Mercer warns Basel III costs could hit derivatives use by pension funds

Implementation of Basel III rules could push up costs and hit operations of European pension funds that use over the counter (OTC) derivatives programmes, according to consultant Mercer.

The costs are linked to the set of regulations known as EMIR, which force interest rate swaps and credit default swaps to be cleared through central exchanges. The rules were introduced after Lehman Brothers collapsed, amid fears that unknown counterparty risk could once more put the entire financial system in jeopardy.

The enforced use of central exchanges is intended to increase transparency as well as improve liquidity by requiring trades to be supported by cash or near-cash collateral.

Pension funds have been given a three-year exemption to adjust to the rules because it is recognised that they may be fully invested, making it difficult to provide cash collateral. The exemption means that they can continue to trade derivatives on an OTC basis.

Mercer said that the problem arises from those OTC trades. Basel III means that banks will be hit by higher capital charges if they engage in OTC trading. These charges in turn are likely to be passed on to the investor; in this case the pension fund. The extra cost could, in effect, force the pension funds into central clearing.

Compounding the challenge for pension funds is the suggestion that most have not prepared for handling either the additional costs that may come through OTC trades, or the costs associated with implementing EMIR requirements faster than the three-year exemption.

Mercer added that even where its own clients – pension funds – want to implement central clearing, it can take up to six months to do so.


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