Pension funds should have adequate capital to cover new requirements imposed on the bulk of over-the-counter (OTC) derivatives trading by the Dodd-Frank Act, according to a white paper by Northern Trust.
The research paper, “Capital Requirements for Pension Funds in the Wake of Dodd- Frank,” is based on a review of current pension fund information in Northern Trust’s database.
To determine the impact of Dodd-Frank’s initial margin requirements on pension funds, Northern Trust identified the requirements across more than 200 accounts holding eligible interest-rate swap products.
The analysis showed that most funds in the sample group with margin requirements of more than USD1m had ample eligible collateral, in the form of high-grade government or corporate bonds, to meet their initial margin requirements.
"New capital requirements associated with the central clearing of formerly OTC derivatives can seem imposing, but it appears some early estimates were overly negative regarding the ability of pension funds to handle the Dodd-Frank margin requirements,” says Judson Baker, product manager for derivatives and collateral management at Northern Trust. "Our research on a significant sample of clients shows that most pension funds should not be deterred from their current trading strategies as they are prepared to handle capital adequacy requirements."
In an effort to reduce risk and increase transparency, the Dodd-Frank Act imposes mandatory clearing and trade execution of certain products in the USD633trn OTC derivatives market. Implementation of central clearing is occurring in phases, with pension plans required to move certain interest rate and credit default swaps to central clearing platforms on 9 September 2013.
Interest rate derivatives account for approximately 77 per cent of total swap activity in the global OTC market and the products are widely used by pension funds in liability-driven investment strategies to extend portfolio duration and hedge long-term pension liabilities.
In addition to initial margin requirements for interest rate swaps, the Northern Trust paper examines requirements for variation margin for interest rate swaps, credit default swaps and uncleared swaps under the new regulations.
“This research can serve as a reality check for plan sponsors and pension fund investors confronting the new regulatory environment for derivatives," says Peter Cherecwich, head of global fund services at Northern Trust. “While our research indicates that plans have adequate collateral for a large portion of their current investment strategies, however, cash and collateral management will pose a real challenge under the new regulations. We are committed to helping our clients navigate these changes, with both research and expanded services, in the years ahead.”