These instruments allow pension plans to reduce risk and manage portfolios more efficiently. However, Towers Watson notes in a Perspectives paper, the financial crisis and subsequent changes in regulation mean it is likely that the way pension plans will use such instruments will change.
Towers Watson explains that regulators have been looking at ways to improve the financial stability and security of the OTC derivatives market by promoting exchange trading and introducing “central counterparty clearing.” The aim of central counterparty clearing is to better manage the systemic, credit, operational and other risks associated with OTC derivatives. In other words, regulators want derivatives to be collateralized with a central counterparty, such as a clearinghouse, that is perceived to be less risky than bank counterparties due to the central counterparty’s more focused business activities and risk management framework. (Both the bank and the pension plan would face a third party rather than each other.)
However, not all OTC derivatives will be subject to central clearing in the short term. For example, some types of interest rate swaps, swaptions and longevity swaps are not being initially considered for central clearing.
While pension plans cannot move all their interest rate derivatives to central counterparty clearing today, they should understand the impacts changes in regulation are bringing to market practice, according to Towers Watson.
Pension plans should assume the following:
- They will move to a “cash as eligible collateral” world (and maybe short-dated government debt, too).
- Bank counterparties’ credit quality has weakened and could weaken further. This makes it important to take counterparty diversification, a counterparty bank’s credit quality and the package of terms a bank will offer into account when assessing with whom to transact.
- Either regulation or economic incentives will mean that both existing and new interest rate derivative exposures will eventually be pushed toward central counterparty clearing.
- It will become more common for other instruments to be used to gain leverage in order to invest more efficiently — for example, equity derivatives.
Markets continue to be volatile, which means that effective risk management through the use of derivatives is as important as ever, the paper concludes. The operational uncertainty created by market and regulatory changes is not a reason to hold off from managing economic risks, but is an important implementation consideration.
The full paper can be downloaded at http://www.towerswatson.com/united-states/research/6949.