As the temporary central clearing exemption granted by the European Commission expires, Frank Odendall, head of securities finance, product development and business at Eurex, finds that pension funds are voluntarily turning to CCP clearing to mandatory and non-mandatory products, including pensions

The next few years will mark a new era in the relationship between pension plans (PSAs) and clearing houses, mainly due to the upcoming expiry of the temporary exemption from the OTC derivatives centralized clearing obligation. (OTC) transactions. By granting an exemption to PSAs, the European Commission recognized a series of structural problems that needed to be resolved before they could be taken into account. As these issues move closer to resolution, many PSAs are anticipating expiration and voluntarily embracing netting for mandatory and non-mandatory products and asset classes, including repos.

Repos play a vital role in financial markets by linking participants who lend and borrow short-term against securities pledged as collateral, providing an essential source of funding and a substitute for unsecured deposits. The special and general collateral segments enhance the usefulness of the repo market by providing a means to fund securities portfolios and a mechanism to seek out valuable collateral, which is critically important given the level of quantitative easing .

In the bilateral market, PSAs must maintain multiple bilateral relationships with a series of sell-side institutions, each with their own customized contractual commitments, which is costly on several levels (see Figure 1). Building and maintaining these relationships is time-consuming and labor-intensive, and repurchase transactions are still often negotiated over the phone or fax. These types of relationships also make price discovery and regulatory reporting cumbersome and costly, adding to this inefficiency.

Figure 1

Centrally cleared repo markets are a natural evolution of bilateral markets, bringing new efficiencies to market participants with additional benefits for market stability. Eurex’s ISA Direct clearing model for repo is the industry-leading solution for PSAs to enter the cleared repo market, where the PSA faces the clearing house directly but is supported by a compensation that covers default fund contributions and default management obligations (see Figure 2).

Figure 2

Cleared repos which are executed electronically through a multilateral trading platform such as Eurex Repo, offer a range of benefits to PSA participants. More importantly, PSAs can reinvest or raise funds for variation margin (VM) for Eurex-cleared (IRS) over-the-counter interest rate swaps (IRS) more efficiently and safely by accessing the cash repos Eurex Repo GC Pooling. In this article, we explore some of the many use cases in more detail.

Public Service Announcement Perspective

PSAs are now in line with Eurex’s cleared repo offering and actively place excess liquidity in the overnight and forward cleared repo markets. Each PSA has established a panel of dealer banks and uses the request for quotation (RFQ) functionality of Eurex Repo F7 (see Figure 3). PSAs trade on the most competitive quotation available from the panel banks. Based on the feedback received, the rates are considered better than those achievable through money market funds and also generally better than bilateral markets.

figure 3

The main advantages of PSAs are summarized below:
• a deep pan-European liquidity pool means better price discovery
• more than 150 participants are registered with Eurex Repo, including commercial and central banks, and government funding agencies
• Secure the raising and placement of cash against more than 13,000 national and international securities
• centrally cleared markets with proven liquidity in times of crisis
• reduction of indirect constraints linked to punitive bank capital requirements
• simplified and efficient electronic processes
• standardization of legal documentation
• more control and flexibility in counterparty risk management on cleared and bilateral markets
• optimal management of margin funding needs for cleared and non-cleared derivatives
• Dealer point of view

Cleared repo markets in Europe have always been the domain of banks that trade anonymous repo via the order book and the transaction is then transferred to the clearing house. The comments indicate that when a panel bank’s response to the price request is successful, the bank borrows money at a better rate (1-2 basis points cheaper) than that obtained in the interbank market via the order book.

If the panel bank raises funds at a lower cost than it can raise in the interbank market, it can immediately lend the money in the interbank market and earn a spread as shown in Figure 4. Alternatively, the panel bank can use the cheap funding it raises from the Pension Fund to fund its “special” operations, as shown in Figure 5.

Figure 4

Figure 5

The primary benefit to the dealer bank in the spread trading or special trading use cases is the ability to trade efficiently in terms of capital and balance sheet. First, low risk weights (2 percent) are applied to transactions with CCPs. Second, in both use cases, the two cash legs of the Bank in Panel X offset each other (i.e., they are net). However, several criteria must be met before balance sheet netting can be applied under accounting standards and prudential regulation. Eurex and Clearstream’s integrated trading, clearing and settlement infrastructure is well placed to help banks meet the stringent criteria of the standards, enabling them to achieve the maximum efficiency of available capital and balance sheet.

Summary

Pension funds enjoy many benefits when entering the clearing landscape, including increased liquidity, operational efficiencies, simplified legal documentation, and effective counterparty risk management.

The brokerage banking community has also benefited greatly from the entry of pension funds into the clearing landscape. In addition to new business opportunities, the entry of buy-side firms into the cleared environment enhances the ability to realize the valuable potential of multilateral netting and balance sheet netting that is not otherwise available in the bilateral environment. .

The new era promises to offer a win-win situation for all market players.