million have ample eligible collateral, in the form of high-grade government or corporate bonds, to meet their initial margin requirements,鈥� said the report.
While the clients have sufficient collateral to cover the initial margin required for interest rate swaps, pension funds use other OTC products as well, it added.
Across the sample set of data, 57.4 percent of the trades in the pension accounts were interest rate products. The next most prevalent swap type was credit products, which consisted of 34.5 percent of all trades, leaving 7.9 percent to be distributed across remaining swap categories.
The Dodd-Frank Act imposes initial and variation margin for uncleared swaps as well.
鈥淒ue to the phasing in of product categories under the Dodd-Frank regulations, pension funds may discover they eventually will be required to post collateral to multiple sources for these non-interest- rate products,鈥� said Northern Trust, adding that distributing collateral to counterparties on noncleared derivatives will require sophisticated collateral management to track and ensure proper collateral is available to cover all margin requirements.
鈥淔or the accounts sampled in our data set supplying initial margin should prove no immediate challenge. However, pension plans must also be mindful that margin will also be required for uncleared swaps. Having cash on hand to meet variation margin needs may pose a challenge for some plan managers, especially those with longer duration swaps, which can have large market value swings. The real test will be ensuring that plans are engaging in the more efficient use of their collateral.鈥�
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