The future of the pension fund clearing exemption under UK EMIR

Pension scheme arrangements can face particular challenges when clearing contracts through a central counterparty (CCP). HM Treasury acknowledges this in its call for evidence on the pension fund clearing exemption under UK EMIR and is seeking industry feedback on the long term future of the exemption.

Background

UK EMIR

Since the introduction of the clearing obligation under EMIR, a temporary exemption has been available to pension scheme arrangements from mandatory clearing in respect of OTC derivative contracts that are objectively measurable as reducing investment risks that directly relate to their financial solvency. 

In the UK, this exemption was recently further extended to 18 June 2025.  HMT was tasked with conducting a review of the exemption ahead of its expiry in 2025, allowing time for consideration and implementation of a longer term approach.  On 13 November 2023, HMT published a call for evidence on the exemption. 

In the call for evidence, HMT sets out the background to the clearing exemption for pension funds.  It notes that CCPs typically require variation margin (VM) to be provided in cash.  CCPs also have the ability to require more frequent posting of VM than would be the case for bilateral trades.  As pension scheme arrangements do not typically hold large cash reserves, this can be challenging - they may need to sell assets such as gilts in order to raise the cash.  This could have a negative impact on the stability of financial markets, particularly in stressed market situations. LDI funds, which typically have long-dated, directional, rates positions, in particular may be impacted by any requirement to post cash-VM on their cleared rates swaps and managers of such funds will be interested in responding to the call for evidence.

We would also highlight that the legal model for the clearing relationship itself (buy-side access typically being via a clearing member) poses additional challenges for pension scheme arrangements given the potential for long-dated interest rate derivatives - in particular, where the clearing contract gives the clearing member rights to, upon notice, terminate, increase margin requirements over CCP requirements and apply trading limits and other restrictions on notice.

Contrast with EU EMIR

The pension scheme arrangement exemption has recently expired under EU EMIR.  The European Commission noted in its report to the European Parliament and the Council of 9 June 2022 that, while there is no unique solution to the concerns for pension scheme arrangements, "a range of instruments exists that should allow the pension funds to clear efficiently in different market conditions, including under stress" (particular reference was made to the use of the repo market), and that the Commission's strategy on clearing "will attract greater activity at EU-based clearing houses, providing PSAs with greater access to competitive and efficient clearing services".

It is also worth adding a note here about EMIR 3.0, which is currently working its way though the EU legislative process.  It includes a suite of proposals, the most headline grabbing of which is the 'active account requirement' - a requirement for EU counterparties subject to the clearing obligation to clear at least a certain amount of their trades in specified derivatives at an EU CCP. 

Clearly, with pension schemes subject to the clearing obligation, this will have a greater impact.  Also included, however, is a proposed exemption relating to third-country pension scheme arrangements - there would be an exemption from the clearing obligation where a counterparty enters into a transaction with a pension scheme arrangement established in a third country which is exempted from the clearing obligation under its national law.  This would enable UK pension scheme arrangements to trade otherwise mandatorily clearable OTC derivatives with EU dealers on an uncleared basis (in contrast with EU pension scheme arrangements facing EU dealers, which would be subject to the EU EMIR mandatory clearing obligations).  EMIR 3.0 continues to work its way through the EU legislative process and it remains to be seen what will be included in the final text.

What questions are asked in the call for evidence?

20 questions are asked, split across 6 sections -- summarised below.

Hedging and use of the exemption

• How much of your hedging activity involves derivatives? What types of derivatives do you use?

• Do you use the pension fund clearing exemption?

• What proportion of your derivatives activity is cleared? What requirements are there on the type of collateral you need to post as variation margin, and the frequency of variation margin calls, when clearing?

• If you clear derivatives, how much of this activity do you clear voluntarily (i.e. you are not required to do so, either because of the exemption or because you fall below the clearing thresholds)?

• What factors influence the relative attractiveness of hedging via gilts vs derivatives?

Bilateral markets

• When using uncleared derivatives, how much scope is there to use non-cash collateral to meet variation margin requirements?

• What other costs or benefits do bilateral transactions provide, if any, compared to centrally cleared trades?

• How are changes in the regulation of bilateral transactions, such as Basel reforms, affecting the incentive for counterparties to clear their derivatives?

Facilitating clearing and meeting variation margin requirements

• To what extent is there appetite among clearing members to provide clearing services to pension funds? What are the key drivers for this?

• How effectively can gilt repo markets support the ability of pension funds to raise cash for variation margin at short notice?

• Are there any other measures which you think could help pension funds meet CCP variation margin requirements?

Autumn 2022 'LDI crisis'

(This section addresses the issues that pension funds can face in providing cash variation margin at short notice, as demonstrated in the 'liability-driven investment' (LDI) crisis in autumn 2022.)

• In your opinion, would the events of the 'LDI crisis' in autumn 2022 have been any different if the clearing exemption had not existed?

• What challenges could pension funds face in managing liquidity in a market stress scenario if there was no clearing exemption? What could help mitigate those challenges?

Impact of an expiry of the exemption

• If the exemption expired, what would be the immediate operational impact and costs? What action would be needed to prepare for this scenario and mitigate these costs?

• How would this affect your investment choices, such as your hedging strategy and asset allocations? For example, do you expect that you would increase your cash holdings?

• Would you anticipate any impact on your returns and/or clients?

• If the exemption expired, how would you expect this to interact (if at all) with the government's ambition, as set out at Mansion House, to improve outcomes for savers and increase the availability of funding for high-growth companies?

• In an identical market stress scenario (for example a certain percentage change in gilt yields), would you expect variation margin calls to be higher if there was no exemption, as opposed to if the exemption was kept?

• Are there any lessons the UK can learn from the approach of other jurisdictions to this issue?

Further views and information

• Do you have any further information or views to share on the future of the pension fund clearing exemption?

What does a buy-side firm need to do?

Buy-side firms that manage UK pension scheme arrangements should consider whether to respond to the call for evidence directly or through engagement with industry associations (or via their legal counsel).  The call for evidence remains open until 5 January 2024 and HMT has said that it welcomes responses from all interested stakeholders, particularly pension funds and asset managers.

If you would like to discuss any aspect of this with us, please do get in touch.