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06 Mar 2023

Eurex Exchange

Focus Pension Funds: Central clearing of OTC IR derivatives – a blessing in disguise?

After benefitting from an exemption for a number of years, European pension funds are finally bracing to enter the cleared OTC derivatives markets, with regulation that obliges them to do so set to kick in this June. Ahead of this landmark moment, Eurex caught up with Jamie Gavin, managing director, head of prime brokerage clearing at Société Générale, to see how pension funds are set to engage with cleared markets and how this will affect the broader interest rates derivatives landscape.

With only a few months to go until the exemption expires, what is the tone of conversation that you are having with pension funds clients?

The rubber is hitting the road. Whereas before clients were saying that they would assess clearing when they had time and come back to us, there's now a real need to get live and be prepared.

We are also having conversations about which CCPs they need to be ready on. This is especially important given the regulation, with clients reviewing the impact of the potential active account strategy that's being mooted by the European Commission.

But the main question at the moment is “what do I need to do to be compliant”?

What benefits can pension funds expect when they start clearing?

Rates clearing does add some additional demands on clients, such as creating operational requirements for central clearing. But in compensation, more robust asset segregation, portfolio netting efficiency and standardized margining are all positives. There is work to do to get there but there are benefits that arise from that work.

Similarly for repo clearing, clients get access to a wide range of counterparties, with minimal documentation, streamlined operations, and facing a central counterparty. So, again, while there's work to do, it's all beneficial and creates operational efficiencies.

Ultimately, whether you are clearing repo or rates, what you are getting is certainty and the opportunity to benefit from the enhanced stability and credit outcome of facing a clearinghouse. As a clearing client, you know that your contract has the backing of the CCP.

What are the major operational challenges that pension funds can expect when they start clearing?

Central clearing of rates derivatives is going to create a real need to access cash as pension funds pay variation margin. Pension fund portfolios are normally receive fixed, so in a rising interest rate environment they are going to need to pay more variation margin cash. That's one point where repo clearing is beneficial because they can raise that cash very quickly – intraday in fact.

Could that extra demand for collateral put a strain on liquidity in the overall market?

For the time being, it doesn't appear to be a concern but some of our clients are focused on monitoring this more closely. As the exposures increase, we will see how the landscape evolves. Pension funds are typically long inventory and able to use this for collateral. So for now, we are not hearing material concerns about access to high quality collateral, though it remains to be seen.

Do you expect the increase in pension fund clearing to lead to more cross-margining by clients?

Margin efficiencies across asset classes is a clearing trend that is still in its infancy. Société Générale is one of the few brokers that can already provide cross-margining of rates against futures via Eurex’s solution as well as our in-house VaR offering.

We expect cleared repo to be added into Eurex’s cross-margin product suite at a later stage. That will be a significant moment and we anticipate it will bring material savings and balance sheet efficiencies for clients and clearing members alike.

How has adoption of cleared repo developed so far and how are clients using the service?

There has been a realization that there is the potential for a real liquidity squeeze, with impacts to be felt most by the larger funds that have the bigger positions and, consequently, the most requirement for cash. They know that it's a dependable market that they can go in to and can access cash from in a short period.

It's about being able to efficiently generate that cash in a time of stress on the same day. There are very few places where you can do that. With cleared repo, you know that you’re facing a solid counterparty, you're going to get best price and an efficient turnaround in terms of generating cash for variation margin.

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