European Market Infrastructure Regulation (EMIR)


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European Market Infrastructure Regulation (EMIR)

  1. 1. Private & Confidential European Market Infrastructure Regulation 4th February 2013European Market InfrastructureRegulation (EMIR) Teach-In4th February 20131
  2. 2. Private & Confidential European Market Infrastructure Regulation 4th February 2013Regulations• What?• Why?• When?Implications• Face Clearing House• Additional Collateral• Cash Variation MarginDecisions• To Clear or Not?• Existing Swaps• New Swaps2European Market Infrastructure Regulation (EMIR)
  3. 3. Private & Confidential European Market Infrastructure Regulation 4th February 2013 3ContentsTeach-In Contents• G20 commitment and subsequent legislative action.• US regulation – Should UK pension funds be concerned.• Impact of European rules.• So why are pension funds clearing now?• European implementation timing.• Universe of clearable interest rate swaps.• Implication 1 – Face Central Counterparty rather than Executing Bank.• Implication 2 – Initial Margin Requirement.• Implication 3 – Cash as Variation Margin.• Decision 1 – To Clear or Not to Clear? Existing Trades.• Decision 2 – To Clear or Not to Clear? New Trades.
  4. 4. Private & Confidential European Market Infrastructure Regulation 4th February 2013European Market InfrastructureRegulation (EMIR) Teach-In4
  5. 5. Private & Confidential European Market Infrastructure Regulation 4th February 2013 5EMIR SummarySummary of RegulationsWhat? 1. Clearing Requirement – All standardised OTC derivatives will be cleared through centralcounterparties (CCPs).2. CCP Requirements – Harmonised framework for the provision of clearing services within Europe.3. Risk Mitigation – Non-cleared derivatives will be subject to additional risk mitigation techniques.4. Reporting Requirements – All OTC and exchange-traded derivatives will be reported to traderepositories (TRs).Why? Increased transparency of OTC markets, reduced counterparty credit risk, reduced risk of systemicshock.When? Clearing requirement likely to come into effect in mid-2014. Pension funds are exempt until 2015.So What? Pension fund asset allocations will be impacted by the move to central clearing.There are a number of decisions which should be made by all schemes as they approach clearing.
  6. 6. Private & Confidential European Market Infrastructure Regulation 4th February 2013So What? The Implications of Central Clearing6
  7. 7. Private & Confidential European Market Infrastructure Regulation 4th February 2013 7So What? – The Implications of ClearingImplications for Pension Funds from Central Clearing1 Face Clearing House (via Direct Clearing Member) rather than the Executing Bank.2 Additional Collateral (Initial Margin) – previously not required.3 Cash as Variation Margin – previously a range of assets such as gilts allowed.
  8. 8. Private & Confidential European Market Infrastructure Regulation 4th February 2013ExecutingBank8Implication 1Facing Central Counterparty (CCP) for derivative transactionsBenefits of facing CCP instead ofExecuting Broker1. Net down of counterparty mark tomarkets.2. Improved counterparty credit risk:• Segregation.• Portability.• Gap risk mitigated.3. Market consistent, independentvaluation.Costs of facing CCP instead of ExecutingBroker• Cash required as variation margin.• Initial margin required – additionalcollateral (cash, gilts or other gov. bonds).• Costs of clearing – CCP fees, DirectClearing Member (DCM) fees.PensionFundExecutingBankAgree swap andcollateralise dailymark to market.Pension Fund andExecuting Bank agreeswap. Once agreed,swaps are given up to theclearing house.Clearing member holdspension fund swaps andmakes daily marginmovements.CCP standsbetween theExecuting Bankand pensionfund in eachtrade.Cleared TransactionBilateral TransactionPensionFundCentralCounterpartyDirectClearingMember
  9. 9. Private & Confidential European Market Infrastructure Regulation 4th February 2013 9Implication 2Initial Margin Requirement• Initial Margin is an additional collateral requirement required for cleared swaps.• The purpose is to mitigate ‘close-out’ risk: the risk of suffering adverse market movements from the loss of swap exposurefollowing the default of a clearing member.• Clearing houses accept cash and certain high quality government bonds (e.g. German bunds) as initial margin.• Using London Clearing House’s (LCH) methodology for calculating Initial Margin, we have calculated the potential initialmargin requirement for a notional pension scheme. The scheme is fully hedged for rates and inflation.• LCH methodology is a portfolio-based historical VaR simulation taking the worst 5-day scenario, using the past 5 yearsof available data and scaled for a 7-day period.Source: Redington, RedAnalytics, BloombergPension Scheme XYZLiability PV (50% Fixed, 50% Real) £1bnPV01 £2.6mIE01 £1.2mHedge Ratio c. 95% (rates & inflation)Total Initial Margin Required £67mAs % of Liability Hedged 6.7%Table 1: Initial Margin Requirement for Notional Pension Scheme using LCH Methodology
  10. 10. Private & Confidential European Market Infrastructure Regulation 4th February 2013 10Implication 3Cash as Variation Margin• Clearing houses require cash as Variation Margin.• In current bilateral transactions pension funds can post avariety of assets as collateral, usually including gilts andindex-linked gilts.• The movement to cash to meet daily mark to marketchanges of swaps could mean higher cash requirements forpension funds in the future.Benefits of Cash as Variation Margin• Swaps do not need to be recouponed.• Immediate access to profit from hedgewhich can be recycled into assetallocation.• Removal of basis risk (sensitivity to OISvaluation of swap mark-to-market).Costs of Cash as Variation Margin• Holding cash is a drag on StrategicAsset Allocation return.• May have to increase use of gilt repo tofund cash for variation margin.Source: Redington, RedAnalytics, BloombergSwap Curve-100bpsSwap Curve-50bpsSwap Curve+0bpsSwap Curve+50bpsSwap Curve+100bpsInflation Curve-100bps 15% 1% -10% -21% -29%Inflation Curve-50bps 22% 7% -6% -16% -26%Inflation Curve+0bps 30% 14% 0% -12% -22%Inflation Curve+50bps 38% 21% 6% -6% -17%Inflation Curve+100bps 49% 30% 14% 0% -12%Table 2: Cash margin requirements for movements in rates and inflation
  11. 11. Private & Confidential European Market Infrastructure Regulation 4th February 2013Decisions Required11
  12. 12. Private & Confidential European Market Infrastructure Regulation 4th February 2013 12So What?Decisions RequiredPlease Note:• The impact of central clearing on each pension scheme depends on the exact nature of theswap portfolio.• The cost may be positive or negative depending on the swap book.Decisions Required by Pension Funds1 Existing swaps:A) Keep out of clearingB) Move into clearing2 New swaps (during the clearing exemption period):A) Make use of the exemption until 2015 / 2018.B) Clear trades early during the exemption period.
  13. 13. Private & Confidential European Market Infrastructure Regulation 4th February 2013 13Decision 1: To Clear or Not to Clear?Existing Trades.Existing TradesMove intoclearingKeep outsideclearingBenefits CostsNetting of counterparty mark tomarket.Variation margin required ascash.Reduced close out risk. Initial Margin must be posted.Frees up bank lines. Other clearing costs.Actions Required1. Estimate the potential future cash margin requirements frommarket movements.2. Estimate the cost of funding cash margin calls.3. Estimate the netting gains of facing one counterparty rather thanmany.Benefits CostsVariation margin can be gilts orbonds.Less efficient collateralmanagement.No additional IM requirement. No mitigation of close out risk.Actions Required1. Analyse existing swap book now to identify inefficiencies andprioritise restructuring before the EMIR cut off.2. Clean up eligible collateral in CSAs.3. Anticipate any upcoming hedging requirements and prioritise thedecision now.
  14. 14. Private & Confidential European Market Infrastructure Regulation 4th February 2013 14Decision 2: To Clear or Not to Clear?New Trades.New Trades (duringthe exemption period)Clear early duringexemption periodMake use ofpension fundexemptionBenefits CostsPricing & liquidity may be better incleared swaps than bilateralCash variation margin requiredfrom the outsetNew trades will be valued by CCPon OIS, consistent with marketstandardClearing costs required to be metahead of the required timeAbility to clear trades if acounterparty is downgradedActions Required1. Begin due diligence of clearing members, begin process to appointclearing members2. This decision should be made in conjunction with the decision on theback bookBenefits CostsVariation margin stays as gilts Potential for bilateral initial marginon non-cleared tradesNo additional IM requirement Bilateral initial margin means costof clearing without the full benefitof improved credit riskActions Required1. Review the credit worthiness of current bank counterparties to see ifcomfortable to continue giving them risk instead of clearing new risk
  15. 15. Private & Confidential European Market Infrastructure Regulation 4th February 2013 15EMIR SummaryActions RequiredClear Don’t ClearExistingTradesEstimate the future cash marginrequirements, cost of funding cashrequirement and initial marginrequirements.Weigh these up against thebenefits of clearing.Restructure swap portfolio toensure collateral efficiency andprioritise derivative activities aheadof the introduction of clearing.Portfolio restructuring completedafter the end of the exemption mayresult in trades falling underEMIR.NewTradesPut the operational processes inplace to allow clearing even ifintending to use the pension fundexemption.Provide yourself with the optionto clear or not.Review the credit worthiness ofexisting suite of counterparties.If there are concerns over creditworthiness, new trades could becleared instead.
  16. 16. Private & Confidential European Market Infrastructure Regulation 4th February 201313-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 GardnerFounder & Co-CEODirect Line: 0207 250 NicollDirectorDirect Line: 0203 326 McCartanAssociateDirect Line: 0203 326 EwerAnalystDirect Line: 0203 326 textFor professional investors only. Not suitable for privatecustomers.The information herein was obtained from various sources.We do not guarantee every aspect of its accuracy. Theinformation is for your private information and is fordiscussion purposes only. A variety of market factors andassumptions may affect this analysis, and this analysis doesnot reflect all possible loss scenarios. There is no certaintythat the parameters and assumptions used in this analysiscan be duplicated with actual trades. Any historical exchangerates, interest rates or other reference rates or prices whichappear above are not necessarily indicative of futureexchange rates, interest rates, or other reference rates orprices. Neither the information, recommendations oropinions expressed herein constitutes an offer to buy or sellany securities, futures, options, or investment products onyour behalf. Unless otherwise stated, any pricing informationin this message is indicative only, is subject to change and isnot an offer to transact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference to theterms of executed transactions should be treated aspreliminary and subject to further due diligence .Please note, the accurate calculation of the liability profileused as the basis for implementing any capital marketstransactions is the sole responsibility of the Trusteesactuarial advisors. Redington Ltd will estimate the liabilities ifrequired but will not be held responsible for any loss ordamage howsoever sustained as a result of inaccuracies inthat estimation. Additionally, the client recognizes thatRedington Ltd does not owe any party a duty of care in thisrespect.Redington Ltd are investment consultants regulated by theFinancial Services Authority. We do not advise on allimplications of the transactions described herein. Thisinformation is for discussion purposes and prior toundertaking any trade, you should also discuss with yourprofessional tax, accounting and / or other relevant advisershow such particular trade(s) affect you. All analysis (whetherin respect of tax, accounting, law or of any other nature),should be treated as illustrative only and not relied upon asaccurate.©Redington Limited 2013. All rights reserved. Noreproduction, copy, transmission or translation in whole orin part of this presentation may be made withoutpermission. Application for permission should be made toRedington Limited at the address below.Redington Limited (6660006) is registered in England andWales. Registered office: 13-15 Mallow Street London EC1Y8RDemail: