EMIR introduces a variety of requirements applicable with respect to OTC derivatives transactions. Some requirements, such as trade reporting and certain risk mitigation techniques, already apply, including with respect to OTC derivatives transactions entered into by UK pension schemes. Additional requirements, particularly the margining obligation with respect to non-centrally cleared OTC derivatives transactions and the clearing obligation, are likely to take effect in 2016 (in each case, subject to a phase-in). There is, however, a delay in imposing the clearing obligation on most OTC derivatives transactions involving pension schemes (commonly referred to as the “pension scheme exemption”)1 until 2017.
Pension scheme exemption
The pension scheme exemption applies at transaction level (thus effectively benefiting both counterparties to the OTC derivatives transaction rather than just the relevant pension scheme). All trust based UK occupational pension schemes should benefit from the pension scheme exemption. However, in order to come within it, the OTC derivatives transaction must be -
“… objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements …”.
This condition suggests that there may potentially be a mismatch between the nature of OTC derivatives transactions subject to the pension scheme exemption and the range of derivative transactions pension schemes are permitted to enter into. Pension schemes are generally permitted to transact derivative transactions which (i) contribute to a reduction of risks or (ii) facilitate efficient portfolio management (including the reduction of costs or the generation of additional capital or income with an acceptable level of risk). This appears to be potentially wider in scope than the pension scheme exemption and so it cannot be assumed that each and every OTC derivatives transaction entered into by a pension scheme will necessarily qualify for the purposes of the pension scheme exemption.
There has yet to be guidance from the European Securities and Markets Authority (ESMA) on the nature of OTC derivatives transactions subject to the pension scheme exemption. With no such guidance, trustees would need to assess if an OTC derivatives transaction entered into for income-generating or speculative purposes (albeit part of the portfolio which is overall risk reducing and otherwise in compliance with pension scheme regulations) is genuinely linked to risk reducing elements of the portfolio.
From a practical perspective, if trustees wish to take advantage of the pension scheme exemption care should be taken that any relevant investment management agreements set out the mandate and investment strategies in a way that precludes the fund manager from entering into OTC derivatives transactions which would not benefit from the pension scheme exemption. Given the uncertainty as to the extent of the pension scheme exemption, trustees will also need to be cautious not to take on unnecessary liability to counterparties to their OTC derivatives transactions for what may turn out to be an incorrect application of the pension scheme exemption.
If any OTC derivatives transaction benefits from the pension scheme exemption, it will still need to comply with the risk mitigation requirements set out in Article 11 of EMIR, including the margining obligation (see section ‘Background’ above). When the start date for the margining obligation comes closer, trustees should be assessing the benefit of reliance on the pension scheme exemption in light of the requirements that are supposed to be applicable to the respective pension scheme under the margining obligation.
CVA charge – does it matter?
The pension scheme exemption is also relevant for calculations of the own funds requirements for credit valuation adjustment risk (the “CVA capital charge”) required under the Capital Requirements Regulation 575/2013 (CRR). Pursuant to the relevant provisions of the CRR, banks facing pension schemes benefiting from the pension scheme exemption would not be required to apply the CVA charge. Incorrect application of the pension scheme exemption may therefore result in the banks failing to apply the required CVA charge.
Crucial from this perspective is the fact that the delegated regulation regarding the pension scheme exemption was only adopted by the European Commission on 5 June 2015 (see our footnote 1) and the pension scheme exemption is not yet published in the Official Journal of the European Union and thus not in force.2 In light of this, banks may need to apply the CVA capital charge following the expiry of the initial transitional period on 15 August 2015, until the extended pension scheme exemption is effective. This may have a significant impact on pricing of OTC derivatives transactions involving pension schemes.
The solution to this issue is not clear and for the moment, it’s a case of ‘watch this space’, with pension schemes potentially being impacted by increased transaction costs.3
Do you want to be able to clear before the pension scheme exemption expires?
Whilst the pension scheme exemption appears helpful, trustees should be considering whether their pension scheme should be set up to clear relevant OTC derivatives transactions voluntarily before the pension scheme exemption expires. There may well be commercial advantages in doing so (such as greater flexibility in addressing potential pricing changes or avoiding the necessity to comply with the margining obligation).
Clearing – what you will need to consider
In order to establish central clearing (whether at this stage or for the August 2017 deadline), trustees will need to consider, amongst other things, the following issues:
Choice of clearing member. Factors to consider will include the pricing and level of service offered and, potentially, the regulatory jurisdiction in which any relevant clearing member is domiciled. We would generally expect that two clearing members are selected - the primary clearing member and the “back-up” clearing member.
Which clearing documentation to use? Currently the two options are the ISDA/FOA Addendum and the FOA Terms of Business. They can both be used for cleared OTC derivatives transactions. In addition, the ISDA/FOA Addendum can be used for non-centrally cleared OTC derivatives transactions, and the FOA Terms of Business can be used for exchange traded derivatives. In making the ultimate decision, the Trustees should take into account which type of OTC clearing documentation is favoured by the market at the relevant time.
Investment management agreements (IMAs). Any current IMAs should be reviewed, particularly to ensure that they allow for such things as the transfer of OTC derivatives transactions from one clearing member to another following the default of the original clearing member (“porting”) and to update them for a potentially wider role by the investment manager with respect to OTC clearing.
Choice of central counterparty (CCP). Factors to consider include the different focus of the various CCPs (both in terms of product type and jurisdiction), as well as their pricing. The lengthy rules of the CCP will need to be reviewed in this context, in order to assess their impact on the terms of the relevant OTC clearing documentation.
Choice of account segregation. The types of account segregation that are available are gross omnibus, omnibus net, individual client segregation and full segregation (with omnibus segregation only providing for a return of the equivalent value of the collateral following a default, and individual or full segregation guaranteeing a return of the same asset that was posted by a posting counterparty). Factors to consider will be cost versus the differing level of protection these types of account segregation allow.
Meeting collateral requirements. At this stage, CCPs will only accept highly liquid assets (generally cash) as collateral to meet margin requirements. This creates a problem for pension funds which do not typically have significant cash holdings. Various solutions may become available, such as the use of repo transactions to provide the required cash (in return for securities), but these have still to be developed.
1 EMIR provides for a temporary exemption from the clearing obligation for certain OTC derivatives transactions entered into by pension schemes. This exemption was due to expire on 16 August 2015. Following a consultation (on Report COM/2015/039) with the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), on 5 June 2015 the European Commission published a delegated regulation extending the exemption by an additional two years. The exemption will, therefore, be available until 16 August 2017 (unless further extended by the European Commission by an additional year).
2 Under EMIR, there is a three-month period (which could be extended by a further three months) for the European Commission’s co-legislators – the Council of the European Union and the European Parliament - to object to the delegated regulation. The delegated regulation can only enter into force if no objection has been expressed by any of them. At this stage, the Council of the European Union’s conclusion is that it will not be objecting to the regulation, but the European Parliament is yet to confirm its position.
3 The European Commission stated that it was aware that the delay in the extended pension scheme exemption taking effect could have implications under the CRR. It confirmed that the extended transitional period will apply to all OTC derivatives transactions concluded up until 16 August 2017, " … including those concluded in the short period between the expiry of the old transitional period and the entry into force of the new one …", and that "… such a retrospective effect has been accepted as valid by the Court of Justice in previous cases [under "certain conditions"].". In our view, this nevertheless does not provide protection in the interim period prior to the extended pension scheme exemption coming into force.