Response on Public Consultation on Derivatives and Market Infrastructures

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1 Response on Public Consultation on Derivatives and Market Infrastructures The Dutch umbrella organizations for pension funds, Vereniging van Bedrijfstakpensioenfondsen (VB), Stichting voor Ondernemingspensioenfondsen (OPF) and Unie van Beroepspensioenfondsen (UvB) hereby respond on the public consultation of the European Commission on derivatives and market infrastructures (June 14 th, 2010). Preliminary Remarks The Dutch umbrella organisations for pension funds represent over 90% of the Dutch working population. The Dutch pension funds have over 700 billion assets under management. Thus they are important institutional investors. The return on investment is solely used for the benefit of the pensioners and to enable sustainable and adequate pensions for the future retirees. The Dutch occupational pension system is based on collective agreements with automatic enrolment for employees that adhere to the collective agreement of a sector wide, company wide or a professional scheme. This enables the pension funds to mitigate risks in times of financial crisis. Pension funds use OTC derivatives as a means of hedging their financial risks with a long term perspective. OTC derivatives as used by pension funds therefore lead to more stable financial positions of pension funds in distressed markets, mitigating the contribution to systemic risk. Pension funds actively manage their counterparty risk by means of a thorough selection process, spreading transactions across counterparties and adherence to collateral management agreements. Keeping in mind as mentioned above that the return on investments of pension funds is solely used to provide for adequate pensions of current and future retirees, regulation should not lead to higher risks or additional costs for the participants of the pension fund that outweigh the benefits of such regulation. We support the general objective of the draft legislation that aims at ensuring efficient, safe and sound derivatives markets and we understand the desire for central reporting. There are, however, concerns about its impact on pension funds. If insufficient attention is given to the needs and current approach towards financial risk management of pension funds, the proposed legislation may inadvertently create barriers to effective risk management. In the analysis below, we would like to address the following issues in more detail: Optional instead of mandatory participation in a central clearing system Mandatory asset and account segregation and mandatory transportability of money and assets Initial margin setup should be based on risk profile instead of on a standard rate per transaction

2 Key issues Optional instead of mandatory participation for pension funds in a central clearing system Pension funds are very conservative and very solvent. They are low risk investors with a long term horizon: pension funds often have obligations to their participants that lie 30 years or more ahead. They are conservative because they mainly use derivatives to minimize the risk on their long term obligations. This risk is mainly comprised of interest risk i.e. the risk that the long term interest rate will fluctuate and cause a negative balance between assets and obligations in the future. Besides this conservative use of derivatives pension funds have certain specific means to deal with difficult market circumstances. They can rebalance bad times by sharing the risks between pensioners and active workers, by setting up buffers or by raising additional contributions from the sponsor. Given the fact that pension funds conservative strategies typically aim at long term, low risk and low turnover, the use of derivative markets in the spectrum of investors can be characterized as opposite to high risk trading funds. Pension funds use OTC derivatives to hedge their financial risk and ensure more stable financial positions in distressed markets, thus mitigating their contribution to systemic risk. Although pension funds are defined as financial counterparties their specific use of OTC derivatives for hedging purposes makes it more accurate to categorise them as special non-financial undertakings with an extremely low risk profile. Most pension funds already adhere to strict and adequate arrangements regarding counterparty risk management. These arrangements are governed by tested ISDA documentation and have proven to be able to weather the credit crisis in all ways. Thus, many pension funds already have robust bilateral collateral management processes in place. These bilateral derivatives arrangements are properly netted and collateralised and accompanied by optimal risk management tools and therefore provide pension funds with a very high level of comfort from a risk perspective. In addition, the risk exposure is diversified contracting with a wide range of market participants with a high credit standing. Mandating pension funds to clear through a clearing system could mean that they move from a low risk bilateral approach to a system where they could run more concentrated risks (one or only few central parties, limited clearing members), because of the interconnection within the system. Market participants with whom pension funds would never enter into bilateral derivatives arrangements given their high risk activities and limited creditworthiness are likely to also participate in the system. As a result, pension funds would absorb risks created by less conservative and less solvent parties. This might even entail taking more risk by other market participants. Pension funds have a primarily responsibility towards their pensioners. They should therefore not be obliged to absorb and ultimately bear risks which they do not create. In the interest of their pensioners pension funds should be able to participate on a voluntary basis. Depending on the risks connected to a new central clearing structure as it will be actually

3 implemented, pension funds should be able to decide whether and to what extent they stake pension assets by participation. Thus, from a pension fund s risk perspective, mandatory participation in a central clearing system does not add value above the currently functioning bilateral derivatives arrangements, which are properly netted and collateralised and accompanied by optimal risk management tools. Pension funds, their managers and investment structures dedicated to pension funds should not be obliged to clear through a central clearing system, as this would increase the risks they run. Due to their unique characteristics, pension funds should have a choice whether or not to participate in a clearing system and to what extent they would like to participate. Mandatory asset segregation and mandatory transportability It is foreseen that both CCP s and Clearing Members have a lot of contractual freedom in the setup of account structures under the new central clearing structure. If the account and asset separation of clients is not mandatory this might pose an unacceptable risk to the financial market. The result of such contractual freedom would be a strong dependence of the stability of the financial market on a clearing member s administration if a clearing member or CCP defaults. Given recent experiences with the administration of big financial institutions that failed, this is an unacceptable situation. The principles should therefore be expanded to incorporate more specific requirements for central clearing, including an obligation to segregate the money and assets of clients from those of the clearing member at both a clearing house and clearing member level. We also note that a clearing member will only have a contractual obligation to accept the transactions of a client in those situations where another clearing member fails. This means that the legislation leaves room for CCP contracts that contain provisions that make the portability of the money and assets dependent on additional conditions. Given the importance of portability for the central clearing structure, this should not be allowed. We therefore plead for mandatory portability of money and assets. A main concern is that the proposed central clearing structure gives parties contractual freedom regarding critical conditions, such as account and asset segregation and the question which type of OTC contracts will be centrally cleared. It should be mandatory prescribed that the accounts and assets of clients should be segregated from those of the CCP or the Clearing Member. The mandatory transportability of moneys and assets should be included in the legislation.

4 Initial margin setup should be based on the participant s risk profile instead of on a standard rate per transaction Currently, the Central Clearing Partners (CCP s) have incorporated a system for the calculation of initial margin that is based on a standard rate per transaction: the IM calculation. The IM calculation has very negative consequences for long term low risk investors like pension funds. Conservative pension fund investment strategies in general create important one way OTC derivatives exposures. Pension funds commonly use long term interest rate swaps to safeguard their large long-term obligations against the influence of interest rate variations (hedging). As a result, it is expected that high amounts of margin will have to be provided to cover these positions and without additional measures (such as lower margin requirements for pension funds) this will result in the pension funds cross-subsidizing of leveraged market users. The beneficiaries of the IM calculation are the clearing members and leveraged market users who do not have the necessity to use long term interest swaps to hedge their obligations. Due to the nature of their financial activities, the IM calculation favors them hugely, resulting in a close to zero initial margin contribution from their side. As a result, the low risk investors will pay the lion share of the total initial margin reserve of a CCP. This means a large performance drag for pension funds. In the end, the participants of the funds pay this bill. Thus, it is the (future) pensioner that ends up paying for the safety device to protect the financial markets from the irresponsible behavior of high risk investors. We think that this side-effect of the central clearing obligation is unnecessary and unfair. The cost of central clearing should be proportionate to the risk profile of the investors and should not be based on a standard rate per transaction. The legislation should contain an obligation towards CCP s to that end. In our view the cost of central clearing should be proportionate to the risk profile of the investors and should not be based on a standard rate per transaction. Without legislation on this subject, the current practice of an IM calculation will disadvantage the low risk investors such as pension funds. The pension funds (at the end at the expenses of its participants) will have to pay up for the largest part of the CCP s margin reserve, whilst the higher risk parties contributions are reduced to a minimum due to their netting possibilities. The legislation should therefore contain an obligation for CCP s to take the risk profile of a pension fund into account when calculating the initial margin.

5 The Dutch umbrella organisations are ready to provide further expertise on the preparation of the legislative proposal on OTC Derivatives. Contact: Sibylle Reichert Tel.: