Background: what is EMIR?
The European Market Infrastructure Regulation (Regulation 648/2012) (‘EMIR’) legally came into force on 16 August 2012, although in practice its provisions will not take effect until much later. Please see our report ‘EMIR: ESMA Final Draft Regulatory Technical Standards’ for more details.
Detailed secondary legislation – a set of regulatory technical standards (‘RTS’) and implementing technical standards (‘ITS’) was published on 27 September 2012 by the European Securities and Markets Authority (‘ESMA’), and was adopted without amendment by the European Commission (‘EC’) on 19 December 2012.
EMIR has three main components:
- an obligation to clear some OTC derivatives contracts through central counterparties (‘the clearing obligation’);
- additional collateral requirements for OTC derivatives contracts that are not cleared through central counterparties; and
- an obligation to report OTC derivatives contracts to a trade repository (‘the reporting obligation’).
The Theory: what does EMIR say about pension schemes?
The reporting obligation and the additional collateral requirements for non-centrally cleared OTC derivatives contracts apply to pensions schemes, just as they do to any other financial counterparty.
However, there is a temporary exemption for pension schemes from the clearing obligation (‘the pension exemption’). This will apply to any OTC derivatives contracts entered into by a pension scheme “that are objectively measurable as reducing investment risks directly relating to the financial solvency of [the] pension scheme arrangements” (Article 89(1) EMIR).
This was included in EMIR in response to fears that, if the clearing obligation were to apply to pension schemes, central counterparty variation margin requirements would require them to hold much more cash than they currently do or convert assets in cash, which would then have a negative effect on returns to policyholders.
However, it is still the EC’s declared aim that central clearing of OTC derivatives contracts be imposed on pensions schemes “as soon as this is tenable”.
The pension exemption will last until at least 16 August 2015. Meanwhile, by 17 August 2014, the EC must decide whether or not central counterparties have made the “necessary effort” to come up with a “suitable technical solution” for using non-cash collateral as variation margin, in a way that would avoid adversely affecting pension schemes. If the EC judges that they have not, then the EC has the power to extend the deadline to 16 August 2018.
The Practice: will the pension exemption work as intended?
Despite the pension exemption under EMIR, there is widespread concern that the pension exemption will not work in practice, or else there will be unintended consequences given the complexity of the surrounding regulations.
Particular concerns that have arisen are that:
- increased collateral requirements for non-centrally cleared OTC derivatives contracts will probably drive costs up. In fact, they might make it cheaper for pension schemes to use central clearing instead. A complex system could arise in practice, where some products are cheaper when centrally cleared, while others are more expensive;
- although interest rate swaps can be centrally cleared, inflation swaps at present cannot. A pension scheme looking to centrally clear interest rate swaps will have to split their portfolios accordingly, potentially incurring further costs;
- if Basel III does not include an exemption from higher capital requirements for banks dealing with pension schemes in non-centrally cleared OTC derivatives contracts, these additional costs might be passed on to the pension schemes or they may end up being forced into central clearing. However, recent developments with respect to additional capital requirements means that it is unlikely that banks will need to pass on any additional costs onto pension schemes that with respect to non-centrally cleared OTC derivatives contracts during the pension exemption;
- if most derivatives contracts relevant to pension schemes are going to be traded on exchanges, it will make sense for pension schemes to adjust to central clearing in any case;
- the pension exemption above has a rather precise definition and pension schemes might find that some of their OTC derivatives contracts fall outside the wording, so that central clearing is actually required; and
- given the time it will take for pensions schemes to prepare for central clearing, and the uncertainty that exists notwithstanding the pension exemption and timetable, some pension schemes may decide it is better to make a start preparing for central clearing well in advance of 2015.