Cash crunch looms as pension funds adopt new margin constraints
Pension funds face liquidity challenges ahead of forthcoming variation margin rules for uncleared derivatives, according to investment manager Northern Trust. Since European Market Infrastructure Regulation (EMIR) outlined that cash may need to be posted multiple times a day, the cost of trading derivatives has sharply risen. In response, some pension schemes have increased their allocation to cash from 1% or 2% to as much as 6% or 7%, Northern Trust reported. The investment manager suggested pension funds ensure a balance of security, liquidity, yield and operating efficiency to prepare for the collateral requirements EMIR is expected to introduce 1 March.

Pension funds are facing a major cash dilemma in light of liquidity challenges and the forthcoming variation margin rules for uncleared derivatives, according to Northern Trust.

Some pension funds have previously stated that increasing cash holding requirements could force them to re-evaluate their hedging strategies. Under new variation margin requirements, set to come into force in March 2017, cash may need to be posted multiple times a day.

Subsequently the cost of trading derivatives has skyrocketed since rising collateral requirements began coming into force.

Northern Trust highlighted cash as an important ‘investment enabler’, adding that while pension funds cannot earn from it, they also cannot invest without it.

Some pension schemes have increased their allocation to cash from 1% or 2% of their investment portfolios to in some cases as high as 6% or 7%, according to the custodian.

And while in the past, cash could earn an institutional investor a return of 2% to 3%, in today’s low interest rate environment, investors can expect a zero rate of return.

Northern Trust has subsequently suggested a series of steps for pensions funds to future proof their investment policies to ensure a balance of security, liquidity, yield and operating efficiency.

"There is no magic solution to this conundrum,” said Penelope Biggs, head of institutional investor group, Europe, Middle East and Africa at Northern Trust. “However, we believe that understanding a portfolio from the point of view of how liquid it might be at any point in time is critical, particularly as the cost of cash liquidity will only continue to increase."

In March 2016, Dutch asset manager APG and pension fund provider PGGM, wrote to Jonathan Hill, Europe’s former financial services commissioner, to express concern about falling bond liquidity and increasing cash holding requirements.

The letter stated that forthcoming rules would require pension funds to either divest physical assets - such as bonds and equities - to release the required cash, or avoid using derivatives altogether.

Pension funds are currently exempt from the clearing requirement for interest rate swaps until August 2018, following a recent announcement from European regulators.

However with volumes increasingly shifting to the cleared world due to pricing differentials and liquidity, schemes may be forced to establish links ahead of schedule.

With schemes relying on the readiness of their asset managers to deal with the regulation, it may encourage them to reconsider their derivatives usage.

"Whilst the low interest rate environment and associated market dynamics, as well as the regulatory changes focused around liquidity, have affected many institutional investors differently, we see pension funds coming under the greatest pressure as a result of a confluence of these factors," said Mark Austin, institutional investor group, Northern Trust.

"For the majority of defined benefit schemes closed to new members and in net decumulation, finding and maintaining appropriate liquidity is vitally important and is becoming increasingly challenging with many schemes across Europe struggling to balance liquidity while creating returns."