Trustees need to start preparing for the impacts of EMIR, says Tom Hibbard, business development at KAS BANK.

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‘Cash is King’, in other words, liquidity is essential to all business and institutions. I sit here writing this on a Thursday and already this week, both BHS and Austin Reed have filed for administration due to cash flow issues.


With central clearing just around the corner for Europe’s pension funds, liquidity as an asset class is becoming an ever more important discussion.

Following the global financial turmoil of 2007/08, in particular Lehman’s $35 trillion derivatives portfolio collapse, regulators in both Europe and the U.S. have brought about sweeping reforms to the derivatives market. In an attempt to mitigate counterparty risk and improve transparency of derivatives trading, the regulators came up with the European Markets Infrastructure Regulation (EMIR).

To try to mitigate the risks that derivatives can pose, this regulation has put in place measures that require portfolio compression, reconciliations and dispute resolution terms, as well as reporting obligations that have already come into play. However, much has been written about this so I won’t bore you further on the topic.

What I personally think is the largest hurdle borne out of this regulation is the mandatory central clearing of certain derivative transactions, which does away with the former direct party-to-counterparty bilateral model. This requires market participants to engage with parties known as General Clearing Members (GCMs) in order to gain access to the Central Counterparty (CCP). The background is complicated as it is important, but where does cash come into the equation?

To get technical for a moment, clearing will require initial margin (collateral at inception) and variation margin (collateral used to cover movements in the market over the duration of the derivative). Currently, you can only post cash as variation margin and not the liquid government bonds that would be preferable for most pension funds given their existing investment strategy.

This means that pension funds are facing the prospect of having to hold up to 25% of the value of their portfolio in cash so as not to run the risks of having their derivative positions closed out due to a lack of margin.

As cash is neither an effective liability matching nor return seeking asset, this poses a problem. On top of this, only the very largest of pension funds have adequately sized treasury functions and repo capabilities that can help to alleviate these concerns.

To put some numbers and meaning around this; let’s assume a market return of 3% and inflation of 1% (2% real growth), shifting 25% of your portfolio into cash will result in a 0.5% loss in expected return. Taking a mid/long-term view, this will reduce funding levels by 10% over a 20 year period. As switching out of derivatives is not a realistic solution due to pension funds’ long-term risk exposures, a solution must quickly be found to this problem of liquidity or missed yield opportunities will see deficits grow ever larger.

So, is the future looking bleak for pension funds? I don’t think we should start packing up shop and shifting either out of derivatives, or largely into cash. In EMIR terms, pension schemes are coming late to the game and therefore they aren’t the first investors to face this challenge and there have been lessons learned. We need to start preparing for the impacts of EMIR and ensure we understand exactly what pension schemes need and get ourselves ready to operate under this new system.

Tom Hibbard, business development at KAS Bank