Pensions Have Adequate Capital for New Swaps Rules

July 31, 2013 (PLANSPONSOR.com) - 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.

In a research paper, “Capital Requirements for Pension Funds in the Wake of Dodd-Frank,” based on a review of current pension fund information in Northern Trust’s database, 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 $1 million had ample eligible collateral, in the form of high-grade government or corporate bonds, to meet their initial margin requirements.

Over-the-counter (OTC) derivatives, such as interest rate swaps, have become standard tools for defined benefit pension plans. These instruments allow pension plans to reduce risk and manage portfolios more efficiently. The financial crisis and subsequent changes in regulation mean the way pension plans use such instruments is changing. It is anticipated they will move to a “cash as eligible collateral” world (and maybe short-dated government debt, too). (See “Regulations Changing DB Use of OTC Derivatives.”)

Regulators looked 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. Regulators want derivatives to be collateralized with a central counterparty (see “CFTC Approves OTC Derivatives Rules”).

"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,” said 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 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. The paper and more information on methodology can be found online at Northern Trust’s Insights and Research page.

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