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Eversheds' Financial Institutions speedbrief: Pension plans and derivatives: To clear or not to clear?

    • Financial services and markets regulation - EMIR
    • Financial institutions


    Key actions

    The trustees of pension plans which use derivatives (and their investment managers) need to consider now how to respond to new EU requirements on the central clearing of certain derivative contracts. They should be:

    • considering whether to clear their eligible derivatives transactions through a clearing house, or to take advantage of the transitional period for pension plans; and
    • ensuring that their ISDA contracts for uncleared derivatives transactions are amended to reflect certain specified “risk mitigation” measures. 

    Derivatives and the new EMIR legislation

    Derivatives are either:

    • privately traded, bi-lateral contracts which are agreed “over-the-counter” (“OTC”) between the parties without going through an exchange or intermediary; or
    • traded on an exchange. 

    The EU Regulation on OTC derivatives transactions, central counterparties and trade repositories (known as “EMIR”) came into force on 16 August 2012, although many of its requirements have not yet taken effect.

    EMIR requires certain types of OTC derivatives transactions (including those entered into by pension plan trustees) to be cleared through a central counterparty (a “clearing house”).

    Clearing OTC derivative contracts

    Pension plans benefit from a three year transitional period, which means that certain OTC derivatives transactions that would otherwise need to have been cleared under EMIR need not be cleared until 15 August 2015.  The reason for this transitional period is because currently central counterparties can only receive cash as variation margin.  

    Variation margin involves the delivery of cash to the central counterparty to protect it against the risk of a counterparty failing to make payments. Pension plans do not typically like to hold large amounts of cash, and so they lobbied against central clearing on the basis that it might require them to sell assets to satisfy margin calls.

    The transitional period is designed to give central counterparties time to identify solutions under which they could receive variation margin other than in cash. This would allow pension plans to post certain types of securities as variation margin rather than be forced to sell assets to generate cash for this purpose.  It is anticipated that this transitional period will be extended by up to three years to 2018.

    Despite the transitional period, however, pension plan trustees and their investment managers should be considering now whether to centrally clear their OTC derivatives transactions or whether to take advantage of the transitional period for the time being. This is because there are a number of strategic issues which need to be considered in deciding whether to adopt early clearing.

    Pension plan trustees should be aware that banks are likely to have to hold increased amounts of capital in respect of uncleared OTC derivatives transactions that they enter into, and that the increased costs of these uncleared transactions are likely to be passed on to their counterparties, including pension plans. It may therefore prove to be more expensive to enter into uncleared OTC derivatives transactions than centrally cleared OTC ones.

    Only “clearing members” (typically banks) can access the central counterparty.  Pension plans will not be clearing members, and so if they wish to centrally clear eligible OTC derivatives transactions they, or their investment manager on their behalf, will need to appoint one or more “clearing members” and negotiate the associated documentation.

    Pension plan trustees should be discussing this with their investment managers.  We expect that investment managers will encourage their pension plan clients to clear their derivatives contracts well ahead of the end of the transitional period, not least because they may want to treat all their clients in the same way (and clearing will be mandatory for many of their other clients). In those circumstances, we expect that investment management agreements will need to be amended.

    Pension plans that decide to centrally clear will need to consider how they will generate sufficient cash for margin purposes until such time as securities can be used for this purpose. This might include entering into “repurchase contracts” to use securities (such as gilts) owned by the plan to generate cash to satisfy margin calls.  This is known as “collateral transformation” and works by a pension plan selling securities to a counterparty and receiving the purchase price in cash with an obligation to repurchase equivalent securities from the counterparty at a later date.

    Additional compliance for uncleared OTC derivatives

    EMIR does not just deal with centrally cleared derivatives transactions, it also imposes obligations on parties that enter into OTC derivatives transactions that are not cleared. These are referred to as the risk mitigation techniques and include obligations around the following areas:

    • Confirmations
    • Portfolio reconciliation
    • Portfolio compression
    • Dispute resolution
    • Marking to market or marking to model
    • Collateral exchange
    • Capital requirements

    The extent to which the risk mitigation techniques apply depends on an entity’s categorisation under EMIR.

    Some of the risk mitigation techniques are already in force, such as requirements relating to timely confirmations. Others are due to become effective on 15 September 2013.

    If pension plan trustees are intending to take advantage of the transitional period or will have transactions that are not eligible for clearing, they should ensure that the ISDA Master Agreements that they have in place with banks, or which their investment managers are using to enter into derivatives transactions on their behalf, are amended to reflect the risk mitigation techniques.  Again, investment management agreements may need to be amended to deal with the flow of information and allocation of responsibilities.

    How we can help

    Eversheds’ derivatives team is advising our investment manager and pension plan clients on EMIR, including training on the regulations, advising clients on their documentation with clearing members, amending their derivatives contracts, amending investment management agreements, and putting in place repurchase contracts for collateral transformation.



    For more information contact

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