UK pension fund clearing exemption ‘good news’ for pension schemes and banks

Igor Zyskind, a derivative and structured products expert at Pinsent Masons, was commenting after the UK government published its response to the call for evidence on the pension fund clearing exemption for OTC derivatives (18 pages/163 KB), confirming the extension.

There is general policy for the governments in the ‘Group of 20’ (G20), including the UK, to push OTC derivatives to be cleared via a central counterparty (CCP), rather than just simply being traded bilaterally. However, the pension fund clearing exemption allows pension funds to avoid the obligation to clear certain derivative contracts through a CCP.

Zyskind said: “The extension was agreed mainly because there is a consensus that it would be difficult for pension funds to comply with these rules, at least for some time, as any clearing of derivatives via a CCP would require cash margin delivered daily or even intra-daily by the counterparties. This may not work for all pension funds as they don’t tend to hold large cash deposits and may lack the operational capabilities for that.”

The call for evidence sought input from industry stakeholders to inform the government’s long-term approach to this exemption.

Up until now this exemption for pensions funds was temporary but was renewed periodically. However, the UK government has decided that the exemption should be maintained for the longer-term. On this basis, the government will now take forward secondary legislation to ensure that the exemption does not expire on 18 June, as currently scheduled, and to remove any further time limit on the exemption.

“In the UK, defined benefit schemes comprise more than half of the overall amount of the pension market. As a result, the UK has one of the largest defined benefit scheme markets in Europe, so those exemptions are critical,” said Zyskind.

The government will, however, keep this policy under review in coordination with the UK regulatory authorities.

Zyskind said: “This is a positive development for pension funds as they will be subject to less regulation and can continue doing bilateral OTC derivatives without clearing.”

The call to evidence also highlighted a number of themes, including that pension schemes predominantly use gilts as an alternative mechanism for hedging purposes. Gilts are considered low-risk investments as they are backed by the government and play a crucial role in pension funding, particularly for defined benefit pension schemes. However, “this method has its limits, and the gilts market may not be large enough if suddenly all pension funds switch from derivatives to gilts”, said Zyskind.

The call for evidence also identified that most firms that use the exemption prefer to trade their derivatives bilaterally. The primary reason for this preference is the CCP margin requirements, which are seen as an additional compliance burden and liquidity constraint. It was further found that mandatory clearing would necessitate pension schemes to increase their cash holding, potentially reducing their ability to invest in higher growth assets which may impact their overall investment strategies. Removing the exemption could exacerbate market stress events by increasing liquidity pressures, respondents suggested.