Baseline report on solutions for the posting of non-cash collateral to central counterparties by pension scheme arrangements : report.
Date: 2015-10-06
Institutions: Directorate-General for the Internal Market and Services
Subjects: financial control, financial instrument, financial transaction, futures market, pension scheme

Baseline report on solutions for 
the posting of non-cash 
collateral to central 
counterparties by pension 
scheme arrangements 

A report for the European Commission prepared 
by Europe Economics and Bourse Consult 

25 July 2014 
© European Union, 2014 
Reproduction is authorised provided the source is acknowledged. 

ISBN -978-92-79-33042-1 
DOI 10.2780/17409 

mmmll

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

The information and views set out in this baseline report are those of the authors and 
do not necessarily reflect the official opinion of the Commission. The Commission does 
not  guarantee  the  accuracy  of  the  data  included  in  this  baseline  report.  Neither  the 
Commission  nor  any  person  acting  on  the  Commission’s  behalf  may  be  held 
responsible for the use which may be made of the information contained therein. 

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European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

EU regulation designed to mitigate risk requires that standardised OTC derivatives are 
cleared via a central counterparty (CCP).  Pension scheme arrangements (PSAs) have 
been granted a temporary exemption from this requirement.  

The  long-term  nature  of  PSAs’  liabilities  and  their  exposure  to  variables  such  as 
interest rates mean that many PSAs hedge, e.g. using interest rate swaps.  At the end 
of  the  exemption  PSAs  will  be  obliged  to  begin  clearing  OTC  derivatives  and  posting 
the cash variation margin required by CCPs (current bilateral practice permits posting 
non-cash  assets).    Pension  funds  aim  to  be  fully-invested  and  a  requirement  to  hold 
cash  against  possible  Variation  Margin  calls  would  affect  investment  performance.  
This  study  aims  to  understand  the  impact  on  PSAs  of  this  and  to  assess  potential 
solutions. 

We developed representative portfolios to model the impacts on PSAs, estimating that 
to prepare for a 100 bps interest rate shock PSAs across the EU28 might need a cash 
buffer  of  €200–€250  billion,  implying  an  investment  drag  of  up  to  €3  billion  per 
annum.  Compounding this over the life of pensioners’ contributions gives the impact 
on  retirement  incomes.    This  is  significant:    the  cumulative  cost  in  the  100  bps 
simulation is up to 3.1 per cent of incomes in the Netherlands and 2.3 per cent in the 
UK. The estimated impact across the EU28 is a 1.1–2.2 per cent reduction.  

In  terms  of  the  alternatives  to  PSAs  posting  cash,  no  one  solution  stands  out  and 
there  is  little  evidence  that  the  industry  is  investing  in  innovative  solutions  to  the 
problem.    A  large  and  liquid  repo  market  is  critical  to  the  most  likely  solutions 
currently available but our analysis indicates that PSAs would not be able to rely fully 
on  it,  and  therefore  would  need  a  substantial  level  of  cash  buffer,  with  its 
commensurate costs. 

Le  Règlement  (UE)  N°  648/2012,  conçu  pour  atténuer  les  risques,  impose  une 
obligation de compensation des produits dérivés de gré à gré (OTC) standardisés par 
une contrepartie centrale (CCP). Les dispositifs de régime de retraite (PSA) bénéficient 
d’une dérogation temporaire à cette exigence.  

La nature à long terme du passif des PSA et leur exposition à des variables telles que 
les taux d'intérêt implique que de nombreux PSA couvrent les risques en utilisant, par 
exemple,  des  swaps  de  taux  d'intérêt.  A  l’issue  de  la  période  de  dérogation,  les  PSA 
seront  tenus  de  compenser  les  produits  dérivés  OTC  et  de  verser  une  marge  de 
variation en espèces (ou en cash) requise par  les contreparties centrales (la pratique 
actuelle  pour  les  opérations  bilatérales  autorise  le  dépôt  de  garanties  sous  forme 
d’actifs non monétaires). Les fonds de pension cherchent à investir la totalité de leurs 
actifs, et l’obligation de détenir des liquidités en prévision d’éventuels appels de marge 
variable nuirait à la performance des investissements. Cette étude vise à comprendre 
l'impact  de  cette  obligation  sur  les  PSA,  ainsi  qu’à  examiner  les  solutions 
envisageables. 

Nous avons développé des portefeuilles représentatifs pour modéliser  les impacts sur 
les PSA et estimé que, pour se préparer à une hausse de taux d'intérêt de 100 points 
de  base  (pb),  les  PSA  des  28  États  membres  de  l’UE  pourraient  avoir  besoin  d'une 
réserve de liquidités de 200 à 250 milliards d'euros, ce qui entraînerait une baisse de 
performance  des  investissements  pouvant  atteindre  3  milliards  d'euros  par  an. 
L’application de ces critères sur la durée des cotisations des retraités permet d’évaluer 
l'impact sur les prestations de retraite. Cet impact est significatif : le coût cumulé dans 
la  simulation  de  100  pb  correspond  à  3,1%  des  revenus  aux  Pays-Bas  et  2,3%  au 

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 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

Royaume-Uni.  Dans  l’ensemble  des  28  membres  de  l’UE,  la  baisse  serait  estimée  à 
1,1-2,2%.  

Aucune  solution  alternative  au  dépôt  de  garanties  en  espèces  par  les  PSA  semble 
faisable,  et  rien  ne  semble  indiquer  que  le  secteur  investit  actuellement  dans  des 
solutions  innovantes  pour  surmonter  le  problème.  Un  marché  des  pensions-livrées 
important et liquide est indispensable aux solutions dont nous disposons actuellement, 
mais notre analyse indique que les PSA ne pourront y avoir recours à chaque fois, et 
auront  besoin  par  conséquent  d'un  niveau  substantiel  de  réserves  de  liquidités,  avec 
les coûts que cela entraîne. 

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 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

Table of Contents 

3.1 

1.4 

2. 
3. 

3.2 
3.3 

1.4.1 
1.4.2 

3.3.1 
3.3.2 

3.1.1 
3.1.2 
3.1.3 
3.1.4 

Table of Contents .............................................................................................. 5 
Executive Summary .................................................................................. 8 
1. 
1.1  Motivation of the study ........................................................................... 8 
1.2  Methodology ......................................................................................... 8 
Results ................................................................................................. 9 
1.3 
Significance of OTC derivatives to PSAs .............................................. 9 
1.3.1 
1.3.2 
The costs and impacts of moving from bilateral collateralisation to central 
clearing and posting cash VM ....................................................................... 10 
Technical solutions for the posting of non-cash collateral to CCPs ........ 11 
1.3.3 
Conclusions ........................................................................................ 14 
Potential impact of posting cash VM on retirement incomes ................ 14 
Conclusions relating to technical solutions ........................................ 15 
1.5  Disclaimer .......................................................................................... 15 
Introduction to the Report ....................................................................... 16 
Overview of the EU Pensions Industry ....................................................... 18 
Size of the affected pensions industry .................................................... 18 
Defined benefit, defined contribution and hybrid schemes .................. 20 
Funding ratio ................................................................................ 22 
Asset allocation ............................................................................. 23 
Size of fund .................................................................................. 25 
Approach to our fieldwork ..................................................................... 27 
Findings from our fieldwork................................................................... 28 
Asset allocation ............................................................................. 28 
Intensity of derivative usage ........................................................... 29 
Modelling Approach ................................................................................. 31 
Introduction ........................................................................................ 31 
Incremental impacts ...................................................................... 31 
Direct and opportunity costs ........................................................... 32 
Building blocks for the modelling ........................................................... 32 
Development of representative portfolios ......................................... 32 
Calculation of VM requirements ....................................................... 35 
Derivative usage across the EU industry ........................................... 37 
4.3  Direct cost model ................................................................................ 41 
Drivers of costs ............................................................................. 42 
Modelling methodology .................................................................. 45 
4.4  Opportunity cost model ........................................................................ 49 
Overview of the model ................................................................... 49 
Size of the cash buffer ................................................................... 50 
Value of assets to be sold to meet cash buffer .................................. 51 
Opportunity costs .......................................................................... 51 
Costs of excess VM call .................................................................. 53 
Scaling of the final costs ................................................................. 53 
Results of Phase 1 and Phase 2 Modelling .................................................. 54 
Costs of Phase 1 .................................................................................. 54 
5.1 
5.2 
Costs of Phase 2.1 ............................................................................... 55 
5.3  Direct costs of Phase 2.2 ...................................................................... 56 
5.4  Direct costs of pre- and post-EMIR collateral administration ...................... 58 
5.5  Opportunity costs of Phase 2.2 .............................................................. 59 
Total costs of complying with cash VM under EMIR .................................. 62 
5.6 

4.4.1 
4.4.2 
4.4.3 
4.4.4 
4.4.5 
4.4.6 

4.2.1 
4.2.1 
4.2.2 

4.3.1 
4.3.2 

4.1.1 
4.1.2 

4.1 

4.2 

5. 

4. 

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 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

6. 

6.4 

5.8 

6.1 
6.2 
6.3 

5.7.1 
5.7.2 
5.7.3 

6.6.1 
6.6.2 
6.6.3 

6.3.1 
6.3.2 
6.3.3 
6.3.4 

6.4.1 
6.4.2 
6.4.3 
6.4.4 

6.5.1 
6.5.2 
6.5.3 
6.5.4 

5.7  Wider impacts on PSAs of complying with cash VM under EMIR ................. 63 
Changes in derivative usage ........................................................... 64 
Changes in investment strategies .................................................... 64 
Reliance on the repo market ........................................................... 65 
Conclusions - impact on retirement incomes ........................................... 67 
Technical Solutions for the Posting of Non-Cash Collateral to CCPs................ 69 
CCP clearing arrangements for OTC derivatives contracts ......................... 69 
The examined solutions ........................................................................ 71 
Collateral transformation by CMs ........................................................... 72 
Description of the solution .............................................................. 72 
Benefits of the solution .................................................................. 73 
Costs of the solution ...................................................................... 73 
Risks of the solution ...................................................................... 74 
Collateral transformation by CCPs .......................................................... 77 
Description of the solution .............................................................. 77 
Benefits of the solution .................................................................. 79 
Costs of the solution ...................................................................... 79 
Risks of the solution ...................................................................... 80 
6.5  Direct acceptance of non-cash assets with pass through to receivers of VM . 81 
Description of solution ................................................................... 81 
Benefits of the solution .................................................................. 83 
Costs of the solution ...................................................................... 83 
Risks of the solution ...................................................................... 84 
6.6 
Acceptance  of  non-cash  assets  with  security  interest  passed  through  to 
receivers of VM ............................................................................................. 87 
Description of solution ................................................................... 87 
Benefits of the solution .................................................................. 88 
Costs of the solution ...................................................................... 88 
6.7  Quad-party collateral for VM security interest .......................................... 89 
Description of solution ................................................................... 89 
Benefits of the solution .................................................................. 90 
Costs of the solution ...................................................................... 90 
Risks of the solution ...................................................................... 90 
Agency stock lending ........................................................................... 90 
Description of solution ................................................................... 90 
Benefits of the solution .................................................................. 91 
Costs of the solution ...................................................................... 91 
Risks with the solution ................................................................... 91 
Secured lending by cash-rich corporations .............................................. 92 
Description of solution ................................................................... 92 
Benefits of the solution .................................................................. 93 
Costs of the solution ...................................................................... 93 
Risks with the solution ................................................................... 93 
6.10  Summary of analysis of technical solutions ............................................. 95 
6.10.1  Collateral transformation by CMs ..................................................... 95 
6.10.2  Collateral transformation by CCPs .................................................... 97 
6.10.3  Acceptance of non-cash assets with pass through to receivers of VM ... 98 
6.10.4  Acceptance  of  securities  with  security  interest  passed  through  to 
receivers of VM ......................................................................................... 100 
6.10.5  Quad-party collateral for VM security interest .................................. 101 
6.10.6  Agency stock lending .................................................................... 103 
6.10.7  Secured lending by cash-rich corporations ....................................... 104 
6.11  Conclusions on the relative merits of the technical solutions .................... 105 
Appendix 1: Risk Management of OTC Derivative Contracts ........................ 109 
Appendix 2: Detailed Modelling Results .................................................... 113 

6.9.1 
6.9.2 
6.9.3 
6.9.4 

6.7.1 
6.7.2 
6.7.3 
6.7.4 

6.8.1 
6.8.2 
6.8.3 
6.8.4 

6.8 

6.9 

7. 
8. 

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8.1.1 
8.1.2 
8.1.3 
8.1.4 
8.1.5 

Regulatory regime ........................................................................ 113 
Historic scenario ........................................................................... 114 
100bps scenario ........................................................................... 119 
EBA stress scenario ...................................................................... 123 
Adverse stress scenario ................................................................. 131 

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1.  Executive Summary 

1.1  Motivation of the study 

REGULATION (EU) No 648/2012 on OTC derivatives, central counterparties and trade 
repositories  (EMIR)  is  an  EU  Regulation  designed  to  mitigate  risks  identified  in  the 
derivatives  market.    One  of  its  pillars  is  ensuring  that  standardised  OTC  derivatives 
are cleared via a central counterparty (CCP).  EMIR came into effect in August 2012, 
but  “pension  scheme  arrangements”  (PSAs)  have  been  granted  a  temporary 
exemption from the central clearing requirement until August 2015.  

The long-term nature of the liabilities of PSAs and their exposure to variables such as 
interest  rates  and  inflation  mean  that  PSAs  seek  to  hedge  against  these  risks.  They 
can do this in a variety of ways, including the purchase of real assets — however the 
use  of  OTC  derivatives  is  widespread  market  practice.    Interest  rate  swaps,  inflation 
swaps and FX forwards are commonly used instruments. 

At the end of the exemption PSAs will be obliged to begin clearing their OTC derivative 
portfolios, at least to the extent that the instruments in these portfolios are clearable. 
CCPs require both variation and initial margin to be posted against all positions and, in 
particular,  require  variation  margin  to  be  posted  in  cash  —  current  bilateral  practice 
permits the posting of high-quality assets such as government bonds.   

Pension funds aim to be fully-invested.  Therefore the concern is that in order to hold 
cash to post variation margin pension funds would need to reduce their investments, 
which  could  have  an  impact  upon  investment  returns.    A  solution  to  these  issues 
would  need  to  be  found  if  pension  schemes  are  to  comply  with  the  clearing 
requirements under EMIR without suffering a reduction in investment performance due 
to  this  siphoning  of  assets  as  margin  or  else  passing  on  increased  risk  exposure  to 
pensioners due to a reduction in hedging. 

If the Commission feels that insufficient progress has been made by CCPs to develop 
appropriate solutions for the transfer of non-cash collateral as variation margin (VM), 
it can decide to extend the exemption from the central clearing requirement for up to 
three more years. This study is input into that decision. 

The main objectives of this study are, therefore, to: 

i)  Identify the extent of over-the-counter (OTC) derivative use by PSAs, and the costs 

currently associated with bilateral collateralization.  

ii)  Identify the costs to PSAs and wider impacts if PSAs are required to meet cash VM 

requirements of CCPs, once the exemption of PSAs from mandatory central clearing 
expires. 

iii) Assess a range of alternative solutions for the posting of non-cash collateral by 

PSAs once the exemption from mandatory central clearing expires.   

1.2  Methodology 

The  first  two  objectives  of  the  study  mentioned  above  were  met  through  modelling.  
We developed the following building blocks as part of our cost modelling: 

(cid:131)  Development of three representative portfolios, based upon actual data obtained 

from the pension industry. 

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 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

(cid:131)  Calculation of VM requirements for the representative portfolios under a range of 

simulated environments. The simulations included the historic market changes over 
the past five years, a 100bps increase in interest rates, and stressed market 
conditions scenarios published by the US Federal Reserve and by the European 
Banking Authority.  These are credible candidates for the types of thought 
experiment and analysis which PSAs might undertake in determining how large a 
VM call they might be exposed to, and hence how large a cash buffer it would be 
appropriate to hold.  In particular, the 100bps move has some currency amongst 
PSAs. 

(cid:131)  Estimation of derivative usage across the EU industry such that the representative 

portfolios could be mapped across to the PSAs of each Member State. 

The latter objective was met by examining a range of technical options for the posting 
of non-cash collateral and examining their feasibility, costs and impact with a range of 
PSAs, their investment managers, clearing members, CCPs and central banks. 

In  support  of  this  this  work  we  conducted  fieldwork  which  was  both  extensive  (pan-
EU)  and  intensive  (we  worked  closely  with  several  PSAs  seeking  to  understand  the 
drivers  and  composition  of  the  asset  and  OTC  derivative  portfolios  that  each  had).  
The  tools  used  included  literature  review,  a  focused  survey  of  PSAs  and  structured 
interviews.    The  interview  programme  included  PSAs,  clearing  members,  CCPs  and 
central banks. 

1.3  Results  

1.3.1 

Significance of OTC derivatives to PSAs 

The aggregate assets of the occupational pensions industry across the EU28 were just 
over €5.2 trillion in 2012. The UK, Netherlands and Denmark accounted for around 70 
per  cent  of  this,  with  the  UK  alone  representing  43  per  cent  (around  €2.3  trillion  in 
assets). 

We have noted at 1.1 why PSAs hedge, and identified some of the advantages of using 
OTC  derivatives.    The  intensity  of  hedging  effort  and  of  derivative  usage  by  a  PSA  is 
influenced by a variety of factors: 

(cid:131)  The structure of the PSA, such as whether it is a defined benefit or a defined 

contribution scheme. 

(cid:131)  The PSA’s funding position.  A fully funded PSA has sufficient assets to cover all its 
pension liabilities.  In under-funded PSAs liabilities exceed the current value of its 
assets.  The gap can be significant: the UK's pension funds have an aggregate 
funding ratio of 61 per cent.  The hedging of interest rate and inflation risk is 
against the liabilities not the assets and managing liability risk will be particularly 
crucial in such under-funded funds. 

(cid:131)  The PSA’s asset allocation. This interacts with derivative use - hedging can be 

achieved by other means, such as the acquisition of physical assets.  

(cid:131)  The size of the fund.  Broadly speaking, there is a scale effect, with larger funds 

likely to have more developed derivative portfolios. 

(cid:131)  In addition, regulators can encourage or provide incentives for hedging, which in 

turn make the use of derivatives more likely. 

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We developed a model of the relative intensity of derivative use which considered 
these variables. This enabled us to map across the representative portfolios to the 
wider EU-wide industry. 

1.3.2 

The  costs  and  impacts  of  moving  from  bilateral  collateralisation 
to central clearing and posting cash VM  

The  total  estimated  cost  impact  on  PSAs  will  depend  upon  their  reference  point  in 
setting  a  cash  buffer.    The  table  below  summarises  our  estimated  range  of  cash 
buffers, and the implied annual cost to PSAs in the EU28. 

Table  1.1:  Total  annual  costs  of  PSAs  posting  cash  VM  (EMIR  without  the 
exemption) 

EU28 impact (100bps) 

EU28 impact (historic) 

EU28 impact (EBA) 

EU28 impact (US Fed Adverse) 

Cash buffer (€bn) 

204.3 

109.6 

301.3 

336.3 

-

-

-

-

255.4 

137.1 

376.6 

420.3 

Total annual cost 
(€bn) 

2.3

1.3

3.4

3.8

- 

- 

- 

- 

2.9 

1.6 

4.2 

4.7 

This  compares  to  the  estimated  annual  cost  of  the  current  bilateral  arrangements  of 
about  €43  million,  and  of  EMIR  (with  the  exemption)  of  €52  million.    This  is  a 
significant increase, driven mostly by PSAs increasing cash holdings in order to be able 
to post  cash VM as and when  required.  (Collateral management costs also increase, 
but this is relatively inconsequential). 

These  results  assume  that  PSAs  create  a  cash  buffer  between  80  and  100%  of  the 
maximum expected VM call under each of the  scenarios considered.   Considering the 
100bps  simulation,  as  noted  in  the  table,  our  modelling  indicates  that  the  aggregate 
VM call would be €204–255 billion for European PSAs.  Of this, €98–123 billion (£82–
103  billion)  would  relate  to  UK  PSAs,  and  predominantly  be linked  to  sterling  assets, 
and €106–130 billion would relate to euro (and perhaps other currency) assets. 

If  all  UK  PSAs  set  the  cash  buffer  at  80  per  cent  of  the  expected  VM  call,  then  they 
would need to enter into repo transactions of a value of about €25 billion.  PSAs in the 
rest of the EU would similarly need to (reverse) repo about €26 billion.  In the UK in 
particular this would likely exceed the daily capacity in the UK gilt repo market.  In the 
rest  of  Europe  capacity  is  less  obviously  constrained  in  the  relevant  parts  of  the 
European government  bond repo market, but there  would still be operational hurdles 
to overcome.  

Given  our  views  on  the  scale  of  the  repo  market  at  present  (and  the  concern  that  it 
may  be  subject  to  future  shrinkage  due  to  increased  regulatory-driven  costs,  even 
outside stressed market conditions) this implies that UK PSAs would be unlikely to set 
a  cash  buffer  at  below  80  per  cent  of  the  expected  maximum  -  and  perhaps  the  90 
and 100 per cent reference marks are more realistic indications of what UK PSAs may 
choose to do. PSAs based in the rest of the EU may be able to set a cash buffer further 
from  the  maximum  –  however  the  repo  market  is  not  a  same  day  cash  settlement 
market and PSAs would need to consider this also in determining the balance between 
reliance on a cash buffer and reliance on repo. 

We  also  note  that  the  implied  conversion  of  pension  assets  into  cash  here  is  very 
significant, i.e. sufficiently large that a price impact on the assets themselves would be 
possible.  

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1.3.3 

Technical solutions for the posting of non-cash collateral to CCPs 

In  the  course  of  the  study  we  examined  seven  potential  technical  solutions  which 
could  potentially  mitigate  the  impact  on  the  investment  returns  of  PSAs  arising  from 
the posting of cash VM to CCPs. We begin briefly introducing these concepts: 

(cid:131)  Collateral transformation by clearing members (CMs): This is a repo service 

provided by CMs in which a PSA would reverse repo securities from its portfolio and 
receive cash which could then be used to meet VM calls from a CCP. 

(cid:131)  Collateral transformation by CCPs: This would be a repo service offered by CCPs 
to PSAs in which the CCP would be a principal, providing cash to the PSA in return 
for PSA securities and executing a back-to-back repo with a third party to raise the 
cash. We consider the situation that, in times of stress, the third party could be a 
central bank. 

(cid:131)  Direct acceptance of non-cash assets with pass through to receivers of VM: 
Here the CCP would allow PSAs to post and receive VM in the form of securities. 

(cid:131)  Acceptance of non-cash assets with security interest passed through to 
receivers of VM: The CCP would again allow PSAs to post VM in the form of 
securities.  The CCP would create a security interest over the securities in favour of 
the VM receiver. 

(cid:131)  Quad-party collateral for VM security interest: A variation of the previous 

solution in which the securities would be held, and the security interest created, by 
a custodian according to an agreement between itself, the PSA, the CM and the 
CCP. 

(cid:131)  Agency stock lending: Here the PSA would lend securities from its portfolio and 

receive collateral in the form of cash from the borrower which could be used to meet 
VM calls. 

(cid:131)  Secured lending by cash-rich corporations: A solution in which non-traditional 
sources of cash could be tapped to provide cash to PSAs – either through repos or 
secured loans – with securities being provided by the PSA to the lender as security. 

CCPs differ in their treatment of the risk relating to the day-to-day changes in market 
value  of  an  OTC  derivatives  contract  from  that  employed  in  bilateral  settlement.1 
Bilateral settlement under a Credit Support Annex (CSA) collateralises the changes in 
market value, whereas CCPs actually crystallise the profits and losses, resulting in the 
VM  actually  being  a  settlement  payment  from  the  loser  to  the  gainer.  This  is  the 
reason that CCPs currently only accept and pay out VM in cash, cash being the most 
negotiable  instrument.    This  distinction  plus  the  fact  that  the  novation  of  an  OTC 
derivatives trade by a CCP breaks the settlement trace between the two parties to the 
trade  are  critical  to  the  assessment  of  these  solutions.    They  also  lie  behind  the 
reasons  why  some  solutions  which  work  adequately  for  bilateral  settlement  are  not 
suitable for CCP clearing. 

Three  of  the  solutions  –  Direct  acceptance  of  non-cash  assets  with  pass-through  to 
receivers of VM, Acceptance of non-cash assets with security interest passed through 
to  receivers  of  VM  and  Quad-party  collateral  for  VM  security  interest  –  would  allow 
PSAs to use securities to cover VM calls, without having to transform them into cash.  
However,  this  gives  rise  to  significant  drawbacks:  in  particular,  it  would  entail  non-
cash  VM  contracts  being  offered  as  separate  product  lines  to  cash  VM  products.  The 

1   i.e. the risk which the posting of VM is intended to mitigate. 

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non-cash  VM  products  would  have  lower  liquidity  and  wider  spreads  than  the  cash 
products.  Direct acceptance of non-cash assets with pass-through to receivers of VM 
would involve so much operational complexity as to rule it out.   

The two solutions involving security interest would be easier to implement technically 
but potential differences in the law on security interests in the different Member State 
jurisdictions  relevant  to  a  transaction  would  heighten  legal  risk.  Even  if  the  legal 
uncertainty could be resolved, we would expect that the split of liquidity between cash 
and  non-cash  products  would  be  enough  to  prevent  the  non-cash  products  from 
gaining traction. 

Two  of  the  solutions  –  Collateral  transformation  by  CMs  and  Agency  stock  lending  – 
build upon existing market competence.  However they would not have the capacity to 
meet  the  full  needs  of  the  European  PSAs  and  this  capacity  would  probably  not  hold 
up in times of market stress.   

Collateral transformation by CCPs appears to be an attractive solution, particularly in 
times  of  stressed  markets.  However,  there  are  two  main  challenges.   First,  whether 
central  banks  would  be  prepared  to  offer  liquidity  to  CCPs  and  whether,  in  practice, 
the conditions on which it might be offered be compatible with the solution.  Second, 
the lack of appetite amongst CCPs to take on and manage the resulting increased risk 
(even with a changed appetite by CCPs it would be subject to regulatory approval) and 
likely concern about the ability of CCPs to maintain current levels of systemic security.  

Agency  stock  lending  can  be  attractive  to  PSAs  because  it  can  enhance  investment 
returns,  but  its  market  capacity  cannot  be  relied  on  and,  at  best,  can  only  form  a 
small part of the solution to the PSAs’ needs. 

Secured lending from cash-rich corporations is an interesting concept and could allow 
PSAs to tap into an additional pool of cash to which they currently have limited access.  
The investment required to develop it would require considerable commitment from a 
custodian or Central Securities Depositary.  In addition, the cash is on balance sheets 
because  of  a  lack  of  suitably  attractive  investment  opportunities  and  has  not  been 
returned to investors due to a mix of faith in future opportunities and perhaps also the 
associated  tax  effects  of  returning  cash  to  investors.   These  motivations  may  not  be 
maintained indefinitely. 

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The  table  below  summarises  our  assessment  of  each  of  the  solutions  in  terms  of  its 
impact on cost and risk factors.  Against each factor in the table we have assessed the 
relative appeal of each of the solutions. 

Table 1.2: Summary of assessment of impact on cost and risk factors  

Collateral 
trans-
formation 
by CMs 

Collateral 
trans-
formation 
by CCPs 

Direct 
pass-
through of 
non-cash 
assets to 
receivers 
of VM 

Security 
interest in 
non-cash 
assets 
passed 
through to 
receivers 
of VM 

Quad-
party 
collateral 
for VM 
security 
interest 

Secured 
lending by 
cash-rich 
corpora-
tions 

Agency 
stock 
lending 

Impact on 
Investment 
Performance 

Impact on 
Swap Market 

Legal & 
regulatory 
complexity 
and risk 
Operational 
Cost 

PSAs 
CCPs 
CMs 

Operational 
complexity 
and risk 
PSAs 
CCPs 
CMs 

Investment 
Required 

PSAs (inc. 
custodians) 

CCPs 
CMs 

Counterparty 
Risk 

PSAs 
CCPs 
CMs 

0 

0 

0 

-1
0 
0 

-1
0 
-1

-1 
0 
0 

0 
0 
0 

0 

0 

-2 

-1 
-2 
1 

-1 
-2 
1 

-1 
-2 
0 

0 
-1 
-2 

0

-2 

-2

-2
-2
-2

-2
-1
-1

-1 
-2
-2

0
0
0

0

-2 

-2

-1
0
0

-1
0
-1

-1 
-2
-1

-1
0
0

0

-2 

-2

-1
0
0

-1
0
-1

-1 
-2
-1

-1
-1
0

1 

0 

0 

0 
0 
0 

0 
0 
0 

0 
0 
0 

0 
0 
0 

0 

0 

-1 

-1 
0 
0 

-1 
0 
0 

-2 
0 
0 

1 
0 
1 

Key: Relative Appeal 
Best 

Worst 

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The table below summarises our assessment of the capacity of the solutions – i.e. the 
extent  to  which  each  solution  would  meet  the  full  requirement  of  the  PSAs  in  both 
normal and stressed market conditions. 

Table 1.3: Summary of assessment of capacity of the solutions 

Collateral 
trans-
formation 
by CMs 

Collateral 
trans-
formation 
by CCPs 

Market Capacity 
(Normal Conditions) 

Market Capacity 
(Stressed Conditions) 

1 

-1 

1 

2 

Security 
interest 
in non-
cash 
assets 
passed 
through 
to 
receivers 
of VM 

2 

2 

Direct 
pass-
through 
of non-
cash 
assets to 
receivers 
of VM 

2 

2 

Quad-
party 
collateral 
for VM 
security 
interest 

2 

2 

Agency 
stock 
lending 

-1 

-2 

Secured 
lending 
by cash-
rich 
corpora-
tions 

-1 

-1 

Key: Capacity to meet PSAs VM requirement
 Would fully meet requirement 

Would meet a small part of requirement 

1.4  Conclusions  

1.4.1 

Potential impact of posting cash VM on retirement incomes 

We have identified substantial potential cost impacts which would ensue as and when 
PSAs are required to post cash VM to CCPs. To the extent that PSAs pass these total 
costs  on  to  pensioners,  these  would  represent  a  €  for  €  reduction  in  retirement 
incomes.  Whilst it is possible that — where relevant — corporates and other sponsors 
of PSAs  could make good any shortfall by increasing their contributions to the funds, 
our  fieldwork  does  not  indicate  that  this  is  a  likely  outcome.  It  would,  anyway,  only 
substitute a reduction in pensioner incomes with a reduction in corporate profits. 

in 

investment  returns.  Compounding  over  the 

The  annual  total  costs  as  a  percentage  of  PSAs’  AUM  would  represent  the  annual 
life  of  pensioners’ 
reduction 
contributions  provides  the  cumulated  effect  and  gives  the  impact  on  retirement 
incomes.    This  is  significant  –  particularly  in  those  countries  with  more  extensive 
pension  industries.    The  cumulative  cost  in  the  100  bps  simulation  is  up  to  3.1  per 
cent in the Netherlands and 2.3 per cent in the UK. The estimated impact across the 
EU28 for the various simulations is shown below.  

Table 1.4:  Indicative  cumulated reduction  in  retirement  incomes over 20, 30 
and 40 years   

20 years 

30 years 

40 years 

EU28 impact (100bps) 

EU28 impact (historic) 

EU28 impact (EBA) 

EU28 impact (US Fed Adverse) 

1.1% 

0.6% 

1.6% 

1.8% 

1.7% 

0.9% 

2.4% 

2.7% 

2.2% 

1.3% 

3.3% 

3.7% 

The key driver of these opportunity costs is the difference in return between cash and 
higher yielding assets (in particular government bonds).  At present these spreads are 
relatively low: if the spreads should widen – or if PSAs chose to fund the cash buffer 
from  assets  other  than  government  bonds  –  then  we  would  expect  a  much  more 

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significant impact on retirement incomes. Similarly, if PSAs focused  on an alternative 
simulation to the 100 bps one –  such as the other  stressed  simulations – the impact 
would  deepen.    It  is  also  worth  noting  that,  no  matter  how  well  prepared  PSAs  may 
be, the actual shocks which they may eventually face could still be worse. 

1.4.2 

Conclusions relating to technical solutions 

No one solution stands out as the obvious candidate and there is currently little hard 
evidence that the industry is investing in innovative solutions to the core problem. 

Our  assessment  is  that  the  three  solutions  involving  the  posting  of  non-cash  VM  are 
not viable because of the negative impact of all three on the pricing of the contracts, 
the  operational  complexity  of  one  of  them  and  the  legal  risk  of  the  other  two.  PSAs 
must therefore expect to have to post and receive VM in cash for cleared contracts. 

A  PSA  would  therefore  have  to  maintain  a  cash  buffer  in  order  to  meet  potential  VM 
calls or rely on transforming securities from its portfolio into cash at short notice using 
one of the solutions described or, most likely, a combination of both. 

The  only  substantial  transformation  solution  with  any  expectation  of  traction  at 
present  is  collateral  transformation  by  CMs.    A  PSA’s  appetite  for  reliance  on  this 
solution will depend on how the cost of the solution compares to the opportunity cost 
of maintaining a larger cash buffer instead.  Critically, it will also depend on its view of 
the capacity of the repo market to satisfy its likely needs.  There are serious concerns 
that the repo market, as presently constructed, could not meet the liquidity demands 
of the PSAs in times of stress.  

Our analysis indicates that UK PSAs as a group would not be able to rely fully on the 
gilt repo market in the UK, and most likely other EU PSAs would not be willing or able 
to rely fully on euro government bond repo markets in the rest of Europe.  Whilst the 
repo  of  other  assets  could  increase  the  potential  capacity  available  these  other  repo 
markets are much more susceptible to losses of liquidity in a crisis situation.  As such, 
reliance upon them is not likely to be seen as a prudent approach. Therefore, absent 
any change in the size of the repo market or very substantial progress on some other 
technical solution, PSAs would need to create a cash buffer to cover the shortfall over 
and above the capacity that they judge the repo market would be likely to be able to 
provide.  The  scale  of  this  cash  buffer  is  likely  to  be  substantial,  with  commensurate 
costs. 

1.5  Disclaimer  

The information and views set out in this baseline report are those of the authors and 
do not necessarily reflect the official opinion of the Commission. The Commission does 
not  guarantee  the  accuracy  of  the  data  included  in  this  baseline  report.  Neither  the 
Commission  nor  any  person  acting  on  the  Commission’s  behalf  may  be  held 
responsible for the use which may be made of the information contained therein. 

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2.  Introduction to the Report 

REGULATION (EU) No 648/2012 on OTC derivatives, central counterparties and trade 
repositories  (EMIR)  is  an  EU  Regulation  designed  to  mitigate  risks  identified  in  the 
derivatives  market.    One  of  its  pillars  is  ensuring  that  standardised  OTC  derivatives 
are cleared via a central counterparty (CCP).  EMIR came into effect in August 2012, 
but “pension scheme arrangements” have been granted a temporary exemption from 
the central clearing requirement until August 2015.  

Under EMIR (Article 2(10)): pension scheme arrangement (PSA) means: 

a) institutions for occupational retirement provision within the meaning of Article 6(a) 
of Directive 2003/41/EC, including any authorised entity responsible for managing 
such an institution and acting on its behalf as referred to in Article 2(1) of that 
Directive as well as any legal entity set up for the purpose of investment of such 
institutions, acting solely and exclusively in their interest;  

b) occupational retirement provision businesses of institutions referred to in Article 3 

of Directive 2003/41/EC;  

c)  occupational retirement provision businesses of life insurance undertakings covered 
by Directive 2002/83/EC, provided that all assets and liabilities corresponding to 
the business are ring-fenced, managed and organised separately from the other 
activities of the insurance undertaking, without any possibility of transfer; and 

d) any other authorised and supervised entities, or arrangements, operating on a 

national basis, provided that:  

(i)  they are recognised under national law; and 

(ii)  their primary purpose is to provide retirement benefits. 

This definition incorporates broad elements (i.e. (d)) and we conclude that it includes 
a very large part of the European pension fund industry.   

PSAs  use  OTC  derivatives  for  a  variety  of  reasons.    The  central  motivation  is  the 
hedging of their liabilities to current and future pensioners against relevant risks: 

(cid:131)  Interest rate movements: interest rates can have a material impact on the value of 
a pension fund, especially where the fund holds a substantial amount of long-dated, 
floating-rate fixed income securities.  A pension fund can hedge against interest rate 
moves by, e.g. purchasing interest rate swaps (IRS).   

(cid:131)  Inflation: pension funds in environments where inflation is high or uncertain may 
wish to hedge against the effects of rising prices on the value of their portfolios, 
returns on investment, or pay-outs.  This is especially important for defined benefit 
pension schemes (including hybrid schemes). 

(cid:131)  Currency movements: investing in foreign currency-denominated assets carries 

foreign exchange (FX) risk in addition to the two risks mentioned above.  FX risk 
may arise for pension funds in two ways.  First, where large volumes of FX are 
needed to make future purchases, pension funds might not want to take a risk that 
domestic currency will depreciate versus foreign currency — thereby making the 
future purchase more expensive — and purchase an FX derivative to lock-in an 
exchange rate.  This could be achieved by purchasing an FX forward, swap, or call 
option on the foreign currency.  Second, a pension fund could face FX risk when 
realising returns on foreign investment.  If the domestic currency appreciates 

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against the foreign currency, coupons on foreign-denominated bonds or capital 
gains on foreign-denominated assets could be worth less.  Pension funds can hedge 
against this risk by purchasing the other side of an FX forward or swap or buying a 
put option on the foreign currency. 

The  long-term  nature  of  the liabilities  that  PSAs  are  seeking  to  hedge  against  means 
that OTC derivatives are currently generally more  suitable than any exchange traded 
alternatives,  which  are  generally  short-dated  meaning  contracts  need  to  be  rolled.  
The use of derivatives is not the only way in which some of these risks can be hedged: 
a PSA can also achieve an effective hedge in many instances through the acquisition of 
real  assets.  The  choice  to  use  derivatives  is  reflective  of  the  trade-off  between 
transactional  and  operational  costs,  and  the  extent  of  the  hedging  achieved.    If  the 
extent  to  which  liabilities  are  hedged  reduces,  then  ultimately  the  pensioner  is 
exposed  to  increased  risk  and  more  volatile  and,  potentially,  lower  pension  incomes 
are achieved. 

PSAs have also used derivatives as an efficient way to enhance returns, e.g. through 
equity  derivatives,  by  levering  exposure  more  than  would  be  possible  with  physical 
assets.   

The  level  of  collateral  required  by  banks,  as  counterparties  in  OTC  derivatives,  is  a 
feature  of  the  perceived  credit  standing  of  the  client.    Consequently,  until  now, 
pension  funds  have  typically  not  been  required  to  post  initial  margin  when  trading 
bilaterally with banks, as they are considered highly creditworthy counterparties.  The 
intention of EMIR is to bring more derivative transactions into central clearing through 
CCPs  and,  for  those  transactions  that  remain  executed  bilaterally,  to  require 
margining.  Under  EMIR,  CCPs  require  both  variation  and  initial  margin  to  be  posted 
against all positions and it is conventional for CCPs to require variation margin (VM) to 
be  posted  in  cash.    (Bilateral  settlement  under  a  Credit  Support  Annex  (CSA) 
collateralises  the  changes  in  market  value,  whereas  CCPs  actually  crystallise  the 
profits  and  losses,  resulting  in  the  VM  actually  being  a  settlement  payment  from  the 
loser to the gainer. This is the reason that CCPs currently only accept and pay out VM 
in cash, cash being the most negotiable instrument.2   

Pension funds aim to be fully-invested.  Therefore the concern is that in order to hold 
cash to post variation margin pension funds would need to reduce their investments, 
which  could  have  an  impact  upon  investment  returns.    A  solution  to  these  issues 
would  need  to  be  found  if  pension  schemes  are  to  comply  with  the  clearing 
requirements under EMIR without suffering a reduction in investment performance due 
to  this  siphoning  of  assets  as  margin  or  else  passing  on  increased  risk  exposure  to 
pensioners due to a reduction in hedging. 

2   A detailed explanation of the risk management of OTC derivatives (both bilateral and cleared) is provided as Appendix 1 to this 
document.  It  includes  an  explanation  of  some  of  the  differences  between  bilateral  settlement  and  CCP  clearing  of  OTC 
derivatives contracts which lead CCPs to require variation margin in cash. 

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3.  Overview of the EU Pensions Industry  

In this section we present an overview of the pensions industry in the EU.  

The information gathered here has been used to: 

(cid:131)  Understand the potential size of the pensions industry subject to the temporary 
exemption from central clearing under EMIR — and which would therefore be 
affected by the termination of this exemption in the absence of a technical solution 
to the posting of non-cash collateral. 

(cid:131)  Select sample Member States on which to focus our data gathering and modelling.   

(cid:131)  Provide the basis for extrapolation of the results of this modelling to establish EU-

wide impacts. 

3.1  Size of the affected pensions industry  

The aggregate assets of the occupational pensions industry across the EU28 were just 
over  €5.2  trillion  in  2012  according  to  PensionsEurope  and  the  OECD.3    As  shown  in 
the chart below the UK, Netherlands and Denmark accounted for around 70 per  cent 
of this, with the UK alone representing 43 per cent (around €2.3 trillion in assets).4   

3   The  PensionsEurope  data  presented  here  includes  voluntary  and  mandatory  schemes,  and  excludes  assets  held  under  book 

reserves.  

4   The  OECD  data  do  not  include  pension  fund  assets  held  as  book  reserves  and  as  such  differ  from  the  data  collected  by 
PensionsEurope.  There are some residual differences, even after this adjustment.  The most notable differences are with respect 

to Germany, where pension assets are reported by OECD to be €168bn in 2012, and total occupational pension assets reported 

by PensionsEurope to be €500bn.  Of the latter, around €265bn is in book reserves.  We do not believe that these can qualify for 

the exemption and as such are not relevant to this analysis.  It follows that the comparable figure to that presented by the OECD 

is €235bn.  

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Figure 3.1: Total assets of occupational pensions in the EU, 2012 

Source:  PensionsEurope  (2012)  “Statistical  Survey  2011”.    Data  from  2011  are  uplifted  to  2012  values 
using the 2011/2012 ratio from the OECD dataset on private pensions.  
Note: * represents data on private pensions from OECD (2013) “Pension Markets in Focus No.10". 

Assets  held  within  a  country’s  pension  schemes  were  highly  significant  relative  to  its 
GDP in a number of Member States.  This is highlighted in the chart below, with such 
assets  being  nearly  200  per  cent  of  GDP  in  Denmark  and  just  under  170  per  cent  of 
GDP in the Netherlands.  

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Figure 3.2: Occupational pension assets relative to GDP, 2012 

Notes: * represents data on private pensions from OECD (2013) “Pension Markets in Focus No.10" 
Source: PensionsEurope (2012) “Statistical Survey 2011”.  Data from 2011 have been uplifted to estimated 
2012 values using the 2011/2012 ratio from the OECD dataset on private pensions.  

As  noted  above,  the  exemption  in  EMIR  applies  to  PSAs  as  defined  by  Article  2(10) 
EMIR  and  includes  institutions  for  occupational  retirement  provision  and  occupational 
retirement provision businesses of life insurance undertakings provided that all assets 
and liabilities corresponding to the business are ring-fenced from the other activities of 
the insurance undertakings.   

An obligation to clear OTC derivatives would of course have greatest impact on PSAs 
that most actively use these instruments.  OTC derivatives are generally used by PSAs 
to hedge risks associated with long-term liabilities (although they can also be used to 
enhance investment returns).  Data on the level of derivative use among PSAs across 
the EU are very limited.  However, there are a number of indicators that imply a level 
of derivative use for which data are available. 

3.1.1 

Defined benefit, defined contribution and hybrid schemes 

Defined  benefit  (DB)  pension  schemes  impose  an  obligation  on  the  underlying 
institution to pay defined retirement benefits to the PSA’s members.  These retirement 
benefits represent liabilities of the PSA, and can change over time according to, most 
notably, interest  rates  (as  interest  rates  fall,  the  value  of  pension  liabilities increases 
and vice versa),5 inflation6 and longevity.7 

5   A decline in interest rates means that a larger asset base is needed when converting to an annuity to achieve the same level of 

annuitized benefits. 

6   Defined  benefit  scheme  may  be  obliged  to  increase  pay-outs  in  line  with  inflation,  i.e.  the  benefits  are  set  in  real  rather  than 

nominal terms.  

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OTC derivatives, in particular interest rate and inflation swaps, can be used to hedge 
against  these  risks.    Holding  interest-bearing  assets  such  as  government  and 
corporate bonds can also be used to hedge interest rate risks (and potentially inflation 
risks).   

OTC derivatives have a number of advantages over physical assets:  

(i)  being capable of being designed to precisely fit an identified risk;  

(ii)  enabling  the  of  unbundling  risks  (i.e.  duration,  convexity,  and  other  risks  can  be 

dealt with individually); 

(iii)  having lower transaction costs (i.e. lower bid-offer spreads); and 

(iv) using less of the PSA’s available resources so that its assets can be worked harder 

in order to achieve — it is hoped — superior returns to bonds. 

Benefit  pay-outs  under  defined  contribution  (DC)  schemes  are  typically  based  on  the 
inputs  made  by  members  and  on  the  investment  performance  achieved,  rather  than 
according to a pre-determined formula.  As such those risks associated with the level 
of  the  final  pay-out  are  generally  speaking  borne  directly  by  the  pensioners  rather 
than by the fund or its funding entity.   

In  practice,  certain  DC  schemes  incorporate  features  such  as  guaranteed  minimum 
returns  which  make  the  distinction  with  DB  less  clear  cut.  Local  regulation  can  also 
encourage  DC-style  schemes  to  adopt  practices  which  reduce  the  exposure  of 
members  to  interest  rate  and  other  forms  of  risk.    So-called  collective  DC  schemes 
(such  as  in  the  Netherlands)  incorporate  a  degree  of  risk-sharing  between  the 
sponsors and the  employees.   Nevertheless the use  of OTC derivatives is more likely 
to be concentrated in Member States with significant use of defined benefit schemes, 
and this is an important driver of overall intensity of use (we discuss the others in the 
following  sub-sections,  concluding  at  4.2.2).    The  chart  below  shows  where  defined 
benefit schemes are most common.  

7   An increase in life expectancy means that a larger asset base is needed to provide the same level of benefits over what should 

be a longer retirement period. 

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Figure  3.3:  Defined  benefit,  defined  contribution  and  hybrid  schemes  in 
selected EU Member States, 2012   

Source:  OECD  (2013),  "Pension  Markets  in  Focus  No.10",  except  those  marked  (*)  which  are  drawn  from 
information published by the relevant national supervisors or equivalent institutions.  

3.1.2 

Funding ratio 

The funding ratio refers to the relationship between the assets and liabilities held by a 
PSA.    A  fully  funded  PSA  has  sufficient  assets  to  cover  all  its  pension  liabilities.    In 
under-funded PSAs liabilities exceed the current value of its assets.  Managing liability 
risk  will  be  particularly  crucial  in  such  under-funded  funds,  and  who  are  therefore 
more likely to use derivatives.  Data on the funding ratio are less available than other 
metrics  (for  Member  States  where  PSAs  are  mostly  or  exclusively  on  a  defined 
contribution basis, this is perhaps unsurprising).  The chart below shows that for most 
Member  States,  where  data  are  available,  pension  scheme  arrangements  are  in 
aggregate fully-funded (or indeed over-funded).  The exceptions are the UK, Romania 
and Ireland.  

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Figure 3.4: Funding ratios for a sample of Member States, 2012 

Source: EIOPA (2013) “Quantitative Impact Survey on IORPS” and pensions regulators8  

3.1.3 

Asset allocation 

The  range  of  assets  in  which  pension  funds  invest  may  also  have  a  bearing  on  their 
use of OTC derivatives.  Interest-bearing assets such as bonds may provide a natural 
hedge  against  elements  of  interest  rate  risk.  The  chart  below  presents  the  average 
allocation  across  assets  for  Member  States.    In  the  majority  of  Member  States,  cash 
and interest-bearing assets account for at least 40 – 50 per cent of assets.   

8   EIOPA’s  QIS  is  based  on  a  sample.    We  have  therefore  preferred  Member  State-wide  data,  where  available.    The  UK  is  a 
particular case: there are two under-funding ratios current for the UK.  The Pension Protection Fund’s Purple Book references the 

s.179 ratio of 84 per cent (based on what the PPF would pay-out as statutory compensation) and the full pay-out ratio of 61per 
cent (based on the actual benefits promised by funds).  For our purposes, it is the latter ratio which we consider to be relevant. 

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Figure 3.5: Asset allocation of pension scheme arrangements, 2011/2012 

Notes:    
1. * denotes an assumed split between public and private fixed income of 70/30. 
2. The original data include ‘mutual funds’ as an asset type rather than as an investment wrapper.  We have 
allocated  the  value  of  these  mutual  funds  across  other  asset  classes  in  proportion  to  the  industry’s  direct 
holdings by asset class. 
3. The remainder of the assets is allocated to ‘other’ categories.  This include alterantive investments such 
as  hedge  funds  and  private  equity,  and  also  —  potentially  —  OTC  derivatives  at  their  marked-to-market 
value.   
Source:  Source:  OECD  (2013),  "Pension  Markets  in  Focus  No.10"  and  Pensions  Europe  (2012)  “Statistical 
Survey 2011”.   

The above chart represents average asset allocations across all pension funds in each 
Member State.  However, the range of assets in which individual pension funds invest 
will  likely  vary  according  to  the  structure  of  their  liabilities.    For  example,  data  from 
the UK show that even among defined benefit schemes there are structural drivers of 
differences in asset allocation.  The increasing closure of private sector defined benefit 
schemes  has  led  to  a  reduction  in  the  holding  of  equities  and  an  increase  in  the 
holding  of  fixed  income  assets.  This  reflects  the  evolving  nature  of  risks  faced  by  a 
pension  fund  that  is  closed  to  new  entrants  (if  fully  funded,  a  closed  fund’s  assets 
could  be  allocated  close  to  100  per  cent  in  government  bonds).    Pension  funds  are 
increasing  their  allocations  to  index-linked  gilts  and  corporate  bonds  once  schemes 
close to either new members or to both new members and to future accruals.  

A more detailed decomposition of asset allocation is available from a survey conducted 
by Mercer  covering pension funds in 13 EU Member States.  The funds surveyed had 
assets  of  just  over  €750  billion.9    In  particular  the  data  show  a  more  detailed 

9   Mercer (2013) “Asset Allocation Survey: European Institutional Marketplace Overview 2013”.  The asset  allocations reported in 
the Mercer study differ markedly in  some cases from the OECD allocations, in particular with regard to the  allocation to public 

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breakdown  of  asset  allocation  between  different  bond  categories,  including  between 
domestic and non-domestic government bonds.  

Figure 3.6: Allocation of bond asset classes, 2013 

Source: Mercer (2013) “Asset Allocation Survey: European Institutional Marketplace Overview 2013”. 

As  can  be  seen,  domestic  government  bonds  represent  a  significant  share  of  the 
invested  assets  in  the  majority  of  countries  captured  by  the  survey.    The  survey 
represented around 20 per cent of occupational pension assets in the EU. 

Asset  allocations  do  change  over  time,  but  do  not  follow  a  neat  secular  trend.    In 
addition  there  are  some  market  and  regulatory  developments  which  are  not  yet 
determined. For example, the impending Solvency II regulation is anticipated by some 
market  observers  to  drive  a  degree  of  asset  reallocation  within  the  portfolios  of 
pension  schemes.    In  particular  long-duration  corporate  bonds  may  decline  in 
importance  with  increased  weight  being  attached  to  asset  classes  such  as 
infrastructure  and  residential  property.  We  have  not  sought  to  model  such  effects  in 
the  baseline  for  straightforward  reasons:  first  there  is  residual  uncertainty  as  to  the 
likelihood and scale of such a shift and second, given our results, it would be unlikely 
to  materially  affect  the  results.    The  latter  point  is  simply  because  in  our  cascade  of 
assets (see 4.4 below) which would be sold to fund an increased cash buffer the model 
rarely enters the corporate bond layer.       

3.1.4 

Size of fund 

The  size of fund may also have a bearing on the extent  of its derivative usage.   Our 
fieldwork indicates that, all else being equal, larger funds tend to invest in derivatives 
to  a  greater  degree  than  smaller  funds.    (It  should  also  be  borne  in  mind  that  the 

and corporate fixed income. The Mercer study represents on average 26 per cent of total occupational pension assets within each 
country, with three, nine and 15 per cent on the Netherlands, Denmark and the UK being represented respectively. 

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PSAs may outsource fund management to a specialist fund manager, who will actually 
be the responsible party for derivatives activity – again, larger asset managers may be 
more  active  here  than  small  ones.    Nevertheless  we  understand  that  the  size  of  the 
underlying fund is still relevant to the intensity of derivatives usage). 

We do not have data that looks directly at either (i) the distribution of PSAs by assets, 
or  (ii)  the  joint  distribution  of  PSAs  managing  their  own  assets  and  also  of  asset 
managers.  We therefore consider an alternative way of unpicking the size distribution 
of  PSAs,  which  will  enable  us  to  understand  the  intensity  of  derivative  usage  more 
fully.  

We  consider  it  a  reasonable  assumption  that  pension  assets  held  will  have  a  broadly 
proportional  relationship  to  the  number  of  members.  (There  will,  of  course,  be 
exceptions to this.  The most obvious would be where small PSAs are for the benefit of 
the  most  highly  paid  executives  and  workers.)    The  chart  below  illustrates  the 
distribution of funds in terms of the number of members.   

Figure 3.7: Distribution of pension funds by number of members 

Source: PensionsEurope (2012) “Statistical Survey 2011”.   

We  have  then  used  these  data  to  estimate  the  average  assets  under  management 
(AUM) per PSA member in each Member State and then used this to approximate the 
average fund size in terms of AUM within each size band displayed above. 

We  set  an  indicative  threshold  of  €50  million  AUM  above  which  a  fund  would  be 
considered  ‘large’  for  the  purposes  of  derivative  use  intensity  (described  further  in 
section 3.3.2 below).  The chart below presents the results of this analysis. 

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Figure 3.8: Large and small funds as a proportion of aggregate AUM  

Source: OECD 2013 and Europe Economics analysis.  

3.2  Approach to our fieldwork  

Our fieldwork comprised of two strands: 

(cid:131)  In-depth interviews with PSAs and other market participants from a sub-section of 
Member States where the impacts of EMIR’s central clearing obligation would be 
expected to be greatest.      

(cid:131)  Broad data collection across EU Member States through a focused survey.  This 
sought to understand the level of OTC derivative usage by PSAs across Member 
States and the drivers thereof. 

Our in-depth fieldwork sought to gather information from the industry about the costs 
and impacts of central clearing under EMIR (focusing on the requirement to post cash 
variation  margins),  and  about  the  viability  of  a  number  of  solutions  to  the  posting  of 
non-cash collateral.  We consulted PSAs, clearing members, custodian banks, clearing 
houses  and  central  banks.    We  also  collected  portfolio  data  from  funds  to  construct 
representative  portfolios  with  which  to  model  the  impacts  of  the  removal  of  the 
exemption.   

We  focused  on  those  Member  States  where  the  impact  of  central  clearing  would  be 
greatest, namely Member States with large pension industries that engage extensively 
in  OTC  derivative  use  and  those  Member  States  that  had  expressed  to  the  European 
Commission interest in relation this issue.  Based on the industry data and the initial 
feedback from trade associations, we narrowed the selection for our in-depth fieldwork 

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to  the  UK,  the  Netherlands  and  Denmark.    The  broad  data  collection  strand  included 
approaches to all associations of pension funds within the EU.10          

3.3  Findings from our fieldwork  

Pension  funds  providing  details  of  their  asset  allocations  and  derivatives  portfolios 
(including  those  funds  interviewed  as  part  of  the  in-depth  fieldwork)  account  for 
around  €1.1  trillion  in  AUM,  approximately  20  per  cent  of  total  occupational  pension 
AUM across the EU.11  Survey responses account for just below 70 per cent of AUM in 
the Czech Republic, nearly 60 per cent of AUM in the Netherlands and just over 20 per 
cent  of AUM in the UK.  Other Member States represented in the survey are Austria, 
Germany,  Denmark,  Italy,  Greece,  and  Portugal.    Funds  from  the  EFTA  (Norway  and 
Switzerland) also participated.  

The low (or even non-existent) response rate from some EU Member States is likely to 
be  in  part  reflective  of  the  low  relevance  of  the  EMIR  clearing  obligation  and 
exemption  to  PSAs  across  the  EU.    Feedback  from  the  relevant  trade  associations  in 
Member  States  from  which  we  received  no  responses  often  indicated  that  OTC 
derivative usage by PSAs was considered to be low or negligible — or simply unknown.  
As  can  be  observed  from  the  industry  data,  in  many  other  Member  States  the 
pensions  industry  is  entirely  defined  contribution  (implying  little  need  to  hedge  long-
term liabilities), or is of low importance as a share of GDP.   

Reponses  to  our  survey  represent  a  significant  share  of  the  parts  of  the  pension 
industry we  expect to be most affected.  For  example, the  survey responses account 
for about 35 per cent of defined benefit AUM across the EU28.    

3.3.1 

Asset allocation 

The  allocation  of  assets  among  the  PSAs  in  our  sample  is  broadly  similar  to  the 
average allocation at the Member State level. Cash holdings generally account for less 
than  10  per  cent  of  assets.    Government  bonds  are  the  largest  asset  class  in  many 
Member  States,  broadly  confirming  the  detailed  distributional  data  from  the  Mercer 
survey described above.    

The  figure  below  presents  the  weighted  average  allocation  (by  AUM)  within  each 
Member State represented in the fieldwork.    

10  All associations across the EU 28 were contacted, and we engaged with associations about the level of derivative usage from AT, 

HR, CZ, DK, EE, FR, EL, IE, LV, LU, MT, NL, PT, RO, SK, and UK. 

11  This figure includes the AUM of some large fund managers. 

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Figure  3.9:  Weighted  average  asset  allocation  across  Member  States  in 
survey   

Source: Europe Economics Focused Survey 2013. 

3.3.2 

Intensity of derivative usage  

Our  fieldwork  provides  insight  into  derivative  usage  by  PSAs  not  available  in  public 
statistics.  Interest rate swaps (including swaptions)12 were the most commonly used 
instrument, followed by FX forwards, and inflation swaps. 

For  example,  the  level  of  interest  rate  swaps  as  a  proportion  of  non-interest-bearing 
assets  (e.g.  excluding  government  and  corporate  bonds)  is  an  approximate  way  of 
assessing  the  total  level  of  hedging  of  interest  rate  risk.    The  weighted  average 
notional value of interest rate swaps as a proportion of non-interest bearing AUM was 
over  100  per  cent  in  the  Netherlands,  around  14  per  cent  in  the  UK,  27  per  cent  in 
Germany  and  around  50  per  cent  in  the  Czech  Republic.13    (If  assessed  against 
liabilities the UK figure would increase.) 

We  used  metrics  such  as  the  sensitivity  of  the  derivatives  portfolios  to  changes  in 
interest and inflation rates (e.g. DV0114, IE0115), relative to AUM as a way of indexing 

12  Swaptions  are  options  to  enter  into  a  swap  transaction.    Since  they  typically  refer  to  options  on  interest  rate  swaps  we  group 

them together. 

13  The  results  for  the  Czech  Republic  are  influenced  by  two  of  the  larger  funds  having  the  majority  of  their  assets  (over  70  per 
cent) invested in government bonds.  Comparing the countries on the basis of interest rate swap notional values as a proportion 
of total AUM, the Czech Republic is lower than most at around 4 per cent.   

14  DV01  of  an  instrument  is  the  sensitivity  of  the  value  of  the  instrument  to  a  one  basis  point  (or  0.01  per  cent)  increase  in  the 
relevant interest rate;  that is the euro or sterling change (in this context) in the value of the instrument caused by a one basis 
point increase in the relevant interest rate. 

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the intensity of overall derivative usage.  This work indicates that Member States with 
the most intense usage are the UK and the Netherlands, with the occasional high-use 
fund  present  elsewhere,  e.g.  in  Denmark.    Indeed  a  report  on  liability-driven 
investment  (LDI)  notes  that  “the  use  of  derivatives  seems  to  be  particularly 
widespread in Denmark, the United Kingdom and the Netherlands”.16  Pension funds in 
Sweden  and,  to  a  lesser  extent,  Germany  are  also  identified  in  this  study  as  being 
more intensive in their derivative usage.  

The data are not sufficient to draw out clear trends in derivative usage.  Nevertheless 
our fieldwork indicates that derivative usage in the UK has seen growth over the past 
decade,  albeit  that has largely  stalled  since  the  credit  crunch.    This  growth  has  been 
fostered by increased adoption of LDI strategies, particularly in the UK.   At least some 
of the UK participants in our fieldwork expect a return to growth in the medium term. 

15  IE01  of  an  instrument  is  the  sensitivity  of  the  value  of  the  instrument  to  a  one  basis  point  (or  0.01  per  cent)  increase  in  the 
relevant inflation rate; that is the euro or sterling change (in this context) in the value of the instrument caused by a one basis 
point increase in the relevant inflation rate. 

16  EDHEC-Risk Institute (2014), "Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for 

Pension Funds? A survey of the LDI practices for pension funds". 

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4.  Modelling Approach   

4.1 

Introduction 

Our  analysis  considers  three  phases  of  the  situation  in  the  absence  of  technical 
solutions.    We  look  at  the  situation  prior  to  EMIR,  the  situation  under  EMIR  with  the 
exemption, and the situation under EMIR where central clearing is required. 

(cid:131)  Phase 1: Baseline costs of bilateral collateralisation prior to EMIR.  In this 

phase we calculate the costs to PSAs of current bilateral collateralisation 
arrangements for OTC derivatives under the existing credit support agreements.  
This represents the costs to PSAs prior to EMIR.  

(cid:131)  Phase 2.1: Costs of bilateral collateralisation arrangements under EMIR 
with the exemption.  In this phase we calculate the expected costs of PSAs 
complying with bilateral VM requirements on the basis of the draft regulatory 
technical standards for OTC-derivatives not cleared by CCP under EMIR (Draft 
RTS).17 In this phase PSAs can access the clearing exemption but their OTC 
derivative contracts are required to be collateralised bilaterally. 

(cid:131)  Phase 2.2: Costs under EMIR with no exemption and no solutions. In this 

phase we estimate the expected costs to PSAs of complying with current CCP cash 
VM requirements for OTC derivatives subject to central clearing.  This phase 
represents the ‘counterfactual’ to the technical solutions, i.e. the situation under 
EMIR once the clearing exemption has ended but in the absence of any solutions for 
the posting of non-cash collateral.  In order to assess the impact of possible 
technical solutions to the posting of non-cash collateral, an understanding is 
required of the costs of the situation in the absence of any such solutions.  This 
phase also includes the costs of bilateral collateralisation associated with OTC 
derivatives contracts that are not eligible for central clearing.   

This  section  describes  our  methodologies  used  to  calculate  the  costs  of  the  different 
phases of our assessment. 

4.1.1 

Incremental impacts 

The concern about central clearing for PSAs centres on CCPs’ requirement for cash VM, 
and the need for PSAs to maintain a cash buffer in order to respond to CCP VM calls, 
which  would  lead  to  high  opportunity  costs  for  PSAs.    This  requirement  for  cash 
variation  margin  is  not  specifically  required  under  EMIR,  the  text  of  which  allows  a 
relatively  broad  set  of  assets  to  be  used  as  variation  margin.  Nevertheless,  CCPs 
restrict  their  offerings  to  cash  VM  for  various  operational  and  risk  reasons,  which  we 
describe fully in Section 6. 

The  clearing  obligation is  already  set  in  EMIR  and  our  analysis  does  not  examine  the 
costs  or  benefits  to  PSAs  of  central  clearing  as  a  whole,  but  focuses  on  the  costs 
associated with collateralisation. 

The  costs  calculated in Phase 1  represent the  costs  of collateralisation prior to  EMIR.  
This  reflects  what  happens  currently  in  the  absence  of  any  regulation.    Phase  1 
therefore provides a baseline situation against which to measure the costs associated 
with collateralisation under EMIR. 

http://www.eba.europa.eu/documents/10180/655149/JC+CP+2014+03+%28CP+on+risk+mitigation+for+OTC+derivati

17

ves%29.pdf 

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The costs under Phase 2.1 represent the costs of bilateral collateralisation under EMIR 
but with an exemption, i.e. PSAs do not undertake central clearing.    

Phase 2.2 represents the costs of bilateral collateralisation and clearing under EMIR in 
the  absence  of  technical  solutions.    If  we  consider  that  the  clearing  obligation  under 
EMIR is set, then Phase 2 represents the baseline situation against which to measure 
the costs and benefits of the technical solutions. 

The incremental costs of EMIR with the exemption are therefore the costs of Phase 2.1 
less  the  costs  of  Phase  1.    The  incremental  costs  of  EMIR  without  an  exemption  are 
the costs of Phase 2.2 less the costs of Phase 1.  The incremental costs and benefits of 
the technical solutions are therefore the costs of the solutions less the costs of Phase 
2.2.  

4.1.2 

Direct and opportunity costs 

We model two categories of costs to PSAs:  direct costs and opportunity costs.  

(cid:131)  Direct costs are the upfront costs associated with posting and managing collateral 
calls, such as managing Credit Support Annexes (CSAs) and relationships with 
clearing members, and transferring/receiving assets to and from counterparties.  
Given the scope of our work we focus on the costs associated with administering 
collateral rather than the wider costs of trading and/or clearing OTC derivatives.  
Data on the direct costs were gathered through our fieldwork.   

(cid:131)  Opportunity costs relate to the foregone yield due to holding cash instead of other 
assets to be ready to pay cash VM under the central clearing obligation.  These 
costs only apply to Phase 2.2 as the need to hold cash is the result of the central 
clearing obligation and CCPs’ requirement for cash VM.  We do not consider there to 
be opportunity costs associated with asset allocation for VM under bilateral 
arrangements, as PSAs optimise their collateral arrangements in the CSAs they have 
and this is part of the usual cost of derivative trading not influenced by regulation.  
We describe how we assessed the opportunity costs in more detail below.    

4.2  Building blocks for the modelling 

Before modelling the direct and opportunity costs associated with collateralisation, we 
developed the following building blocks: 

(cid:131)  Development of representative portfolios. 

(cid:131)  Calculation of VM requirements for representative portfolios.  

(cid:131)  Estimation of derivative usage across the EU industry. 

4.2.1 

Development of representative portfolios    

The  first  step  was  the  creation  of  three  representative  derivatives  portfolios  drawing 
on real portfolio data obtained from funds through our fieldwork.  These are made to 
stand for the whole universe of portfolios.  This is obviously a significant simplification 
—  however  we  note  that  the  risks  faced  (such  as  interest  rates,  inflation  and 
longevity) have a high degree of commonality across all pension funds.  For example, 
we  would  expect  all  pension  funds  will  seek  to  protect  themselves  against  rising 
interest  rates.    Therefore  this  approach  is  more  reasonable  here  than  would  be  the 
case if considering a more heterogeneous group (e.g. corporates). 

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These  representative  portfolios  –  two  representing  UK  funds,  one  for  LDI  funds  and 
one for non-LDI funds and one representing a Eurozone18 fund – are used as the basis 
for the European industry.   

The separation of UK PSAs into non-LDI funds and LDI funds is driven by differences in 
their  utilisation  of  assets,  which  results  in  differences  in  the  VM  call  they  face.  
Additionally,  differences  in  the  intensity  utilisation  between  these  two  types  of  funds 
affects  the  scaling  factor  described  later.    Forty  per  cent  of  total  AUM  (about  £750 
billion) is allocated to LDI funds. 

The  Eurozone  portfolio  acts  as  the  proxy  for  non-euro  pension  assets.    This  is  a 
realistic assumption: in the case of Denmark, for example, hedging activity is often in 
euro-denominated assets in order to access the greater liquidity in those markets. 

The representative portfolios reflect the derivative exposure of typical high derivative-
use  funds.    The  derivatives  held  in  the  three  portfolios  are  interest  rate  swaps  (IRS) 
and  inflation  swaps.    In  addition  to  simplifying  our  modelling,  these  are  the  two 
derivatives  that  are  both  likely  to  be  centrally  cleared  (albeit  inflation  swaps  are  not 
expected  to  be  clearable  until  late  in  2014)  and  are  commonly  used  by  PSAs  for 
hedging.    The  duration  and  currency  of  the  IRS  typically  used  by  PSAs  are  already 
clearable.  (Perhaps 85–90 per cent of IRS are in the top four currencies — $, €, £ and 
¥.    These  are  clearable  by  more  than  one  CCP,  and  at  least  one  CCP  clears  IRS 
denominated in around 10–12 additional currencies.) 

As  noted  IRS  and  Inflation  swaps  are  the  main  constituents  of  PSAs’  OTC  derivative 
portfolios, particularly of the longer-dated instruments.  Some PSAs will use FX, equity 
and CDS instruments.  The first two are not foreseen to be imminently clearable. CDS 
are  clearable  across  a  relatively  wide  pool  of  instruments.    However  our  fieldwork 
indicates  that  these  are  used  by  relatively  few  PSAs,  and  in  limited  quantities.    We 
therefore excluded these from the representative portfolios.19 

PSAs will seek to hedge liabilities not assets.  As we have noted at 3.1.2 above there 
can be significant discrepancies between the two.  In the Eurozone portfolio assets are 
nearly equivalent to the liabilities (indeed, it is taken to be over-funded, with a funding 
ratio  of  108  per  cent:  the  portfolio  drew  on  Dutch-derived  data,  and  this  is  the 
average  funding  ratio  in  the  Netherlands).  In  contrast,  the  UK  portfolios  assume  a 
degree  of  under-funding.  The  funding  ratio  in each  UK  portfolio is  set  at  61  per  cent 
(i.e.  assets  are  61  per  cent  of  liabilities):  this  is  for  simplicity,  being  in  line  with  the 
average for the UK pension industry. 

The three portfolios are shown below, beginning with the UK portfolios.  The non-LDI 
portfolio is composed as follows: 

18  Based on portfolio data obtained from Dutch funds.  
19  Of thirty portfolios of pension funds actively using OTC derivatives, just four had CDS exposure — and of these four just one had 

significant CDS coverage.  No fund outside the UK or Netherlands providing us with data had CDS exposure. 

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Table 4.1: Representative UK (£ Sterling) non-LDI portfolio asset allocation  

Asset 

Market value (£m) 

Money market instruments (cash) 

Short-term Government Bonds (UK) 

Government Bonds 

Corporate Bonds 

Equity 

Other long-term investments 

Value of derivatives 

Total AUM 
Source: Bourse Consult.  

39.6 

- 

185.2 

119.6 

502.2 

93.6 

59.8 

£1,000 

% 

4.0% 

0.0% 

18.5% 

12.0% 

50.2% 

9.4% 

6.0% 

Table  4.2:  Representative  UK  (£  Sterling)  non-LDI  portfolio  derivative  usage 
(as % of AUM) 

Time bucket 

≤1 yr 

≤3 yr 

≤5 yr 

≤10 yr 

≤20yr 

≤30yr 

≤40 yr 

≤50 yr 

Total 

DV01 

-0.00001% 

-0.00036% 

-0.00016% 

-0.00234% 

-0.01355% 

-0.01771% 

-0.00938% 

-0.00573% 

IE01 

0.00001% 

0.00044% 

0.00035% 

0.00180% 

0.00573% 

0.00938% 

0.00521% 

0.00417% 

-0.04924% 

0.02709% 

Source: Bourse Consult.  

Turning to the UK LDI portfolio: 

Table 4.3: Representative UK (£ Sterling) LDI portfolio asset allocation  

Asset 

Market value (£m)

Money market instruments (cash) 

Short-term Government Bonds (UK) 

Government Bonds 

Corporate Bonds 

Equity 

Other long-term investments 

Value of derivatives 

Total AUM 
Source: Bourse Consult.  

42.3 

10.8 

423.6 

120.9 

220.6 

75.7 

106.2 

£1,000 

% 

4.2% 

1.1% 

42.4% 

12.1% 

22.1% 

7.6% 

10.6% 

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Table  4.4:  Representative  UK  (£  Sterling)  LDI  portfolio  derivative  usage  (as 
% of AUM) 

Time bucket 

≤1 yr 

≤3 yr 

≤5 yr 

≤10 yr 

≤20yr 

≤30yr 

≤40 yr 

≤50 yr 

Total 

Source: Bourse Consult. 

The third portfolio is: 

DV01 

-0.00001% 

-0.00038% 

-0.00016% 

-0.00136% 

-0.01465% 

-0.03038% 

-0.01411% 

-0.01139% 

IE01 

0.00001% 

0.00046% 

0.00037% 

0.00187% 

0.00922% 

0.01628% 

0.00977% 

0.00787% 

-0.07244% 

0.04585% 

Table 4.5: Representative Eurozone portfolio asset allocation  

Assets 

Money market instruments (cash) 
Short-term  Government Bonds 
Government Bonds (DE, FR and NL) 
Corporate Bonds 
Equity 
Other long-term investments 
Value of derivatives 

Total AUM 
Source: Bourse Consult analysis. 

Market value 
(€m) 
21.6 
- 
327.9 
193.1 
219.3 
149.2 
89.0 

€1,000 

% 

2.2% 
0.0% 
32.8% 
19.3% 
21.9% 
14.9% 
8.9% 

Table 4.6: Representative Eurozone portfolio derivative usage (as % of AUM) 

Time bucket 

≤1 yr 

≤5 yr 

≤10 yr 

≤20yr 

≤30yr 

≤40 yr 

≤50 yr 

DV01 

0.00097% 

-0.00091% 

-0.00445% 

-0.01779% 

-0.02041% 

-0.01158% 

-0.00536% 

IE01 

0.00000% 

0.00000% 

0.00055% 

0.00737% 

0.01060% 

0.00085% 

0.00012% 

Total 
Source: Bourse Consult analysis. 

-0.05953% 

0.01950% 

4.2.1 

Calculation of VM requirements    

Variation  margin  represents  “the  settlement  of  the  running  profit/loss  of  a  derivative 
and  …  [is]  …  a  transfer  of  resources  from  one  party  to  another”.20    It  is  effectively  a 
risk reset. It reduces the counterparty risk to that covered by the IM, being a payment 

20  Ibid, page 8.   

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from  the  party  that  has  moved  out  of  the  money  since  the  last  reset  (normally  the 
previous  day)  to  the  party  which  has  moved  into  the  money.    Portfolios  are  usually 
revalued  at  the  end  of  each  trading  day  (although  revaluation  may  occur  intraday  if 
price movements are unusually sharp). 

The VM requirements for a fund will depend on the make-up of its derivative portfolio 
and on changes in market conditions.  The amount of VM for a specific fund’s portfolio 
of derivatives would remain the same regardless of who makes the call (i.e. a bilateral 
counterparty or a CCP) although the frequency of the call may differ.  Under the new 
arrangements  both  bilateral  and  centrally  cleared  derivative  portfolios  will  be  subject 
to daily margining.21    

A PSA (or the asset manager acting on its behalf) needs to estimate the likely scale of 
VM calls that it might be subject to over the life of the derivative transactions which it 
enters  into.    This  is  not  a  trivial  exercise  as  it  will  depend  on  the  movement  (or  co-
movement)  of  variables  in  the  future  that,  in  fact,  the  fund  is  seeking  to  hedge 
against.    Our  approach  incorporated  a  mimetic  exercise  in  order  to  estimate  the 
quantum of assets that a fund would consider appropriate to hold against potential VM 
calls.   

We model the VM requirements for the three portfolios in a scenario in which only IRS 
are  cleared,  and  then  in  a  scenario  in  which  IRS  and inflation  swaps  are  cleared  and 
capable of being netted (e.g. by being cleared at a single CCP).  Due to the potential 
netting of IRS and inflation swap exposure under the latter case, the VM requirements 
are typically lower than under the scenario where only IRS are clearable.22  However, 
in  certain  cases  clearing  of  both  IRS  and  inflation  swaps  may  lead  to  higher  VM 
requirements where there is a contemporaneous VM call for both the IRS and inflation 
swap.  (Whilst these instruments are negatively correlated, this correlation is far from 
perfect). 

In a centrally cleared world (where it is assumed that only cash VM is accepted) funds 
will  need  to  make  a  decision  about  the  appropriate  level  of  “cash  buffer”  to  hold 
against VM calls.  If VM calls exceed the buffer then assets would need to be realised 
into  cash  either  through  outright  sale  or  a  repo  transaction.    This  would  need  to  be 
effected in a timely manner.  VM will normally be calculated and notified at the end of 
the  trading  day  for  payment  the  following  morning.    However  if  an  intra-day 
calculation is made, payment could be required by the end of that day.  The lower the 
buffer, the more frequent the recourse to such transactions.  In certain circumstances 
— such as in a crisis where interest rate expectations have increased sharply — such 
transactions may be difficult to achieve, at least at normal pricing and possibly at all.   

There  is  no  definitive  way  in  which  an  entity  reaches  a  view  on  this.    To  understand 
the possible choices better we have considered the following situations: 

(cid:131)  First we use historical data on interest rate swap and inflation swap changes dating 

back to the beginning of 2007 to produce a stream of daily mark-to-market changes 
over a five year period. Whilst no one would deny that this period includes times of 
severe economic stress and even market dislocation it may not include the extreme 
levels of interest rate and inflation moves which PSAs feel that they should plan for.  
Therefore we also model mark-to-market changes under three stress scenarios.   

21  Ibid, page 9 and EMIR article 41.1. 
22  The relationship between interest rates and inflation is much studied.  In the empirical literature, for example, Barr and Campbell 
(1996)  investigated  UK  nominal  and  inflation-linked  government  bonds.    They  found  a  strong  negative  correlation  between 

expected  inflation  and  changes  in  real  rates  over  short  horizons,  but  that  this  relationship  breaks  down  over  longer  horizons.  
This suggests that any netting will be far from perfect, especially since PSAs tend towards longer-dated instruments. 

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(cid:131)  The of these scenarios uses forecasts of interest rate and inflation movements 

drawn from the ‘adverse’ scenario created by the US Federal Reserve.23  This — 
helpfully from our perspective — decomposes shocks across a wide set of 
instruments relevant to this study.  (The US Federal Reserve has also published a 
‘severely adverse’ scenario which is broadly speaking twice as bad as the adverse 
one.  We do not include the detailed results of this scenario in this study).  

(cid:131)  One stress scenario uses inputs from the EU-wide stress test scenarios outlined by 
the European Banking Authority (EBA).  These data were, of course, designed for a 
different purpose and the parameters do not include the impact of the shocks on 
longer-dated instruments (e.g. 40 year IRS).  We have interpolated these based 
upon the scale of the shocks on shorter-dated instruments. 

(cid:131)  The final stress scenario assumes a 100bps parallel move to the historical interest 
rate curve.  From our fieldwork this appears to be a common heuristic within the 
pension industry. 

We  have  then  modelled  the  mark-to-market  changes  implied  by  these  scenarios  on 
the  value  of  the  two  representative  portfolios.    The  results  –  presented  as  a 
percentage  of  assets  under  management  for  each  portfolio  –  are  the  basis  for  our 
modelling to determine the opportunity costs of holding cash to cover VM calls.   

4.2.2 

Derivative usage across the EU industry  

The data gathered on the direct costs of collateral management, and our estimates of 
VM requirements from the representative portfolios, are based on funds and portfolios 
with a particular asset allocation and (generally speaking, high) intensity of derivative 
use. 

In order to enable the extrapolation of our cost models to the EU industry as a whole 
we  must  develop  an  understanding  of  the  intensity  of  derivative  usage  of  funds  in 
other Member States, and calculate scaling factors to adjust the results of our models 
accordingly. 

Derivative use intensity  

As  noted,  data  on  derivative  usage  across  Member  States  are  very  limited.    The 
results  of  our  focussed  survey  enable  us  to  classify  responding  Member  States  in 
terms  of  the  intensity  of  derivative  use,  either  through  data  on  derivative  usage  or 
through feedback from trade associations about the general level. 

To  classify  the  remaining  Member  States  we  use  data  on  a  range  of  factors  that,  as 
described  in  section  3.1  above,  are  likely  to  influence  the  intensity  of  a  fund’s 
derivatives usage.  These are: 

(cid:131)  Whether the pension industry is defined benefit or defined contribution.  Derivative 

usage is likely to be significantly lower among defined contribution schemes 
compared with defined benefit schemes. Defined contribution schemes do not need 
to hedge against risks associated with large, long-term liabilities in the same way as 
defined benefit schemes and the risks associated with the final pay-out under the 
former schemes are in general borne by the pensioners rather than the fund.  

(cid:131)  Whether the pension industry is under-or over-funded.  Managing liability risk will 

be more crucial for under-funded schemes, and it is likely that derivatives form part 
of this management.   

23  US Federal Reserve 2014 stress test parameters: 2014 CCAR Severely Adverse Market Shocks Data; 2014 CCAR Adverse Market 

Shocks Data. 

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(cid:131)  Whether there are regulatory incentives towards hedging.  For example, UK DB 

pension plans can get regulatory relief by holding assets with pay-outs that mirror 
the behaviour of their liabilities (provided that they can demonstrate the 
effectiveness of the risk transfer).24 

(cid:131)  Whether the fund is large or small.  Our fieldwork confirmed the assumption that 
large funds are significantly more likely to use derivatives than small funds.  Very 
large funds may have their own derivative operations in-house; others are likely to 
use the services of an asset manager. For the purposes of this analysis we classify 
as “small” individual funds with AUM less than €50 million.  

Combining  this  information  with  that  from  the  focused  survey,  we  create  four  fund 
categories within each Member State: 

(cid:131)  Large defined contribution. 

(cid:131)  Small defined contribution. 

(cid:131)  Large defined benefit. 

(cid:131)  Small defined benefit. 

Each category is informed by the proportion of AUM within each Member State that is 
represented by large/small funds; and defined benefit/defined contribution funds.  The 
table below presents this information. 

24 BIS, August 2013, "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks". 

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Table 4.7: Characteristics of Member States  

Member 
State 

Defined 
benefit as % 
AUM 

Defined 
contribution as 
% AUM 

Large as % 
AUM 

Small as % 
AUM 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 
UK25 

0.0% 

80.0% 

0.0% 

0.0% 

0.0% 

80.0% 

6.3% 

0.0% 

0.0% 

14.0% 

100.0% 

0.0% 

0.0% 

0.0% 

80.0% 

22.1% 

0.0% 

69.2% 

0.0% 

0.0% 

95.0% 

0.0% 

85.7% 

20.0% 

80.0% 

0.0% 

0.0% 

69.6% 

100.0% 

20.0% 

100.0% 

100.0% 

100.0% 

20.0% 

93.7% 

100.0% 

100.0% 

86.0% 

0.0% 

100.0% 

100.0% 

100.0% 

20.0% 

77.9% 

100.0% 

30.8% 

100.0% 

100.0% 

5.0% 

100.0% 

14.3% 

80.0% 

20.0% 

100.0% 

100.0% 

30.4% 

99.9% 

96.8% 

99.6% 

80.0% 

80.0% 

85.0% 

85.0% 

97.0% 

80.0% 

98.3% 

100.0% 

85.0% 

99.9% 

90.7% 

9.3% 

99.1% 

80.0% 

85.0% 

0.0% 

80.0% 

85.0% 

80.0% 

88.6% 

98.4% 

85.0% 

80.0% 

80.0% 

97.4% 

0.1% 

3.2% 

0.4% 

20.0% 

20.0% 

15.0% 

15.0% 

3.0% 

20.0% 

1.7% 

0.0% 

15.0% 

0.1% 

9.3% 

90.7% 

0.9% 

20.0% 

15.0% 

100.0% 

20.0% 

15.0% 

20.0% 

11.4% 

1.6% 

15.0% 

20.0% 

20.0% 

2.6% 

Source: Europe Economics analysis.  

We  then  assign  the  fund  categories  within  each  Member  State  one  of  the  following 
derivative use intensity score:  

(cid:131)  Ultra high. 

(cid:131)  High. 

25  Aggregating both the LDI and non-LDI elements. 

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(cid:131)  Medium. 

(cid:131)  Low. 

(cid:131)  Ultra low. 

If sufficient information is available from the focused survey or other sources, we used 
this  to  assign  a  derivative  use  score.    For  the  remaining  Member  States  we  have 
assumed that derivative usage is no higher than ‘medium’.  The table below sets out 
our methodology used to assign the remaining scores: 

Table 4.8: Methodology to assign derivative use intensity scores  

Category   

Defined benefit, Large 

Defined benefit, Small 

Defined contribution, Large 

Defined contribution, Small 

Scaling factors 

Derivative use intensity score 

Medium 

Low 

Low 

Ultra low 

The representative portfolios described above were designed to represent funds with a 
‘high’  derivative  use.    For  the  purposes  of  comparing  different  intensities  of  use  we 
have  scaled  from  the  relevant  ‘high’  use  portfolio  in  accordance  with  the  intensity 
scores.  The values for the rest of the derivative use scores are modelled according to 
the scaling factors presented below.  These draw upon our fieldwork. 

Table 4.9: Scaling factors for derivative use intensity  

Derivative use intensity score 

Scaling factors 

Ultra high 

High 

Medium 

Low 

Ultra low 

122% 

100% 

56% 

22% 

11% 

Provided that the composition of a fund’s portfolio of derivatives is in line with those of 
the  representative  portfolios  then  this  linearity  should  hold  without  need  for  further 
adjustment.  As we have noted already there  is significant commonality between the 
risks  faced.  This  does  not  necessarily  mean  that  the  derivative  portfolios  will  be 
equally common at different levels of derivative use intensity (e.g. a fund less reliant 
on derivatives might only use them for risks of a very specific duration).   However we 
note  that  this  issue  is  greatest  at  lower  levels  of  intensity,  and  these  represent  at 
most 20 per cent of the estimated total use.   

We apply these scaling factors to the AUM represented by the four fund categories in 
each  Member  State  to  arrive  at  a  blended  scaling  factor  as  a  percentage  of  AUM  for 
that country’s pension industry.  The scaling factors applied to defined benefit funds is 
further adjusted to reflect the average funding ratio within each Member State relative 
to the representative portfolio — this is important because it is the liabilities ultimately 
that a fund is seeking to hedge.  

These scaling factors are applied to the results of our direct cost and opportunity cost 
models to extrapolate the results up to the EU-level. 

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Table 4.10: Final scaling factors for each Member State 

Member State  Final scaling factor

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

22.21% 

45.64% 

22.17% 

20.00% 

46.67% 

86.72% 

93.80% 

21.89% 

20.00% 

26.91% 

47.62% 

20.56% 

22.21% 

21.19% 

61.18% 

29.96% 

20.00% 

43.61% 

11.11% 

20.00% 

99.67% 

20.00% 

48.14% 

23.27% 

75.55% 

20.00% 

48.89% 

UK (non-LDI) 

UK (LDI) 

101.33% 

85.46% 

Source: Europe Economics and Bourse Consult analysis. 

4.3  Direct cost model 

The direct cost model calculates the expected direct costs to PSAs of administering VM 
under the three phases:  

(cid:131)  Bilateral collateralisation prior to EMIR (Phase 1). 

(cid:131)  Bilateral collateralisation under EMIR with the exemption (for the same universe of 
OTC derivatives as above, but subject to daily margining under the Draft RTS – 
Phase 2.1). 

(cid:131)  Costs of meeting cash VM requirements (central clearing) under EMIR with no 

exemption plus the costs of bilateral collateralisation for non-clearable derivative 
contracts (Phase 2.2). 

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For  each  phase,  costs  are  estimated  in  respect  of  the  existing  portfolio  and  trading 
volume  of  PSAs  for  the  year  2012.    We  use  data  gathered  from  the  fieldwork  for  a 
sample of funds on the costs  currently incurred in meeting bilateral VM requirements 
and on the foreseen costs under EMIR.  Our direct cost estimates focus on the costs of 
administering  collateral,  rather  than  on  the  total  costs  of  managing  derivative 
contracts or of central clearing.   

The  Draft  RTS  may  impact  the  costs  of  administering  collateral  for  bilateral  OTC 
derivatives under EMIR. To date, these regulations state that VM must: 

(cid:131)  Cover the full mark-to-market exposure. 

(cid:131)  Be paid in the form of liquid assets, which will hold their value in times of financial 

distress (taking haircuts into account).  There is also a restriction that no more than 
50 per cent of the value of collateral put up from an entity can come from a single 
(or group of closely related) Sovereign, regional authority or PSE issuer.26   

(cid:131)  Be exchanged daily. 

These margining requirements are only applicable to new contracts and will be phased 
in over time.  

4.3.1 

Drivers of costs 

Direct costs of administering bilateral collateral under current arrangements  

Collateral management is resource intensive, and the direct costs of meeting collateral 
requirements  consist  largely  of  staff  and  systems  costs.    For  current  bilateral 
arrangements (i.e. under existing CSAs) these costs include:  

(cid:131)  Managing CSAs and collateral lines. 

(cid:131)  Deciding on which assets to move through the system as collateral. 

(cid:131)  Arranging for the transfer of assets. 

In  the  sample  funds  on  which  our  costs  are  based,  settlement  is  T+1  around  90  per 
cent of the time.  Daily settlement is therefore required, and collateral moves need to 
be agreed daily with other parties.  This is unlikely to be the case across the industry: 
respondents  to  the  BIS/IOSCO  OTC  Margin  Requirement  Quantitative  Impact  Survey 
(QIS)  posted  VM  for  bilateral  OTC  derivative  contracts  on  average  around  every  2 
days.27   

The above would apply to CSAs which specify cash or bonds as acceptable collateral.  
Where  CSAs  also  specify  that  only  cash  is  to  be  used  as  VM,  costs  could include,  for 
example, money market operations to raise cash. 

The  costs  associated  with  meeting  collateral  requirements  under  existing  CSAs  are 
largely  operational,  particularly  when  non-cash  assets  make  up  the  majority  of 
collateral  transfers.    These  operations  can  be  outsourced,  or  if  undertaken  in-house 
this by ‘back office’ staff. 

26  There are also other limits on the share of collateral that is made up of securitisations, convertible bonds, equities and units in 

UCITS. 

27  Basel Committee on Banking Supervision and the International Organization of Securities Commissions, “Margin requirements for 

non-centrally cleared derivatives: Second consultative document”, February 2013.  The QIS was conducted in 2012. 

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Direct costs of administering bilateral collateral under EMIR RTS  

The  ‘unit’  costs  of  administering  collateral  for  bilateral  arrangements  under  EMIR  will 
be  broadly  similar  to  the  costs  under  current  arrangements,  with  some  changes 
resulting  from  the  Draft  RTS.    In  the  case  that  PSAs  are  able  to  access  the  clearing 
exemption,  all  their  OTC  derivative  contracts  would  be  subject  to  these  costs  of 
bilateral  clearing.    In  the  case  of  no  exemption,  only  those  OTC  derivative  contracts 
not eligible for central clearing would be bilaterally collateralised, which would imply a 
significant  reduction  in  the  volume  of  bilateral  OTC  derivative  contracts  and  thus  a 
reduction in absolute costs of bilateral collateralisation in the long term compared with 
the current situation.28 In the medium term, existing bilateral contracts will still need 
to  be  serviced  regardless  of  whether  the  derivatives  are  eligible  for  central  clearing, 
and  therefore  the  bilateral  collateralisation  costs  under  EMIR  with  no  exemption  are 
relatively similar to the bilateral collateralisation costs with an exemption.      

To  the  extent  that  daily  margining  is  a  new  requirement  for  funds  under  EMIR,  this 
may  increase  the  complexity  of  bilateral  collateral  management  and  thus  require 
additional  resources  to  manage  the  additional  VM  calls.  We  anticipate  this  additional 
cost  would  be  small  given  the  relative  frequency  of  current  bilateral  VM  calls  as 
indicated by the BIS/IOSCO QIS. 

The  restrictions  imposed  by  the  EMIR  RTS  on  the  proportion  of  collateral  in  a  single 
asset class could pose some indirect costs on PSAs. For example, CSAs might need to 
be  re-written  to  take  into  account  of  any  implications  of  the  collateral  restriction.   In 
extreme  cases,  some  funds  might  need  to  re-allocate  their  assets  available  for 
collateral.     

Direct costs of administering cash VM under central clearing 

Meeting cash VM requirements for CCPs in the context of central clearing under EMIR 
(i.e.  in  a  situation  with  no  exemption)  will  be  a  different  matter.    On  the  one  hand, 
posting cash as VM is operationally simpler than posting securities — these processes 
can  be  systematised  to  a  greater  degree,  with  fewer  operational  challenges.    In 
addition,  under  central  clearing,  funds  would  be  able  to  benefit  from  netting 
arrangements with fewer clearing members and thus be exposed to fewer transactions 
and margin calls (assuming that under current bilateral arrangements they holds CSAs 
with  a  broad  range  of  counterparties).    These  changes  imply  that  collateral 
management  is  a  less  resource-intense  process  under  central  clearing  compared  to 
bilateral arrangements.   

On the other hand, more complex decisions will need to be taken with the posting of 
cash VM.  Our modelling assumes that funds would create a cash buffer in preparation 
for  central  clearing,  and  maintain  this  buffer  throughout.    Decisions  would  therefore 
need  to  be  taken  on  how  much  liquidity  to  hold  in  the  cash  buffer,  how  to  raise  the 
cash  (e.g.  which  assets  to  sell)  and  how  to  maintain  the  buffer.    This  would  entail 
input from ‘front office’ staff (and possibly trustees, as liquidity management decisions 
cannot  be  outsourced)  both  as  a  one-off  set  up  cost  and  an  ongoing  cost.    A  cash 
buffer held to cover VM calls within a certain degree of confidence would also need to 
be  supplemented  occasionally  with  additional  cash  when  a  VM  call  (or  a  stream  of 
calls)  exceeds  the  buffer.    For  this,  some  additional  resource  would  be  required  to 
manage repo transactions.    

The  costs  of  collateral  management  under  current  bilateral  arrangements  are  driven 
largely by the number of CSAs and collateral lines that need to be managed. This is in 
turn  related  to  the  volume  of  bilateral  derivatives  traded  and  the  intensity  of 

28  There would of course be additional cost associated with central clearing in this latter case, which we model in Phase 2.2. 

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derivative use.  The costs of collateral management under central clearing will also be 
linked  to  the  volume  of  derivatives  traded,  scaled  to  reflect  increased  operational 
efficiency  and  netting  capabilities.    The  volume  of  OTC  derivatives  considered  under 
each modelling phase will differ as follows: 

(cid:131)  Bilateral collateralisation under current arrangements. Here we consider the 

entire existing OTC derivative portfolio.  All OTC derivatives will be subject to 
bilateral collateral arrangements.  Costs are benchmarked directly on the current 
costs of bilateral collateralisation obtained from our fieldwork.   

(cid:131)  Bilateral collateralisation under EMIR with exemption.  Again we consider the 
entire existing OTC derivative portfolio across PSAs.  All PSA’s OTC derivatives will 
still be bilaterally collateralised.  Costs are benchmarked on the costs of the current 
situation, but adjusted to take into account the impacts of the Draft RTS, namely 
daily margining.   

(cid:131)  Bilateral collateralisation under EMIR without clearing exemption.  Only 

those OTC derivatives not eligible for clearing will be subject to bilateral 
collateralisation arrangements in the long run.  In the medium term, however, there 
will remain bilateral contracts of (now) centrally clearable derivatives that still 
require management.  We term these ‘legacy’ bilateral contracts.      

(cid:131)  Central clearing under EMIR with no clearing exemption.  We model two 

scenarios: one in which only IRS are cleared (thus leaving inflation swaps and other 
derivatives such as FX forwards and CDS in the bilateral space) and one in which 
both IRS and inflation swaps are centrally cleared.  Based upon our fieldwork the 
latter situation should be in effect before the end of 2014. 

Figure 4.1: VM pre- and post-EMIR with no exemption 

The  costs  associated  with  the  different  volume  of  derivatives  in  each  phase  will  not 
adjust linearly in line with the change in derivative portfolios.   

(cid:131)  Under EMIR bilateral arrangements without the exemption (where PSAs will 

centrally clear all eligible derivative contracts and only those non-eligible contracts 
will be subject to bilateral arrangement), even though the volume of bilaterally 
traded derivatives will reduce compared to current bilateral arrangements (as many 
will migrate from the bilateral space to the centrally cleared space), the number of 
CSAs will not reduce directly in line with this as there will be a fixed element based 
on the number of contracts (rather than the size of each).  In addition, the CSAs 
and collateral lines related to existing contracts for now centrally clearable 

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derivatives would remain and would need to be managed for at least the medium 
term.  

(cid:131)  The draft RTS state that bilateral collateralisation requirements under EMIR must 

include daily mark-to-market and daily VM calls.  Our fieldwork indicates that daily 
collateral exchange already frequently occurs, and the BIS/IOSCO QIS found that 
collateral is exchanged on average around every 2 days.  The unit costs of bilateral 
collateral management under EMIR should therefore be only marginally higher 
compared with the current situation.    

(cid:131)  For centrally cleared portfolios under EMIR, PSAs will have to manage collateral 
movements to and from their clearing members.  It is likely that PSAs will have 
relationships with fewer clearing members than with current bilateral counterparts 
for a similar volume of derivatives, although would still diversity across a sufficient 
number of clearing members and CCPs for risk management purposes. The lower 
‘unit’ costs per volume of derivative traded would however be augmented by 
additional ‘front-office’ liquidity management costs and some money-market 
capability.  

4.3.2 

Modelling methodology  

We  used  the  following  steps  to  estimate  the  direct  costs  of  meeting  collateral 
requirements. 

Estimate of the costs under the three phases for the representative portfolios 

First, for the sample portfolios we calculated the relationship between derivative usage 
(expressed as the mark-to-market of all derivatives as a proportion of the AUM in the 
portfolio)  and  the  number  of  CSAs  and  subsequently  full-time  equivalent  employees 
(FTEs) associated with these portfolios.  This represents the resources required under 
current bilateral collateralisation arrangements (phase 1).   

Second,  using  the  same  universe  of  OTC  derivatives  but  adjusting  the  resources  for 
daily  margining,  we  obtained  the  costs  of  phase  2.1  (bilateral  collateralisation  under 
EMIR with an exemption).  

We  then  estimated  the  derivative  usage  under  phase  2.2  (EMIR  with  no  exemption, 
i.e.  central  clearing  of  eligible  OTC  derivatives  and  bilateral  collateralisation  of  non-
eligible derivatives) using the mark-to-market as a proportion of AUM for the various 
derivatives included in in central clearing and bilateral collateralisation respectively.   

We  considered  the  scenarios  where  both  IRS  and  inflation  swaps  are  cleared  and 
where  IRS  only  are  cleared.    We  assume  that  if  IRS  and  inflation  swaps  are  both 
centrally  cleared,  the  VM  paid  and  received  against  each  would  be  capable  of  being 
netted  off.    Whilst  this  need  not  be  the  case,  it  is  a  reasonable  assumption  as,  at 
present, one clearing house dominates IRS clearing and it is the same clearing house 
that is expected to be first in offering clearing of inflation swaps.  Indeed in the case 
when more than one category of derivative is cleared, it will be more efficient to clear 
them on the same CCP rather than on different CCPs.29 

Under  both  scenarios  for  the  bilateral  collateralisation  element  of  phase  2.2  we 
assume that in the medium term the existing CSAs for (now) clearable derivatives will 
largely remain.   

Fourth,  by  linking  the  ratio  of  derivative  usage  to  the  number  of  CSAs  we  calculated 
the CSAs required for the bilateral elements of the sample portfolios for phase 2.2. For 

29  Darrell Duffie and Haoxiang Zhu (2010), "Does a Central Clearing Counterparty Reduce Counterparty Risk?” 

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each  scenario  (IRS  and  inflation  swaps  both  cleared  and  IRS  only  cleared)  we 
estimated  the  CSAs  relating  to  non-clearable  OTC  derivative  contracts  and  the  CSAs 
relating  to  the  legacy  of  (now)  clearable  derivatives.30    We  scaled  the  reduction  in 
CSAs  for  non-clearable  OTC  derivatives  by  only  a  part  of  the  reduction  in  derivatives 
traded  to  account  for  the  fixed  element  of  CSAs  and  the  uncertainty  around  the 
proportion  of  funds’  derivative  portfolios  that  will  be  subject  to  clearing.    We  then 
linked the number of CSAs to FTEs.  

Fifth,  we  estimated  the  number  of  additional  FTEs  required  for  the  central  clearing 
element  of  phase  2.2.    The  requirement  for  back-office  FTEs  to  manage  the  new 
relationships  with  clearing  members  and  CCPs  is  benchmarked  against  the  FTEs 
needed  to  manage  equivalent  derivative  volumes  for  current  bilateral  arrangements, 
with  a  scaling  reduction  to  reflect  operational  and  netting  efficiencies.    We  also  add 
additional  FTEs  to  represent  the  front-office  costs  of  managing  cash  buffers  and 
liquidity decisions, and resources for small-scale repo transactions.          

Finally  we  used  average  employment  costs  of  €100,000  for  back-office  FTEs  and 
€150,000 front-office FTEs to estimate the total resource costs.   

The table below presents the data and results of these steps for the sample portfolios, 
which are classified as very large, high intensity use. 

30  The latter would reduce over time as these legacy contracts reach full term.  Given the uncertainty around when this would occur 

we model the costs in the medium term. 

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Table  4.11:  Resources  required  for  collateral  management  for  the  sample 
portfolios 

Market value 
of derivatives 
as % of AUM 

Number 
of FTEs 

Cost 
(€000s)

Notes 

Current bilateral  

9.10% 

20 

€ 2,000 

EMIR bilateral 
(with exemption) 

9.10% 

24 

€ 2,400 

EMIR bilateral no 
exemption (IRS 
and INFL 
clearable) 

0.2% (bilateral) 
+ 8.9% (legacy 
clearable) 

21.0 

€ 2,105 

EMIR bilateral no 
exemption(INFL 
not cleared) 

0.5% (bilateral) 
+ 8.6% (legacy 
clearable) 

21.2 

€ 2,116 

EMIR central 
clearing (IRS and 
INFL cleared and 
netted) 

EMIR central 
clearing (INFL not 
cleared) 

9.10% 

16 

€ 1,800 

9.40% 

16.60 

€ 1,868 

Note: Sample portfolios are defined as large, high intensity use.    
Source: Sample portfolios and Europe Economics analysis.   

All derivatives in the sample 
portfolios.  Less-than-daily 
margining; small repo facility 
to represent high-use fund 

All derivatives in the sample 
portfolios, subject to draft 
RTS (daily margining). 

Remaining derivatives in the 
sample portfolio not eligible 
for central clearing (FX 
forwards and swaps, CDSs) 
PLUS legacy CSAs of now 
clearable derivatives.  
Number of new bilateral 
CSAs for non-clearable 
derivatives reduced by only 
50% of the change in MV to 
reflect fixed element of CSAs 

Remaining derivatives in the 
sample portfolio not eligible 
for central clearing (Inflation 
swaps, FX forwards and 
swaps, CDSs) PLUS legacy 
CSAs of now clearable 
derivatives.  
Number of new bilateral 
CSAs for non-clearable 
derivatives reduced by only 
50% of the change in MV to 
reflect fixed element of CSAs 

Additional FTEs to bilateral 
collateralisation to manage 
new relationships with 
clearing members (CMs) and 
CCPs (efficiency saving of 
60% from bilateral situation) 
and man repo desks 
Additional FTEs to bilateral 
collateralisation to manage 
new relationships with CMs 
and CCPs (efficiency saving 
of 60% from bilateral 
situation) and man repo 
desks 

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Extrapolate costs to other fund types 

These  portfolios  represent  large,  ‘high’  intensity  derivative  use.    Funds  with  a  lower 
intensity  of  derivative  usage  will  incur  lower  collateral  management  costs  as  a 
proportion  of  their  AUM.    Using  our  derivative  usage  scaling  factors  described  in 
section  4.2.2  (from  Ultra  high  to  Ultra  low)  we  adjust  the  costs  for  each  phase  for 
each Member State.  We do not adjust the costs directly in line with the scaling factors 
to  take  account  of  the  fact  that  there  will  be  a  base  level  of  fixed  collateral 
management costs regardless of the derivative use intensity.  

We  also  adjust  the  costs  to  include  an  uplift  of  25  per  cent  for  outsourcing.    This  is 
applied  to  the  proportion  of  funds  with  a  Low  or  Ultra  Low  intensity  score  under  the 
assumption  that  small  funds  would  outsource  their  collateral  management  and  incur 
higher unit-costs that those able to do this in-house.  

The final outcome of this step is a range of costs, expressed as a cost per €1 billion of 
AUM, for each type of derivative intensity.  

Table  4.12:  Total  costs  of  collateral  management  across  different  derivative 
use intensities and phases, as cost per €1 billion AUM 

Ultra High 

High 

Medium 

Low 

Ultra Low 

Bilateral (current) 

7,900 

7,100 

5,600 

6,500 

6,000 

EMIR bilateral 
(with exemption) 

EMIR bilateral (IRS 
and INFL cleared) 

EMIR bilateral 
(INFL not cleared) 

EMIR central 
clearing (IRS and 
INFL cleared) 

EMIR central 
clearing (INFL not 
cleared) 

9,500 

8,600 

6,700 

7,900 

7,100 

8,400 

7,500 

5,800 

6,900 

6,300 

8,400 

7,600 

5,900 

6,900 

6,300 

7,100 

6,400 

5,000 

5,900 

5,400 

7,400 

6,700 

5,200 

6,100 

5,600 

We  note  that  the  total  costs  under  EMIR  will  be  the  sum  of  the  EMIR  bilateral  costs 
and  the  EMIR  central  clearing  costs  under  either  clearing  scenario.    The  table  below 
presents this.  

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Table  4.13:  Total  costs  of  collateral  management  across  different  derivative 
use intensities, pre- and post-EMIR, as cost per €1 billion AUM 

Ultra High 

High 

Medium 

Low 

Ultra Low 

Bilateral (current) 

7,900 

7,100 

5,600 

6,500 

6,000 

EMIR bilateral (with 
exemption)  

9,500 

8,600 

6,700 

7,900 

7,100 

EMIR Total (IRS and INFL 
cleared) 

15,500 

13,900 

10,800 

12,800 

11,700 

EMIR Total (INFL not 
cleared) 

15,800 

14,300 

11,100 

13,000 

11,900 

Extrapolation to Member State level 

As the final step we extrapolate the above costs according to the AUM in each Member 
State as shared across the different derivative use intensity scores. 

The  total  direct  costs  are  presented  alongside  those  results  of  the  opportunity  cost 
modelling in section 5. 

4.4  Opportunity cost model 

The  opportunity  cost  model  calculates  the  expected  costs  to  PSAs  of  complying  with 
current  cash  VM  calls  for  centrally  cleared  transactions  in the  event  that  the  clearing 
exemption expires and a solution for the posting of non-cash collateral is not found.     

4.4.1 

Overview of the model 

The model estimates the yield loss incurred by PSAs if they were to hold a cash buffer 
to meet VM calls, as opposed to holding higher-yielding assets.   

We assume that PSAs would hold enough cash to cover most VM calls.  However there 
may be instances when the VM call exceeds the cash buffer and PSAs are required to 
enter  into  a  short-term  repo  to  raise  the  necessary  additional  cash.  The  model 
therefore also estimates the cost of this “excess VM call”.  The smaller the cash buffer, 
the more often a fund would be required to conduct a repo transaction.  

The cash buffer would be created prior to the beginning of the central clearing period 
and thus the opportunity cost from holding cash instead of other assets would extend 
over the life of the fund.  

In  creating  the  cash  buffer,  we  assume  that  funds  ring-fence  their  existing  cash 
allocation  to  a  certain  degree.    The  rest  of  the  buffer  would  be  made  up  by  selling 
assets according to a simplified waterfall of assets as follows: 

Government bonds → corporate bonds → equities → other long-term assets 

This cascade seeks to take into account both the liquidity of the assets and the returns 
achieved on them (Government bonds have a lower return than corporate bonds, and 
so  on).    Our  fieldwork  indicates  that  it  is  at  least  reasonably  realistic,  as  this  would 
tend to reduce the opportunity cost.  One caveat here is the point, as already noted, 
that  bonds  can  play  a  hedging  role  themselves.    It  follows  that  holding  a  lower 

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proportion  of  assets  in  Government  bonds  (or  other  interest-bearing  instruments) 
could affect the effectiveness with which the fund’s liabilities are hedged. 

The  opportunity  cost  is  calculated  as  the  difference  in  return  between  the  asset  sold 
and the return on cash the funds would be able to earn. 

A  slice  of  government  bonds  would  also  be  reserved  at  the  outset  to  cover  initial 
margin.  This indirectly affects the opportunity cost, as it means that the cash buffer is 
more likely to trip into asset classes other than Government bonds. 

The figure below illustrates the logic behind the model. 

Figure 4.2: Stylised logic of the opportunity cost model  

4.4.2 

Size of the cash buffer 

The model assumes that PSAs will hold a cash buffer to cover a proportion of VM calls 
with  a  certain  degree  of  confidence.    The  size  of  the  cash  buffer  is  informed  by 
aggregate  VM  calls  over  a  five-day  period:  taking  the  simulated  VM  calls31  developed 
in  the  VM  Model  (described  in  section  4.2.1  above)  between  January  2007  and 
December  2012,  the  model  considers  VM  calls  over  rolling  five  day  periods.    The 
model then creates the cash buffer based on 100 per cent, 90 per cent and 80 percent 
of the maximum five-day call. 

In cases when there are VM calls in excess of the cash buffer we assume a short-term 
repo transaction would take place to raise the cash for the excess VM call. 

31  VM calls were simulated for sterling and euro portfolios and for both a model incorporating clearable inflation swaps and interest 
rate swaps and for a model incorporating only clearable interest rate swaps.  The euro model was used for every Member State 
except the United Kingdom. 

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Under  the  stress  scenarios,  the  key  consideration is  the  likely  frequency  of  a  VM  call 
high  enough  to  breach  the  stress  cash  buffer.    Stress  situations  such  as  those 
modelled would be very seldom.  We therefore estimate an indicative average excess 
VM  call  repo  cost  for  2012  based  on  the  cost  of  a  repo  to  meet  the  excess  VM  call 
averaged over the likely frequency of such an occurrence (10 years).          

4.4.3 

Value of assets to be sold to meet cash buffer 

Once the required initial cash buffer is set, the model calculates what assets must be 
sold to obtain it according to the asset cascade described in the previous section.  For 
every  Member  State  the  overall  asset  allocation  of  the  pension  industry  is  identified 
within  the  following  categories:  cash,  government  bonds,  corporate  bonds,  equities 
and other assets.32   

We  have  assumed  that  funds  will  ring-fence  a  proportion  of  their  existing  cash 
allocation; once the remaining cash is used up for the cash buffer the other assets will 
be sold in a waterfall of government bonds, corporate bonds, equities and finally other 
assets.    For  funds  with  existing  cash  allocations  less  than  five  per  cent  of  AUM  we 
assume that the entire cash allocation would be ring-fenced, and that the cash buffer 
would  be  drawn  entirely  from  the  asset  waterfall.    For  funds  with  an  existing  cash 
allocation  greater  than  five  per  cent,  we  assume  that  up  to  half  of  the  required  cash 
buffer will be drawn from the cash allocation, and the remainder drawn from the asset 
waterfall.  In the more severe scenarios, where half of the desired cash buffer exceeds 
the  initial  cash  level  as  a  percentage  of  assets  under  management,  all  of  the  initial 
cash level would contribute to the cash buffer. 

As  noted  above  the  model  also  allows  for  an  indicative  slice  of  government  bonds  to 
be  ring-fenced  for  IM  (expressed  as  a  proportion  of  AUM).    This  increases  the 
likelihood  that  the  waterfall  will  use  up  the  remaining  government  bonds  and  move 
onto  corporate  bonds.    We  assume  that  the  IM  slice  for  the  IRS-only  representative 
portfolios is 7 percent, and 11 per cent for IRS and inflation swap portfolios.33  This IM 
slice is scaled for each Member State by our derivative use intensity factors to reflect 
the fact that IM will be a smaller proportion of AUM for lower intensity Member States. 

Our  model  relies  on  average  asset  allocations  drawn  from  data  aggregated  at  a 
Member State level.  In any Member State, PSAs will have heterogeneous allocations 
deviating  more  or  less  from  their  peers.    Some  PSAs  could  have  very  low  allocations 
of, say, Government Bonds compared to the national average.  Dependent on the size 
of  the  cash  buffer,  considering  only  the  average  could  imply  that  only  Government 
Bonds  were  sold,  whereas  some  funds  could  be  obliged  to  move  further  along  the 
cascade.  To  account  for  this  we  allocated  a  portion  of  the  assets  (25%)  in  each 
Member  State  a  higher  than  average  allocation  of  assets  at  the  beginning  of  the 
cascade, and another portion a lower than average share (also 25%), with the balance 
at the average allocation. The changes were calibrated so that the overall level of AUM 
and the aggregate Member State asset allocation are unaffected.   

4.4.4 

Opportunity costs  

The  model  calculates  the  annual  opportunity  cost  from  selling  each  type  of  asset  to 
increase  cash  holdings.    This  is  based  upon  the  quantity  of  an  asset  sold  and  the 
difference in the return of the asset over the return the PSA can receive on cash.  The 
selection of assets used to represent each asset class is outlined in Table 4.14 below.  

32  OECD 2013. 
33  We base this indicative IM value on an industry assessment. 

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Table 4.14: Opportunity cost model inputs 

Input 

Description 

Initial asset 
allocation 

A breakdown of the average percentage of assets under 
management held as cash, government bonds, corporate 
bonds, equity and other assets at a Member State level 

Assets under 
management 

Investment 
asset 
returns 

Investment 
assets 

Proportion 
of maximum 
VM call 

Scaling 
factor 

The value of assets under management for pension funds 
in each Member State, used to convert the cost of posting 
cash collateral in percentage terms into a cost in terms of 
euros. 
The model used investment asset returns calculated using 
daily data between 1999 and 2013.  An average for each 
calendar day was taken over this period and then 
compounded to get an annual return 
Cash: EONIA or SONIA for euro and sterling returns 
respectively (less 30bps as a maintenance charge); 
Government bonds: UK 10 year gilts34 and German 10 
year Bunds; 
Corporate bonds: IBOXX € CRP TR7-10 and IBOXX £ CRP 
TR 7-10 
Equity: DAX TR Index and FTSE 100 TR GBP 
A percentage of the maximum VM call over the range of 
VM calls in each simulation.  These are taken at 100, 90 
and 80 per cent. 

A scaling factor applied to reflect the intensity of 
derivative usage for each Member State, based upon the 
funding ratio of PSAs, the ratio of defined benefit to 
defined contribution funds and the size of pension funds. 

Initial 
margin (IM) 
slice 

A percentage of government bonds which PSAs will not 
use for the purposes of obtaining cash to post variation 
margin. 

Haircuts 
applied to 
repo 
transactions 

The asset used in a repo transaction incurs a haircut, to 
protect against the risk that the value of assets posted 
exceeds the level of cash received as part of the repo 
transaction.  Riskier assets incur a greater haircut due to 
the risk that their value will decrease below the level of 
cash involved in the repo transaction.  This cost is 
relevant to the cases where the cash buffer is not 
sufficient to cover the required level of VM to be posted.  
In stress scenarios, an additional haircut is applied. 

Data sources 
and 
adjustments 

OECD (2013), 
"Pension Markets 
in Focus No.10" 

OECD (2013), 
"Pension Markets 
in Focus No.10" 

Price data 
accessed via 
Bloomberg 

Bloomberg 

Europe Economics 
analysis 

11 per cent for 
the IRS and 
inflation swap 
portfolio; this is 
then scaled for 
each MS to reflect 
the intensity of 
derivative usage. 

Fieldwork 

34  We reviewed the period from 1999 through to 2013. It is worth noting that over this period, the yield differential between SONIA 
and  gilts  is  much  more  volatile  than  that  between  EONIA  and  bunds.  For  the  UK  we  focused  on  the  past  five-six  years,  which 

gives a higher yield loss than if one looked back all the way to 1999, and is also more comparable to that applied for the rest of 

Europe.

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Input 

Description 

Data sources 
and 
adjustments 

We have applied haircuts based upon current market 
practice and estimates from market participants as to how 
haircuts would vary between normal and stressed market 
conditions. 

For completeness we note that there is ongoing work led 
by the Financial Stability Board (FSB) on mandatory 
minimum haircuts.  This policy would have the intent of 
reducing the pro-cyclical effects of haircuts (which can 
increase significantly in stressed times).  The design and 
parameterisation of any such policy is still to be 
determined. 

Fixed number of basis points on the size of the repo 
transaction.  This cost is relevant to the cases where the 
cash buffer is not sufficient to cover the required level of 
VM to be posted. 

Fieldwork 

Repo cost 

4.4.5 

Costs of excess VM call 

For those days when the VM call exceeds the cash buffer, we assume PSAs will enter 
into a short-term (one month) repo of assets to raise the additional cash.  A haircut is 
applied  to  the  required  level  of  assets  which  must  be  posted  as  part  of  a  repo 
operation,  this  varies  depending  upon  the  asset  (from  2.7  per  cent  for  Government 
bonds up to 6.4 per cent for other assets in the normal scenario and from 2.7 per cent 
for Government bonds up to 15 per cent for other assets in the stress scenarios).  The 
costs of the repo consist of the charge levied by the counterparty (which increases in 
line  with  the  perceived  riskiness  of  the  asset  subject  to  the  repo  trade)  and  an 
overnight opportunity cost which is the difference in the return of the asset over cash 
on  that  day.    Under  the  historic  scenario  the  cost  of  a  repo  is  between  13bps  for 
government  bonds  up  to  19bps  for  other  assets.    The  cost  increases  to  between  25 
and 38bps under the stress scenarios. 

As  described  above,  to  arrive  at  the  cost  of  excess  VM  calls  for  the  2012  portfolios 
under the historic scenario we calculate the individual repo costs for each time the VM 
calls  exceed  the  cash  buffer.    Under  the  stress  scenarios  we  estimate  an  indicative 
annual  repo  cost  by  dividing  the  cost  of  an  excess  repo  by  the  frequency  with  which 
this is likely to occur (20 years).     

4.4.6 

Scaling of the final costs 

The opportunity costs and excess VM call costs are expressed as a proportion of AUM 
for each Member State, and then scaled up based upon the total level of assets under 
management for that Member State via the intermediate steps described above).  The 
simulated VM calls as a proportion of AUM are  taken for the  representative portfolios 
which are classified as ‘high’ derivative use intensity.  In order to reflect the fact that 
the  intensity  of  derivative  usage  will  vary  across  –  and  within  –  Member  States,  we 
scale  the  final  opportunity  costs  by  the  blended  scaling  factors  described  in  section 
4.2.2 above. 

The costs of meeting cash VM requirements are extrapolated over 20, 30 and 40 years 
to represent the impact of the cash buffer on the typical pensioner.  

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5.  Results of Phase 1 and Phase 2 Modelling 

In this chapter we present the results of the modelling exercises described in Chapter 
4.  These results represent the costs to PSAs of administering collateral under different 
phases, and cover: 

(cid:131)  Direct costs of administering collateral.  

(cid:131)  Opportunity costs of holding cash to meet cash VM calls. 

Phase 1 represents the baseline costs of bilateral collateralisation prior to EMIR.  Only 
direct costs are included in Phase 1.  We do not consider there to be opportunity costs 
associated  with  VM  under  bilateral  arrangements,  as  PSAs  optimise  their  collateral 
arrangements  in  the  CSAs  they  have  and  this  is  part  of  the  usual  cost  of  derivative 
trading not influenced by regulation.   

Phases  2.1  and  2.2  represent  the  costs  of  collateralisation  under  EMIR.    Phase  2.1 
covers  the  expected  costs  to  PSAs  of  complying  with  bilateral  variation  margin 
requirements in the case of an exemption from the clearing obligation – as with Phase 
1  only  direct  costs  are  included  in  Phase  2.1.    Both  direct  and  opportunity  costs  are 
included  in  Phase  2.2,  which  represents  the  costs  to  PSAs  of  complying  with  current 
CCP cash VM requirements. 

For each phase we estimate the costs to PSAs for the year 2012 using representative 
eligible portfolios and trading volumes for 2012.  

5.1  Costs of Phase 1 

The  direct  annual  costs  of  administering  collateral  under  current  bilateral 
arrangements  across  the  EU28  are  summarised  in  the  table  below.    The  total  costs 
across the EU28 are just under €44 million for 2012.  

These  costs  are  based  on  our  sample  funds  as  described  in  Chapter  4  and  scaled 
across  the  EU  to  reflect  different  fund  sizes  and  intensities  of  derivative  usage.    The 
costs  are  driven  by  the  number  of  CSAs  and  volume  of  derivative  usage  rather  than 
the value of VM exchanged.  They assume that VM collateralisation does not generally 
take place daily (but more frequently than weekly), and that CSAs can stipulate a mix 
of cash and non-cash assets as suitable VM collateral.  

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Table  5.1:  Direct  costs  of  administering  collateral  under  current  bilateral 
arrangements across the EU28, 2012 

Member State  Direct cost (€000s) 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

132 

332 

21 

0 

61 

1,788 

3,329 

12 

0.6 

1,143 

690 

1,044 

46 

20 

538 

643 

1.9 

5.4 

2.3 

3.7 

6,652 

435 

78 

19 

1,525 

15 

39 

25,336 

43,913 

Source: Europe Economics and Bourse Consult analysis. 

5.2  Costs of Phase 2.1 

The  expected  direct  annual  costs  of  bilateral  collateralisation  under  EMIR  with  the 
exemption  across  the  EU28  are  summarised  in  the  table  below.    The  total  expected 
costs across the EU28 are approximately €52 million. 

These  costs  are  based  on  existing  portfolios  and  trading  volumes  for  2012.    The 
increase  in  costs  from  current  bilateral  arrangements  is  driven  by  the  move  to  daily 
margining  which  would entail  a  slight increase  in  the  resources  needed  to  administer 
collateral under CSAs.       

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Table  5.2:  Expected  direct  costs  of  administering  collateral  under  EMIR 
bilateral arrangements across the EU28, 2012 

Member States  Direct costs (€000s)

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

159 

436 

25 

0 

73 

2,304 

4,015 

14 

0.7 

1,399 

895 

1,415 

56 

24 

669 

786 

2.3 

6.8 

2.8 

4.5 

8,622 

522 

101 

20 

2,038 

18 

47 

28,496 

52,151 

Source: Europe Economics and Bourse Consult analysis. 

5.3  Direct costs of Phase 2.2 

Phase 2.2 includes the expected direct annual costs to PSAs of administering cash VM 
for  clearable  OTC  derivative  contracts  under  EMIR  once  the  exemption  has  expired; 
and  the  direct  costs  of  managing  bilateral  collateralisation  for  non-clearing-eligible 
OTC  derivative  contracts  and  the  remaining  ‘legacy’  bilateral  contracts  of  (now) 
clearable derivatives. 

These costs are presented in the table below. We present the costs under two clearing 
scenarios: the first where both IRS and inflation swaps are clearable, and the second 
where only IRS are clearable.   

The total costs across the EU28 are approximately €85 million in the first scenario and 
€87 million in the second.  These include the direct costs of posting collateral to CCPs 

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for  clearing-eligible  derivative  (around  €40  million  where  both  IRS  and  inflation  are 
clearable  and  €41  million  where  only  IRS  are  clearable)  and  the  direct  costs  of 
bilateral  collateralisation  for  the  remaining  non-clearing-eligible  contracts  and  the 
legacy  contracts  for  (now)  clearable  derivatives  (approximately  €45  million  and  €46 
million respectively).   

The  slightly  higher  costs  in  the  scenario  where  only  IRS  are  cleared  reflect  the  fact 
that cash VM calls from IRS and inflation swaps would not be netted off at the clearing 
member level and the assumption that this would result in more frequent VM calls.    

These  costs  are  based  on  the  assumption  that  a  similar  volume  of  IRS  and  inflation 
swaps currently represented by the 2012 portfolios would be centrally cleared.  Costs 
are  driven  by  the  relationships  that  funds  would  need  to  manage  with  clearing 
members which, although related to derivative volumes, would be subject to efficiency 
savings.    Additional  costs  to  cover  liquidity  management  decisions  and  repo 
transactions are included. 

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Table 5.3: Expected direct costs of administering CCP cash VM and remaining 
bilateral VM under EMIR with no exemption across the EU28, 2012 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

IRS and Inflation 
clearable 
Direct costs 
(€000s) 
259 

710 

40 

0 

120 

3,749 

6,533 

23 

1.1 

2,277 

1,456 

2,302 

91 

39 

1,088 

1,278 

3.7 

11 

4.6 

7.2 

14,028 

849 

164 

33 

3,317 

28 

77 

46,365 

84,852 

Only IRS clearable 
Direct costs 
(€000s) 

264 

724 

41 

0 

122 

3,825 

6,666 

23 

1.1 

2,323 

1,485 

2,349 

92 

40 

1,110 

1,304 

3.8 

11 

4.7 

7.4 

14,313 

866 

168 

34 

3,384 

29 

78 

47,307 

86,576 

Source: Europe Economics and Bourse Consult analysis. 

5.4  Direct costs of pre- and post-EMIR collateral administration  

The table below summarises the total direct costs across the EU28 for all phases. 

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Table 5.4: Total annual costs of collateral management under all phases 

Phase 

Total Direct Costs EU28

Current Bilateral Arrangements 

Bilateral EMIR (with exemption) 

Total EMIR with no exemption (IRS and INFL 
cleared) 

Total EMIR with no exemption (only IRS cleared) 

43,459 

52,151 

84,852 

86,576 

This cost increase, whilst not wholly trivial, is of significantly less importance than the 
potential opportunity cost calculation to which we now turn. 

5.5  Opportunity costs of Phase 2.2  

In addition to direct costs, the expected costs to PSAs of complying with current CCP 
cash  VM  requirements  include  the  opportunity  costs  of  holding  a  cash  buffer  at  the 
expense of higher yielding assets.  

The  opportunity  costs  will  vary  according  to  different  scenarios.    We  consider  two 
clearing scenarios – the first where only IRS are clearable, and the second where both 
IRS and inflation swaps are clearable.  

For  each  clearing  scenario  we  have  modelled  the  opportunity  costs  under  different 
levels of market stress which PSAs might take into consideration when setting up the 
cash  buffer  to  cover  possible  VM  calls.    These  various  market  stress  scenarios  are 
developed from: 

(cid:131)  Historic interest rate and inflation moves, where the cumulative five-day move was 

considered. 

(cid:131)  A simulated 100bps increase in historic interest rate moves.  The 100bps shock only 
reflects a shift in interest rates and the results are not duplicated for the case where 
both inflation and IRS are cleared.35 

(cid:131)  Interest rate and inflation moves from the Federal Reserve’s “adverse stress 

scenario”.36 

(cid:131)  Interest rate and inflation moves from the EBA’s macroeconomic scenario for the 

2014 stress test.37   

In the Appendix detailing the full modelling results we present for each scenario: 

35  We examined the historic government bond yields from Germany, the Netherlands and the UK using data dated back to  1980, 
1986  and  1984  respectively,  and  accessed  from  Eurostat.    This  analysis  identifies  that  relatively  rapid  100+  bps  movements 

have  been  experienced  previously,  albeit  infrequently  (being  very  infrequent  in  the  Netherlands,  less  infrequent  in  the  UK).  

Whilst interest rates have typically been less volatile since the mid-1990s than before this should not be construed as a sign that 
greater volatility will not be a feature of the future. 

36  US Federal Reserve 2014 stress test parameters: 2014 CCAR Severely Adverse Market Shocks Data; 2014 CCAR Adverse Market 

Shocks Data. 

37  https://www.eba.europa.eu/-/eba-publishes-common-methodology-and-scenario-for-2014-eu-banks-stress-test 

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(cid:131)  The total VM requirement to be held as a cash buffer by PSAs in each Member 

State. 

(cid:131)  The opportunity cost to PSAs of holding the cash buffer over one year. 

(cid:131)  The cost to PSAs of conducting repo over one year to cover the excess VM calls.   

(cid:131)  The total combined opportunity and repo cost to PSAs over one year. 

The results are presented for three different levels of cash buffer representing 100 per 
cent,  90  per  cent  and  80  per  cent  of  the  maximum  VM  call.    Whilst  our  model  has 
considered  this  range  of  possible  approaches  the  actual  level  of  the  cash  buffer  that 
pension funds would adopt is uncertain and will depend in part on market conditions at 
the time and on how conservative pension funds choose to be.   

Our  fieldwork  has  indicated  the  100bps  move  as  a  commonly  cited  reference  point.  
We  believe  funds  would  be  unlikely  to  consider  anything  below  the  historic  VM  calls. 
We therefore consider this to be a reasonable estimate for expected costs.  Below we 
focus largely upon the 100 bps shock.  We include the impacts of the other simulations 
in Appendix 2. 

The  table  below  presents  the  cash  buffer  implied  by  PSAs  preparing  for  a  100  bps 
shock.   

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Table  5.5  Total  cash  VM  requirement  to  be  held  under  the  IRS  clearable-
100bps scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
267 

90% of maximum 
calculated VM call 
241 

80% of maximum 
calculated VM call 
214 

1,799 

41 

0.09 

302 

14,540 

26,926 

23 

1.02 

2,889 

4,438 

2,234 

94 

39 

2,932 

1,814 

3.52 

23 

2.6 

6.87 

1,619 

37 

0.09 

272 

13,086 

24,233 

21 

0.92 

2,600 

3,994 

2,011 

84 

35 

2,639 

1,633 

3.17 

21 

2.34 

6.18 

1,439 

33 

0.08 

242 

11,632 

21,541 

19 

0.82 

2,311 

3,551 

1,787 

75 

31 

2,346 

1,451 

2.81 

19 

2.08 

5.5 

59,777 

53,800 

47,822 

805 

410 

34 

12,863 

27 

198 

122,901 

255,393 

725 

369 

31 

11,577 

24 

179 

110,611 

229,854 

644 

328 

27 

10,291 

22 

159 

98,321 

204,315 

Source: Europe Economics and Bourse Consult analysis. 

The table below presents the total costs to  PSAs across the  EU28 if they held a cash 
buffer based around coping with a 100 bps shock.   

For  those  countries  with  a  relatively  high  initial  cash  holding,  the  additional  cost  of 
conducting larger and more frequent “emergency” repo operations as the cash buffer’s 
size decreases could outweigh the saving from a reduced  opportunity cost.  However 
typically  in  our  model  the  opportunity  cost  change  outweighs  substantially  the  repo 
cost, i.e. at face value the lowest possible cost would appear to be at the lower cash 
buffer – but this does not mean this approach would be adopted, due to concerns over 
the ability to repo at the levels implied.  We return to this point at 5.7.3 below. 

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Table  5.6  Annual  total  cost  (opportunity  cost  and  emergency  repo  costs) 
under IRS clearable-100bp scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of 
maximum 
calculated VM 
call 
1,703 

90% of 
maximum 
calculated VM 
call 
1,540 

80% of 
maximum 
calculated VM 
call 
1,376 

11,454 

264 

0.6 

1,922 

185,188 

342,951 

149 

6.52 

18,401 

56,530 

14,229 

1,193 

305 

37,345 

23,104 

22 

149 

17 

148 

10,356 

238 

0.54 

1,738 

167,048 

309,358 

135 

5.89 

16,636 

50,993 

12,864 

1,076 

281 

33,687 

20,841 

20 

135 

15 

124 

9,257 

213 

0.49 

1,554 

148,908 

275,764 

120 

5.27 

14,871 

45,455 

11,499 

959 

258 

30,029 

18,578 

18 

120 

13 

103 

761,372 

686,793 

612,213 

5,129 

2,611 

518 

163,839 

172 

1,263 

1,173,383 

2,803,369 

4,637 

2,360 

476 

147,791 

156 

1,142 

1,059,236 

2,529,680 

4,145 

2,110 

433 

131,742 

139 

1,021 

945,089 

2,255,994 

Source: Europe Economics and Bourse Consult analysis. 

PSAs in the UK and Netherlands are those most affected in absolute terms (and also in 
relative terms, compared to total AUM). 

5.6  Total costs of complying with cash VM under EMIR 

The total expected  costs to PSAs  of  complying with VM collateral requirements under 
EMIR  will be the sum of the direct costs of  complying with bilateral VM requirements 
based  on  the  Draft  RTS  for  non-clearable  derivatives;  the  direct  costs  of  complying 
with CCP cash VM requirements for clearable OTC derivatives; the opportunity costs of 
holding  sufficient  cash  to  meet  current  CCP  cash  VM  requirements;  and  any  costs 
associated with meeting any shortfall between the cash buffer and extreme VM calls. 

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The  opportunity  costs  will  differ  according  to  the  size  at  which  PSAs  set  the  cash 
buffer.  The tables below present the total direct and opportunity costs across the EU 
pensions  industry  under  the  two  approaches  and  across  different  cash  buffer  levels.  
Interest  rate  swaps  are  already  clearable  across  a  wide  range  of  products.  Inflation 
swaps  are  not  yet  clearable  —  however  our  fieldwork  indicates  that  at  least  one 
clearing house is already seeking approval for various inflation swap products from its 
regulator.  Although  the  set  of  inflation  swap  products  to  be  approved  is  not  yet  set, 
we  understand  that  it  should  be  broad  enough  to  be  of  substantial  benefit  to  those 
PSAs using inflation swap products.  The timing of the approval of inflation swaps for 
clearing is not yet certain but we expect inflation swaps to join interest rate swaps as 
being clearable by the end of this year (i.e. 2014).  

Table  5.7:  Total  expected  annual  costs  to  EU  pension  industry  in  IRS  only 
clearable scenario, €millions 

100bps scenario  

100% of 
maximum 
calculated 
VM call 
2,890 

90% of 
maximum 
calculated VM 
call 
2,616 

80% of 
maximum 
calculated VM 
call 
2,343 

Table  5.8:  Total  expected  annual  costs  to  EU  pension  industry  in  IRS  and 
inflation swap clearable scenario, €millions 

100bps scenario  

100% of 
maximum 
calculated 
VM call 
2,888 

90% of 
maximum 
calculated VM 
call 
2,615 

80% of 
maximum 
calculated VM 
call 
2,341 

Total costs under the 100bps scenario are very similar across the two clearing cases.  
This  is  due  to  the  fact  that  this  scenario  does  not  adjust  the  margin  on  the  inflation 
swaps  (i.e.  in  effect  it  assumes  that  there  is  no  correlation  between  these  two 
variables at the point that the 100 bps increase occurs). This is a strong assumption. 

5.7  Wider impacts on PSAs of complying with cash VM under EMIR 

Section  5.5  above  shows  that  the  costs  to  PSAs  of  complying  with  current  CCP  cash 
variation  margin  requirements  in  the  absence  of  the  exemption  and  any  technical 
solutions  will  be  significant.    The  biggest  cost  element  is  the  yield  drag  arising  from 
holding  a  cash  buffer  instead  of  higher-yielding  assets.  The  total  expected  annual 
costs  to  the  total  pension  industry  under  the  scenario  where  both  IRS  and  inflation 
swaps are clearable would range from €1.3 billion if PSAs referenced the size of their 
cash  buffer  to  historic VM  calls  to  €2.9  billion if  they  referenced  their  cash  buffers  to 
VM calls under a 100bps increase in interest rates.  

In  response  to  the  significant  costs,  PSAs  face  a  trade-off.    On  the  one  hand  PSAs 
could  choose  to  retain  their  current  level  and  structure  of  hedging  and  incur  these 
opportunity  costs.    These  costs  in  the  form  of  foregone  yields  would  most  likely  be 
passed  onto  pensioners  in  the  form  of  reduced  retirement  benefits,  particularly  for 
funds which are under-funded and whose sponsors cannot guarantee to meet the gap.  

On  the  other  hand  PSAs  could  try  and  reduce  the  extent  of  these  costs  by  changing 
their derivative usage through different hedging or investment strategies. 

Our  fieldwork  indicates  a  degree  of  behavioural  change  from  PSAs:  smaller,  less 
sophisticated  funds  would  stop  hedging  using OTC  derivatives  if  it  became  too  costly 

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or complex. This reaction, however, is only partly driven by the costs of maintaining a 
cash  buffer  –  the  general  increase  in  complexity  and  cost  arising  due  to  central 
clearing would have a significant impact on funds’ decisions.  

5.7.1 

Changes in derivative usage  

By changing their use of OTC derivatives PSAs could reduce the VM requirements from 
CCPs  for  centrally  cleared  OTC  derivatives  and  thus  hold  a  smaller  cash  buffer  and 
incur  lower  costs.    PSAs  could  move  towards  hedging  their  long-term  liabilities  using 
derivatives  associated  with  lower  VM  calls,  such  as  short-dated  or  exchange-traded 
derivatives.  Whilst a number of funds have suggested they would explore the use of 
alternative derivatives to offset the costs of clearing, there is concern throughout the 
industry that this would have consequences of less efficient hedging and reductions in 
innovative  hedging  solutions.  OTC  derivative  contracts,  by  their  bespoke  nature,  can 
be tailored to perfectly match the specific risks of a fund.  Exchange traded derivatives 
would be more standardised and would not exactly match the risks being hedged – as 
with short-dated derivatives these would not match pension funds’ liabilities which are 
of  long  maturities  and  need  to  be  inflation-linked.    The  industry’s  view  is  that 
exchange traded derivatives are not yet available at desired liquidity levels. 

A move to short-dated derivatives is seen as particularly sub-optimal as, in addition to 
the risk mismatch, it would involve extensive roll risk and would introduce significantly 
more operational risk as it would require much more active management of positions 
to ensure that the relevant duration profile was correctly matched.  

The mismatch resulting from the use of alternative derivatives is particularly relevant 
for  inflation  risks.  Given  the  seasonality  of  inflation  (e.g.  low  in  June,  high  in  April, 
with  as  much  as  a  120bps  range  —  at  least  in  “normal”  inflationary  times)  it  is  very 
important  to  link  the  swap  to  the  month  to  which  the  benefit  pay-out  is  uplifted.    In 
the  bilateral  world  it  is  possible  to  trade  a  bespoke  swap  linked  to  the  exact  month 
needed.  If swaps are to be standardised then the market needs to decide on one (or 
a few) months to link these to as there would not be enough volume/liquidity to have 
different  swap  products  linked  to  every  month.  Moving  to  standardised  swaps  could 
thus result in a mismatch for many hedges. 

Funds may also decide to hedge their liability risks using alternative assets rather than 
derivatives.  For example, interest-bearing assets like government bonds are a natural 
hedge against interest rate risk.  As with other alternatives to OTC derivatives, the use 
of other assets would most likely result in less efficient hedging.    

5.7.2 

Changes in investment strategies  

It  is  likely  that  some  funds  across  the  industry  would  maintain  a  similar  use  of  OTC 
derivatives  and  incur  the  costs  of  foregone  yields.    Indeed,  part  of  the  pension  fund 
industry  views  stopping  or  limiting  hedging  as  the  worst  outcome  for  PSAs,  and  that 
all  alternative  solutions  should  be  explored,  even  incurring  the  additional  costs  of 
maintaining cash for VM.  

PSAs may seek to boost yields to offset the opportunity costs by investing in an asset 
portfolio  that  includes  more  high-yielding,  (generally  illiquid)  assets.  A  drawback  of 
this strategy would be that sudden changes in the economic environment would make 
it  difficult  to  turn  these  assets  into  liquid  cash.  Some  pension  funds  in  the  US  have 
chosen  to  make  up  for  the  lost  yield  by  selling  index  credit  default  swaps  (CDSs), 
replacing the lost credit exposure without upfront payments. However, the volatility of 
long rate duration is usually significantly higher than that of credit spreads, so the risk 
of large, volatile margin calls on cleared index CDSs is lower.  In addition, a rising-rate 
environment  normally  indicates  the  economy  is  fragile  –  under  those  circumstances, 

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the  likelihood  is  that  credit  spreads  will  narrow,  reducing  margins  for  the  CDS 
positions. 

Another possible change would be to insulate the portfolio by trading payer swaptions 
(which cover interest rate risk). This would protect the firm in the short end if interest 
rates  rose.  If  rates  rise,  the  fund  would  receive  collateral  on  the  swaption  positions 
and can then post it out on its duration hedges. But this strategy depends on the cash 
collateral  being  received  on  the  uncleared  swaptions  –  if  the  counterparty  has  the 
ability to post bonds under its bilateral agreement, the strategy would not work. 

5.7.3 

Reliance on the repo market 

Many in the PSA industry see raising cash for VM from the repo market as preferable 
to  reducing  hedging  activity  or  incurring  significant  costs  of  holding  cash  buffers.    In 
particular,  responses  to  our  fieldwork  view  reducing  hedging  activity  as  very 
undesirable.    Views  were  split  between  not  cease  hedging  activity  or  else  only 
reducing  it  if  the  costs  of  clearing  were  “excessive”  and  no  solution  were  found 
(“excessive”  was not defined by participants in the fieldwork –– this views may have 
some equivalence). 

There  are,  however,  concerns  about  the  capacity  of  the  repo  market  to  meet  the 
needs of the pension funds, particularly in extremis. 

The  European  repo  and  reverse  repo  market  had  in  aggregate  about  €5.5  trillion 
outstanding at the end of 2013.38  This is substantially below its peak size, but shows 
significant recovery from the market’s low in 2008.  About two-thirds of this total was 
denominated  in  euros,  and  a  further  10  per  cent  in  sterling.    Government  securities 
were  the  most  used  asset  as  collateral,  representing  38.5  per  cent  of  the  total 
outstanding (about €2.1 trillion).   The directional size of the market would therefore 
be about €1 trillion. 

In the UK, outstanding gilt repo transactions stood at about £300 billion at November 
2013  (i.e.  about  €360  billion),  with  about  £100  billion  of  this  outstanding  with  non-
banks.    Reverse  repo  (i.e.  the  other  side  of  the  transaction)  showing  similar  figures.  
These data are higher than that implied by the ICMA survey where sterling trades are 
about  10–11  per  cent  of  overall  total  repo  transactions.    There  are  various  possible 
explanations  for  this:  ICMA  is  a  survey,  and  so  may  be  missing  some  material  data, 
sterling  repo  may  be  particularly  prominent  in  Government  securities,  or  there  could 
be a decline in activity between the end of November and the year end. 

Even taking both datasets at face value, this implies that the repo market in European 
Government  bonds  would  be  at  least  €700  billion  in  outstanding  transactions  (and 
likely higher). 

The  size  of  the  market  at  any  one  time  is  less  clear.    About  twenty  per  cent  of  the 
repo  transactions  in  the  ICMA  survey  were  overnight  trades  (this  is  across  all  asset 
classes),  i.e.  on  average  20  per  cent  of  the  outstanding  value  is  being  transacted 
daily.    ICMA’s  data  are  analysed  by  maturity  (overnight,  two  days  to  one  week,  one 
week to one month, and so on).   If it is assumed that the trades within a particular 
maturity  are  equally  distributed  across  the  number  of  trading  days  within  then  the 
stock  data  within  the  ICMA  survey  can  be  used  to  identify  —  in  broad  terms  —  the 
flow  of  repo  transactions.    Our  analysis  indicates  that  about  25  per  cent  of  the 
outstanding transaction value is being traded on an average trading day.  This would 
imply that about £75 billion of gilt repos are being transacted on an average day.   

38  International Capital Market Association: European repo market survey, Number 26 - conducted December 2013.  This measures 

the stock of outstanding transactions, not the flow during the year. 

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Our  fieldwork  indicated  that  UK  LDI  schemes  are  currently  using  the  repo  market  to 
increase their exposure to gilts. This is either to raise cash for liquidity management or 
for  return  enhancement  purposes,  so  achieving  a  degree  of  leverage.39  One  estimate 
was that as much as £80 billion in outstanding gilt repo was with LDI schemes — this 
would be about 80 per cent of the UK gilt repos outstanding with non-banks (or over a 
quarter  of  the  total).  This  means  that  there  is  currently  a  base  level  of  repo  already 
committed  to  the  pension  sector,  although  this  is  largely  influenced  by  the  current 
price  differential  between  swaps  and  gilts,  which  may  not  extend  into  the  future. 
Nevertheless  if  we  reverse  the  logic  above,  £80  billion  outstanding  would  involve 
about £20 billion transacted on any given day (from the £75 billion total). 

The remaining £55bn in gilt repo might be assumed by PSAs to be available to them, 
but this would be a very strong assumption. Whilst PSAs might further assume some 
fraction of other asset classes providing additional market liquidity it is worth recalling 
that the repo market for government bonds is about double that for rest, and the gilt 
repo  market  is  also  much  more  resilient  in  stressed  situations.    There  will  be  other 
players  with  needs,  so  even  if  there  is  a  price  war  to  secure  repo,  PSAs  are  not 
guaranteed to be able to win it on economic terms. It looks unlikely that PSAs would 
be  able  to  assume  more  than  £20bn  from  repo  would  be  available  to  contribute 
towards collateral needs, and perhaps less than this.   

This  would  not  be  equally  available  to  all  participants.    The  larger  asset  managers 
have  dedicated  repo  teams  and  well-established  market  connections:  in  the  event  of 
demand  outstripping  supply,  these  would  be  able  to  service  their  own  needs  whilst 
smaller funds and asset managers would not. 

This  means  that larger  funds  would  be  able  to  operate  with  a lower  cash  buffer  than 
smaller players — this would represent an important advantage of scale.   

As  already  indicated  above,  the  equivalent  data  point  for  euro-denominated 
Government bonds is less apparent but would be at least €170 billion if we apply the 
preceding  assumptions.    The  proportion  of  this  related  to  German  bunds  is  not 
evident, but is likely to be substantial. 

A  similar  analysis  (relying  in  large  part  on  mapping  across  UK  market  assumptions) 
indicates that as much as €350 billion available on any given day in the rest of Europe.  
There is typically less experience in repo, although the industry is bigger. They would 
face significant operational issues.  Capacity may be two-three times larger than in UK 
gilt repo. 

Our modelling indicates that the aggregate VM call for a 100 basis point move would 
be  €204–255  billion  for  European  PSAs.    Of  this,  €98–123  billion  (£82–103  billion) 
would  relate  to  UK  PSAs,  and  predominantly  be  linked  to  sterling  assets,  and  €106–
130 billion would relate to euro (and perhaps other currency) assets. 

It  can  be  seen  that  the  total  VM  requirement  for  such  a  move  would  exceed  the 
apparent  daily  capacity  of  the  UK  gilt  repo  markets  and  would  likely  exceed  the  
relevant parts of the European government bond repo market — i.e. primarily that in 
German bunds.   

Capacity  exists  in  other  (less  creditworthy)  asset  classes  and  some  of  this  might  be 
attracted  to  higher  grade  repo  transactions.    Given  that  such  an  event  would  be 
coincident  with  market  stress,  this  is  perhaps  not  unlikely  but  would  still  likely  have 
pricing  implications.    We  additionally  note  that  pension  funds  are  far  from  the  only 
participants  in  repo  (the  Bank  of  England  data  suggesting  that  banks  account  about 

39  Policy  Framework  for  Addressing  Shadow  Banking  Risks  in  Securities  Lending  and  Repos  –  FSB  –  August  2013  - 

http://www.financialstabilityboard.org/publications/r_130829b.pdf 

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two-thirds of activity, at least for gilt repo, although some of this may be undertaken 
on behalf of non-bank counterparties) the aggregate demand in such a scenario would 
likely  overwhelm  the  market  if  that  demand  was  coordinated  and  time  compressed 
(as, indeed, it would be expected to be). 

In  addition  there  is  some  uncertainty  in  some  Member  States  (e.g.  the  Netherlands) 
about whether PSAs are allowed to use repos.  Under Dutch pension law (Article 136) 
there  is  a  general  prohibition  against  pension  funds  taking  out loans  —  however  it is 
possible  for  temporary  liquidity  needs  within  the  remit  of  clear  guidance  of  the 
responsible pension fund board. We understand that the Dutch regulator accepts that 
the regulations needed to be clarified in this respect. 

There is also widespread concern about the capacity and resilience of the repo market 
(we discuss the capacity of the repo market in detail at Section 6.3.4).   

In  any  event  using  the  repo  market  to  fund  VM  calls  would  imply  elements  of 
counterparty credit risk, liquidity risk and roll risk. Since repos are fully collateralised 
they  present  a  significantly  lower  counterparty  credit  risk  than  uncleared  swaps  but 
this can be a  factor if the repo  counterparty is holding the collateral on behalf of the 
PSA.    A  number  of  funds  have  started  monitoring  the  risk  level  in  repo  markets  and 
the  possibility  that  they  might  be  forced  to  let  go  of  repos  at  short  notice  and 
implement  alternative  hedging  strategies,  e.g.  through  the  use  of  long-dated  gilts  to 
meet this new requirement. The main issue remains that these long dated assets are a 
less precise hedge for duration risk than OTC swaps. 

Uncertainty over the scale of costs of meeting cash VM requirements is a likely driver 
of the wide range in opinions among the industry.   

We now  consider the impacts  on retirement incomes if the  opportunity costs were to 
be borne by pension funds.    

5.8  Conclusions - impact on retirement incomes 

To the extent that PSAs pass these total costs on to pensioners, these would represent 
a € for € reduction in retirement incomes.  Whilst it is possible that — where relevant 
— corporates and other sponsors of PSAs could make good any shortfall by increasing 
their  contributions  to  the  funds,  our  fieldwork  does  not  indicate  that  this  is  a  likely 
outcome.   It would, anyway, only substitute a reduction in pensioner incomes with a 
reduction in corporate profits. 

The  annual  total  costs  as  a  percentage  of  PSAs’  AUM  would  represent  the  annual 
reduction  in  investment  returns.  Compounding  over  the  span  of  pensioners’ 
contributions provides the cumulated effect.  The table below presents the cumulated 
percentage  reduction  in  retirement  incomes  under  a  low  assumption  (20  years), 
medium  assumption  (30  years)  and  a  high  assumption  (40  years).    The  table  below 
considers  the  costs  associated  with  a  cash  buffer  set  at  the  maximum  calculated  VM 
call under the 100bps move simulation by Member State, and – by way of comparison 
– the EU28 cost for the others. 

The  impact  on  retirement  incomes  would  be  significant  –  up  to  3.1  per  cent  in  the 
Netherlands  and  2.3  per  cent  in  the  UK  in  the  100bps  scenario.  The  key  driver  of 
opportunity  cost  is  the  difference  in  the  return  between  cash  and  higher  yielding 
assets (in particular government bonds).  At present these spreads are relatively low; 
if the spreads  should widen then we could expect a much more significant impact on 
retirement incomes.   

This  could  also  arise  if  PSAs  chose  to  fund  the  cash  buffer  from  assets  other  than 
government  bonds.    PSAs  could  decide  to  maintain  a  minimum  proportion  of  their 
investable  assets  as  government  bonds,  with  the  result  that  more  higher-yielding 

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assets would be sold to fund the cash buffer.  As a crude example, if PSAs determined 
that  at  least  25  per  cent  of  AUM  should  remain  in  government  bonds  then  a  strict 
interpretation of this “rule” would have a significant impact in some countries (in this 
example,  the  UK  would  be  very  affected  as  the  average  fund  has  holdings  of 
government bonds only a little above this level now) as the yield differential between 
cash  and  (say)  corporate  bonds  is  much  higher  than  that  between  cash  and 
government bonds.  Similarly, if PSAs focused on an alternative metric – such as the 
stressed simulations – the impact would again deepen. 

Table 5.9:  Indicative  cumulated reduction  in  retirement  incomes over 20, 30 
and 40 years   

20 years 

30 years 

40 years 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

0.19% 

0.37% 

0.19% 

0.18% 

0.38% 

1.35% 

1.46% 

0.19% 

0.18% 

0.23% 

0.74% 

0.18% 

0.36% 

0.22% 

0.96% 

0.48% 

0.18% 

0.36% 

0.11% 

0.54% 

1.55% 

0.18% 

0.39% 

0.45% 

1.18% 

0.18% 

0.39% 

1.09% 

0.29% 

0.55% 

0.29% 

0.27% 

0.57% 

2.03% 

2.20% 

0.29% 

0.27% 

0.34% 

1.12% 

0.27% 

0.55% 

0.34% 

1.44% 

0.72% 

0.27% 

0.53% 

0.16% 

0.81% 

2.33% 

0.27% 

0.58% 

0.68% 

1.77% 

0.27% 

0.59% 

1.64% 

0.39% 

0.74% 

0.39% 

0.35% 

0.75% 

2.72% 

2.94% 

0.38% 

0.35% 

0.46% 

1.49% 

0.36% 

0.73% 

0.45% 

1.93% 

0.96% 

0.35% 

0.71% 

0.22% 

1.09% 

3.13% 

0.35% 

0.78% 

0.90% 

2.36% 

0.35% 

0.79% 

2.19% 

EU 28 

1.11% 

1.67% 

2.24% 

EU28 impact (historic) 

EU28 impact (EBA) 
EU28 impact (US Fed 
Adverse) 

1.82% 
Source: Europe Economics and Bourse Consult analysis. 

0.63% 

1.62% 

0.95% 

2.43% 

1.26% 

3.26% 

2.73% 

3.66% 

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6.  Technical  Solutions  for  the  Posting  of  Non-Cash 

Collateral to CCPs 

PSAs  are  concerned  that  a  requirement  to  post  cash  VM  at  CCPs  will  necessitate  a 
substantive  reallocation  of  assets  towards  cash.    Since  cash  is  relatively  low-yielding 
this would result in a drag on investment returns.  The previous chapters in this study 
have  illustrated  the  impact  of  this.  We  now  examine  seven  potential  technical 
solutions of this problem for PSAs.   

The  solutions  provide  potential  mechanisms  for  the  posting  of  non-cash  collateral  to 
CCPs  to  meet  VM  requirements.    For  each,  we  describe  the  solution,  along  with  the 
associated benefits, costs, risks and challenges associated with it in order to provide a 
view of its viability. We then provide a comparative analysis and conclusion as to the 
viability of the solutions. 

However,  before  beginning  this  examination,  we  first  describe  the  existing  CCP 
clearing  arrangements  for  OTC  derivatives  contracts  in  order  to  assist  the  reader  to 
better understand the discussion which follows on each technical solution.  

6.1  CCP clearing arrangements for OTC derivatives contracts 

The following is a description of a typical OTC CCP clearing arrangement which is not 
intended  to  be  exhaustive  but  to  be  illustrative  of  the  main  characteristics  of  CCP 
clearing  which  are  relevant  to  this  study.    Individual  CCPs  will  differ  in  the  specifics 
and detail of their services. 

Figure 6.1: Timeline of illustrative OTC clearing arrangement  

CCP risk management cycle 

The  CCP  operates  to  a  regular  daily  timetable,  represented  in  the  diagram  above,  in 
which  it  accepts  trades  for  clearing,  calculates  risk,  demands  margin  and  settles 
margin transfers and due payments. 

Trade input 

During  the  business  day  new  trades  are  confirmed  and  submitted  to  the  CCP  either 
through its own confirmation system or a third party system.   

Account structures 

Trades novated by the  CCP are held in position accounts in the name of the relevant 
CM.    Trades  relating  to  a  client  of  the  CM  are  segregated,  in  a  client  account,  from 
those  relating  to  the  CM  as  a  trading  principal  which  are  recorded  in  a  “house” 
account.  Traditionally CMs have co-mingled the positions of all their clients in a single 
“omnibus”  client  account  but  now  all  CCPs  offer,  in  addition  to  omnibus  accounts, 
individual  client  accounts  which  allow  the  client,  in  the  event  of  its  CM  defaulting,  to 
transfer its position to another CM or to recover the value of the account directly from 
the CCP. 

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Figure 6.2: Account structures  

Each  client  of  the  CM  chooses  whether  its  positions  should  be  held  in  the  CM’s 
omnibus  client  account  or  an  individual  account  designated  with  the  name  of  the 
client. 

Overnight processing 

After the end of the business day the CCP calculates the amount of IM and VM it now 
requires to cover the risk of each CM’s portfolio, taking into account the trades which 
have  been  accepted  and  novated  during  the  day.  More  and  more  CCPs  are  now 
providing  real  time  or  periodic  information  to  CMs,  so  they  can  see  in  advance  the 
direction and amount of VM and the likelihood of any IM calls the next day. 

Each  CM  will  perform  its  own  overnight  calculations  to  determine  the  amount  of 
collateral  it  will  require  from  each  individual  client  to  cover  the  positions  which  are 
being cleared by the CCP. Irrespective of whether the client’s positions are held in an 
omnibus40 or individual account, the margin amounts that they will have to provide to 
their  CM  are  calculated  individually.    As  far  as  possible  the  CM  will  use  the  same 
margin model as the CCP for these calculations and, in order to facilitate this, the CCP 
will  provide  all  CMs  each  day  with  a  copy  of  the  variable  data  -  e.g.  interest  rate 
curves - it has used in the model. 

Margin calculation 

The  CCP  requires  IM  to  be  covered  by  collateral,  either  in  the  form  of  cash  or 
securities. CCP’s require VM to be paid and received in cash.   

Notification of VM obligations and IM calls 

Some  CCPs  provide  CMs  with  these  calculations  soon  after  trade  acceptance,  others 
overnight.  However,  before  business  opens  each  morning,  every  CM  will  know  its 
obligations for VM payments (or receipts) and any calls to increase the collateral cover 
for IM.  

Posting of collateral 

If the CM intends to meet its IM obligation by posting securities or cash in a different 
currency  to  the  sub-portfolio,  the  value  of  collateral  required  by  the  CCP  will  be  a 
certain percentage greater than the amount of IM calculated.  This is to cover the risk 
of  the  collateral  losing  value  before  it  could  be  liquidated  in  the  event  of  a  default.  
The  percentage  is  related  to  the  historic  volatility  of  the  security  or  the  relevant  FX 
rate and is termed the “haircut”. 

Most CMs - particularly those posting non-cash collateral - prefer not to fine tune the 
amount  of  collateral  covering  their  IM  obligation  on  a  daily  basis  -  this  would  incur 
bank  or  custodian  transaction  fees.    Instead  they  provide  more  than  is  required  in 
order  to  cover  potential  future  increases  in  IM  without  posting  additional  collateral.  

40  An omnibus account is where the positions of all or several clients of a CM are co-mingled and treated as a single portfolio by the 

CCP for risk management purposes. 

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CCPs usually assist by advising the CMs on the current value of the collateral held and 
how it relates to the IM requirement (some do this real time).  They also inform CMs 
when the level of collateral “headroom” is becoming small (e.g. an alert may be issued 
if the IM amount reaches 90% of the value of the collateral held). 

In  order  to  post  collateral  to  cover  its  client’s  portfolios  a  CM  needs  to  receive 
collateral  from  its  clients  in  time  for  it  to  be  able  to  meet  the  CCP’s  deadline  for 
receiving the collateral.  If the client wishes to post non-cash IM collateral the transfer 
will have to have been arranged well before the final IM calculations are made because 
of the inherent delays in securities settlement which are discussed below. 

Payments of IM and VM to the CCP 

An actual call being made for  IM usually has to be settled by the CM  in cash (due to 
the  time  it  can  take  to  transfer  securities).  This  cash  could  later  be  substituted  by 
securities.  VM  has  to  be  provided  in  cash.    There  is  a  strict  cut  off  time  for  such 
payments.  If a payment is delayed the CM is technically in default to the CCP, which 
has serious consequences. 

Payments of IM and VM from the CCP 

CCPs usually make payments of VM only after the receipt of the VM from the paying-in 
CMs.    CMs  who  have  an  excess  of  IM  at  the  CCP  can  make  a  request  anytime  for 
return of that excess. 

Intra-day margin calls 

All  CCPs  reserve  the  right  to  make  intra-day  margin  calls  in  the  event  of  market  or 
other events which negatively changes the value of the collateral held or the value of 
the derivative contracts. Both IM and VM calls can be made (and even payments out 
of VM).  All such calls have to be met with cash within a short timeframe (and, in all 
cases, by the end of the day). 

Posting of securities as margin 

Securities, of the kind acceptable to CCPs as collateral, usually have a fixed settlement 
cycle.    For  example,  for  UK  government  gilts,  settlement  is  on  a  T+1  basis.  German 
government  bonds  normally  settle  on  a  T+3  basis,  but  T+1  settlement  is  possible. 
This  means  that  it  is  impossible  to  use  securities  to  meet  a  margin  call  within  the 
timeframes  required  by  the  CCP  if  the  transfer  is  arranged  at  the  time  the  margin 
reports  are  received.    Therefore  the  securities  transfer  either  has  to  have  been 
arranged  on  a  previous  day  or  the  margin  call  is  met  in  cash  and  subsequently 
replaced  by  securities.    Therefore  the  CM  has  to  ensure  it  has  enough  cash  to  meet 
any likely calls.  If could, of course, use securities to raise cash but, again, due to the 
time it takes to settle bond trades, it cannot rely on this method to meet the margin 
calls. 

6.2  The examined solutions 

In the sections that follow we examine seven potential solutions for the posting of VM 
by PSAs to CCPs, namely: 

(cid:131)  Collateral transformation by clearing members (CMs). 

(cid:131)  Collateral transformation by CCPs. 

(cid:131)  Direct acceptance of non-cash assets with pass through to receivers of VM. 

(cid:131)  Acceptance of non-cash assets with security interest passed through to receivers of 

VM. 

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(cid:131)  Quad-party collateral for VM security interest.   

(cid:131)  Agency stock lending. 

(cid:131)  Secured lending by cash-rich corporations. 

PSA’s  do  not  use  Prime  Brokers.  The  reason  they  evolved  was  purely  to  support  the 
needs  of  Hedge  Funds  and  more  latterly  professional  trading  firms  that  require 
exchange clearing and leverage. Hedge Funds use the leverage of the Prime Broker to 
amplify  the  specific  investments  they  make  to  obtain  a  multiplier  effect  on  the  asset 
return,  which  also  has  a  similar  effect  on  the  risk  profile  if  naked  or  not  properly 
hedged. 

PSA’s  investments  tend  to  be  fully  paid  for  and  therefore  they  do  not  want  to  place 
their  entire  portfolio  under  a  security  interest  where  the  Prime  Broker  has  the  ability 
to  lift  collateral  from  the  account  as  required  to  assist  in  funding  any  leverage  they 
have  extended.  Prime  Brokers  in  the  main  offer  products  based  off  of  Equities,  as 
Fixed  Income  instruments  have  evolved  to  transactional  level  financing  via  Repo 
instead of portfolio level financing via Prime Brokers and blanket rehypothecation. 

The  way  in  which  each  solution  would  operate  is  described  and  the  solutions  are 
assessed in terms of the costs, benefits and risks to the main participants. 

6.3  Collateral transformation by CMs 

6.3.1 

Description of the solution 

In  section 5.5 above,  we model the  opportunity cost for PSAs if they  were to  keep  a 
cash buffer to meet potential cash VM calls for up to 100% of the historical maximum 
5 day requirement and use repo to cover any VM requirement that cannot be met by 
this  cash  buffer.  In  this  section,  we  look  at  the  implications  of  PSAs  maintaining  a 
much  smaller  cash  buffer  and  using  CM  repo  to  meet  virtually  all  of  their  VM 
requirements,  so  that  assets  would  not  need  to  be  sold  to  maintain  a  suitable  cash 
buffer. 

This  solution  is  a  continuation  of  a  service  already  offered  to  PSAs  by  CMs  and,  in 
some  cases,  by  the  asset  manager  of  the  PSA.  However,  such  a  service  can  also  be 
provided to PSAs independently of their CMs by a 3rd party bank. 

Operationally a PSA would make arrangements for a reverse repo facility in which the 
CM would guarantee to provide cash up to a specified limit. The securities needed as 
collateral for this facility could either be provided to the lender in advance of the repo 
being  executed  or  provided  as  necessary  to  meet  the  need  for  cash  -  this  would 
depend  upon  how  the  PSA  wishes  to  manage  its  assets  and  the  terms  it  has 
negotiated with the CM. 

When  the  PSA  was  subject  to  a  VM  call  from  its  CM  and  did  not  have  the  necessary 
cash to meet it, a repo transaction would be triggered.  When the cash was no longer 
needed, or if there was a VM credit in conjunction with the repo coming to an end, the 
assets  used  as  collateral  could  be  returned  to  the  PSA  or  continue  to  be  held  by  the 
CM, depending on the terms of the arrangement.   

Such repos as described above could be either bi-party, in which the PSA provides the 
collateral directly to the CM or tri-party, where the assets are lodged with a custodian 
and  the  custodian  acts  as  agent  for  the  PSA  in  collateral  selection,  payment  and 
settlement  with  the  CM,  and  custody  and  management  during  the  life  of  the  repo 
transaction.  This  Tri-party  repo  arrangement,  thusly  removes  a  lot  of  operational 
effort  and  risk  from  the  PSA.  Custodians  typically  charge  1–3  basis  points  for  such  a 
service  over  and  above  their  normal  custody  fees.    Several  custodians  operating  in 

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Europe are looking at enhancing their tri-party repo offerings and such solutions may 
well become more popular if this solution becomes more common. 

Figure 6.3: Collateral transformation by CMs  

6.3.2 

Benefits of the solution 

The key benefit of this solution is that it is closely aligned to existing practices in the 
industry. The CMs and other cash providers are very well experienced in providing this 
type of service and it would require only a small amount of adjustment in the industry.  

6.3.3 

Costs of the solution 

The  direct  costs  of  using  the  repo  market  to  meet  VM  needs  will  clearly  have  an 
impact on returns.  These impacts result from: 

(cid:131)  An increased use of repo compared to PSAs current operations.  PSAs (or their 

investment managers) would need to invest in the necessary treasury operations 
and risk management infrastructure and staff to manage this activity. This would 
mean costs in additional staff, systems and management time. At an investment 
manager this could involve setting up a repo desk to service multiple PSAs, as well 
as having more staff to manage each PSA as the PSAs will have to make decisions 
about what and when collateral can be made available.  This would expand existing 
treasury operations, perhaps significantly, and could, in some cases, necessitate the 
set-up of a treasury department from scratch.   

The treasury function would manage: 

−  Forecasting of the PSA’s need to provide repo collateral ahead of the VM calls.  

−  The transfer of collateral to the repo provider ahead of the actual need for VM 

cash, since this can take up to three days, depending on the securities 
concerned. 

−  Execution of the repo transactions to meet actual VM calls. 

(cid:131)  Some investment opportunity cost.  If the PSA had the necessary committed repo 
facility in place with the CM and had provided sufficient collateral in advance, then 
there would be no need for it to maintain a cash buffer. However, in practice, there 
will still be occasions when there is an unforeseen need to access cash quickly and 
the CM would require that there is a sufficient cash buffer to cover any short term 
liquidity shortage. This cash would earn less than invested securities and so would 
be a drag on investment returns.  This need for a cash buffer to cover short term 
unforeseen VM needs is common to all the solutions examined. 

(cid:131)  A committed repo facility would incur a fee for the duration of the facility.  For 

example, currently a 180 day facility for UK gilt repos would between 40-100bps. A 
similar euro repo facility could cost up to 200bps. 

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(cid:131)  The costs of the repos themselves (which would be in addition to the cost of a repo 
facility).  As an example, currently UK gilt repo rates vary from 2-5bps over base 
rate for overnight s to 3-25bps for 3month repos.  Euro rates ore from 5-10bps for 
overnight repos to 25-50bps for 3 month repos. 

6.3.4 

Risks of the solution 

Capacity of the repo market 

The key risk is whether the repo market could actually handle the additional volume of 
business  that  covering  the  aggregated  VM  obligations  of  the  PSAs  in  cash  on  a  daily 
basis  would  entail.    This  is  both  at  a  trading  and  at  an  operational  level.    Several 
commentators  have  pointed  out  that  some  major  players  in  the  repo  market  are 
expecting  to  withdraw  from  or  reduce  their  involvement  in  what  is  viewed  as  a  low 
margin  business  and  one  which  is  likely  to  become  less  attractive  if  some  of  the 
regulatory changes under discussion are implemented (see below).  

We  have  described  at  5.7.3  our  estimate  that  the  European  government  bond  repo 
market is at least €0.7 trillion and the UK gilt repo market is about £300 billion. 

The size of the market at any one time is less clear.  Our analysis indicates that about 
25 per cent of the outstanding transaction value is being traded on an average trading 
day.  This would imply that about £75 billion of gilt repos are being transacted on an 
average  day.    As  indicated  above,  the  equivalent  data  point  for  euro-denominated 
Government bonds is less apparent but would be at least €170 billion if we apply the 
preceding assumptions.  The proportion of this related to German bunds is not known, 
but is likely to be substantial. 

Our modelling indicates that the aggregate VM call for a 100 basis point move would 
be  €204–255  billion  for  European  PSAs.    Of  this,  €98–123  billion  (£82–103  billion) 
would  relate  to  UK  PSAs,  and  predominantly  be  linked  to  sterling  assets,  and  €106–
130 billion would relate to euro (and perhaps other currency) assets. 

It  can  be  seen  that  the  total  VM  requirement  for  such  a  move  would  exceed  the 
apparent  daily  capacity  of  the  UK  gilt  repo  markets  and  would  likely  exceed  the  
relevant parts of the European government bond repo market — i.e. primarily that in 
German bunds.   

Capacity  exists  in  other  (less  creditworthy)  asset  classes  and  some  of  this  might  be 
attracted  to  higher  grade  repo  transactions.    Given  that  such  an  event  would  be 
coincident  with  market  stress,  this  is  perhaps  not  unlikely  but  would  still  likely  have 
pricing  implications.    We  additionally  note  that  pension  funds  are  far  from  the  only 
participants  in  repo  (the  Bank  of  England  data  suggesting  that  banks  account  about 
two-thirds of activity, at least for gilt repo, although some of this may be undertaken 
on behalf of non-bank counterparties) the aggregate demand in such a scenario would 
likely  overwhelm  the  market  if  that  demand  was  coordinated  and  time  compressed 
(as, indeed, it would be expected to be). 

The regulatory treatment of repo transactions under Basel III41 is expected to have a 
negative  impact  on  the  repo  market.    The  limitation  on  netting  (when  specific 
conditions are met), and an add-on for credit risk mean banks will have to hold more 
capital  to  support  their  repo  businesses,  which  could  lead  to  a  reduction  in  banks’ 
appetite  to  offer  repo  services  and  a  shrinkage  of  the  repo  market,  and  almost 
certainly an increase in costs for their clients. 

41  Basel III leverage ratio framework and disclosure requirements - January 2014 - http://www.bis.org/publ/bcbs270.pdf 

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In  addition  a  Financial  Transaction  Tax  (FTT)  would  also  have  a  severely  negative 
impact  on  repo  if  such  transactions  were  subject  to  such  a  tax.  A  rate  of  10  basis 
points  could  either  kill  the  market  (as  margins  are  already  small),  especially  at  the 
short end, or else cause a significant reduction in its scale. 

Finally, an introduction of mandatory haircuts for repos, which has been proposed by 
the  Financial  Stability  Board42  (with  the  objective  of  reducing  pro-cyclicality),  could 
also  have  an  unintended  impact  on  repo  market  capacity.    Haircuts  for  government 
euro bond or UK gilt repos currently range from 0.5% to 2%, depending on the term 
of the repo.  The scale of mandatory haircuts are far from being determined, although 
we  note  that  the  current  FSB  proposals  have  haircuts  dependent  on,  and  increasing 
with, the maturity of the collateral securities. This may have particular consequences 
for  PSAs:  we  have  already  noted  that  these  generally  have  significant  holdings  in 
longer-dated government securities and these are likely candidates for repo collateral.   

At  the  time  of  writing  it  is  not  possible  to  predict  the  quantitative  impact  of  these 
regulatory changes since the regulations are not yet finalised and therefore the banks’ 
response  is  not  predictable.    However,  it  is  likely  that  the  volume  of  repos  done 
bilaterally between banks and investing institutions will reduce.  A part of the current 
bilateral  repo  volume  involves  a  bank  executing  back-to-back  repos  between  two 
clients  in  order  to  transfer  cash  to  one  and  collateral  securities  to  the  other  –  e.g. 
between  a  corporate  treasurer  and  an investing  institution.    It  is  possible  that, if the 
bank  decided  not  to  continue  with  this  type  of  business,  at  least  some  of  it  could 
evolve into direct secured lending between the two buy-side parties as discussed later 
in section 6.9.  

Obtaining sufficient repo lines to PSAs 

One major issue for PSAs is that the provision of repo is not guaranteed.  Banks are 
increasingly  reluctant  to  provide  long-term  and  large  size  commitments.  This  is 
because  the  commitment  would  still  consume  balance  sheet  and  regulatory  capital 
even  if  the  line  is  not  drawn  upon.  The  view  from  the  market  is  that  it  might  be 
possible for some large PSA clients to obtain some level of commitment, if it is part of 
a  suite  of  services  the  bank  provides  —  but  even  this  would  only  be  at  a  price  that 
covers the associated balance sheet charges. 

If a bank decides to reduce the resources it is willing to allocate to repo business it is 
likely  that  the  offer  of  repo  lines  would  be  prioritised  to  their  larger  clients  who  buy 
other  services  from  the  bank,  hence  there  is  a  risk  that  smaller  clients  will  not  have 
the  option  to  raise  secured  long  dated  cash  through  repo  to  fund  their  VM 
requirements. 

Counterparty credit risk 

As discussed in section 5.7.3, the principal counterparty credit risk of a repo is largely 
covered  by  the  fact  that  all  repos  are  fully  collateralised.  Remaining  counterparty 
credit  risk  can  be  mitigated  by  using  a  wider  range  of  counterparties  for  repo  or  by 
using  cleared  repo  arrangements.    The  latter  are  currently  offered  by  LCH.Clearnet 
and Eurex.  

Such cleared repo arrangements are not currently open to PSAs directly. LCH.Clearnet 
has  not  yet  finalised    any  plans  to  change  that  but  Eurex  is  actively  working  on  a 
service designed to address the PSAs need to use securities in order to meet the cash 
VM calls required by Eurex Clearing. 

42  Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos – FSB – August 2013 - 

http://www.financialstabilityboard.org/publications/r_130829b.pdf 

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Our  understanding  is  that  the  Eurex  scheme  would,  if  it  comes  to  fruition,  allow  a 
limited  range  of  buy  and  hold  investors  (which  would  include  PSAs  and  insurance 
companies)  to  be  accepted  as  principals  in  its  GC  Pooling  cleared  repo  service.  PSAs 
would  execute  repos  through  the  service  and  the  cash  raised  by  the  repo  could  be 
posted to the CCP to meet VM calls.  The repos themselves would be cleared through 
the  CCP  and  therefore  the  PSA  would  face  the  counterparty  credit  risk  of  the  Eurex 
CCP.  Adding another class of clearing participant raises the question of what default 
fund  would  be  used  by  the  CCP  in  the,  albeit  unlikely,  event  of  the  default  of  a  PSA 
participant  and  how  it  would  be  funded  —  the  trust  document  of  many  PSAs  may 
prohibit direct contributions into a default fund. Whether the cost of the service would 
be acceptable to PSAs is also an open question. 

Cleared  repo  in  general,  is  expected  to  be  more  expensive  than  bilateral  repo. 
Whether that will be the case in future will depend on whether the cost that the banks 
put  on  the  balance  sheet  capacity  which  would  be  consumed  by  bilateral  repo  would 
be  less  than  the  transaction,  margin  and  operations  costs  if  the  repo  was  cleared.  
This is not yet evident. 

Matching the maturity of a repo with the duration of the VM 

Repo  solutions  currently  cannot  match  the  maturity  of  the  repo  with  the  possible 
duration of the VM. Most cleared OTC derivatives contracts are very long dated while 
repo  transactions  at  the  extreme  go  out  for  one  year  (perhaps  two  years 
exceptionally),  which  means  there  will  be  continual  and  significant  roll  risk  and 
associated transactional costs. 

Range of securities that would be accepted 

Only  high  grade  securities  would  be  acceptable  for  such  repo,  such  as  government 
debt  and  supranational  paper.  There  could  be  shortages  of  these  during  stressed 
market conditions. 

Ensuring liquidity provision in both good and distressed markets 

This VM funding requirement needed by PSAs would grow significantly if interest rates 
rise rapidly (when, due to the directional nature of their hedging, most PSAs would be 
pushed  out  of  the  money).    This  sudden  demand  for  repo  services  could  impose 
prohibitive  costs  or  even  overwhelm  the  market  completely  (i.e.  demand  would 
exceed supply).   

The latter instance would, of course, mean that margin calls could not be met if repo 
were  the  only  source  of  funding  available  to  PSAs  at  the  time.    In  the  case  of  a 
bilateral  OTC  contract  the  counterparty  could  choose  to  postpone  a  VM  payment  and 
absorb the risk or cover the risk in some other way.  This discretion is not open to a 
CCP in the case of clearing OTC derivatives.  If a PSA failed to raise the cash required 
to meet a VM call for a cleared contract and its CM was not able to provide emergency 
funding (either from its own resources or, in extremis, from its central bank) to fill the 
gap  the  CM  would  be  called  into  default  by  the  CCP  and  all  its  positions  –  not  only 
those of the PSA in question – would be taken over by the CCP.   

A  single  PSA  getting  into  such  difficulties  would  be  unlikely  to  bring  down  a  CM. 
However,  our  view  is  that  the  repo  market  would  not  be  able  to  cope  with  the 
aggregate  demand  from  PSAs  seeking  to  fund  in  full  cash  VM  calls  due  to  a  severe 
interest rate movement (say 100bps) and PSAs would, as a result, not have access to 
funding  needed  to  meet  VM  calls  if  they  all  chose  to  rely  on  the  repo  market,  whilst 
remaining  fully  invested.    Potentially  (as  suggested  above)  this  could  lead  to  the 
default  of  the  PSA’s  CM,  and  consequently  this  is  a  source  of  systemic  risk.    It  also 
means that the PSAs need to seek other ways to manage this contingent liquidity risk. 

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There  is  also  an  operational  dimension.    A  period  of  volatile  interest  rates  would 
probably mean that the rollover period would significantly reduce (even down to daily) 
as  liquidity  in  all  but  the  shortest  term  repo  markets  dry  up.  There  may  also  be 
changes to the type of collateral accepted for repo (i.e. a move to even higher quality 
assets)  and  the  size  of  haircuts  would  increase.  All  of  this  would  mean  PSAs, 
investment  managers,  custodians  and  CMs  exchanging  a  large  number  of  securities 
and  large  amounts  of  cash  each  day.  The  infrastructure  and  operations  of  these 
entities is built around normal levels of transaction numbers. The system currently has 
low  levels  of  straight-through  processing  (STP)  and  relies  on  staff  managing  the 
workload  and  not  making  mistakes  —  this  means  it  may  lack  the  flexibility  to  cope 
with such stressed events. This translates through to a potentially significant increase 
in operational risk. 

Ensuring  the  return  of  assets  to  PSAs  that  meet  the  same  characteristics  as 
those posted 

Depending on the type  of  repo and agreements in place, there is a challenge around 
the re-use of the collateral. 

If PSAs provide bonds for repo purposes, the cash provider can re-use them so there 
is a risk that the PSAs may not get back from the lender the same securities that they 
sold.  There could be a shortage of the particular securities in the market at the time 
that they need to be returned, for instance.  This could be obviated by having the repo 
agreement  disallow  the  reuse  of  the  securities.  However,  not  allowing  re-use  would 
impact the price of the repo and the availability of repo capacity. 

6.4  Collateral transformation by CCPs 

6.4.1 

Description of the solution 

In this solution, instead of providing a CCP with cash to meet a VM call, the CM of the 
PSA would provide the CCP with high quality assets such as government bonds.  The 
CCP would then use these assets to enter into a repo transaction with either: 

a) a central bank; or 

b) the marketplace, i.e. the commercial banks; or 

c)  the  marketplace,  with  the  central  bank  providing  liquidity  in  times  of  stress  -in 

order to generate the necessary cash to post as VM. 

Figure 6.4: Collateral transformation by CCPs 

The CCP arranging a repo with a sell-side bank would have many of the characteristics 
of  the  collateral  transformation  by  CMs  solution.    If  the  repo  transaction  were  done 
with a central bank there would be some differences, however.  

The big advantage of the CCP being able to repo securities with a central bank would 
be  that  the  bank  has  the  ability  to  create  liquidity  and  the  CCP  could  therefore  have 

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confidence that liquidity would be available in adverse market conditions.  They could 
not  have  the  same  confidence  if  they  were  only  able  to  do  repos  with  commercial 
banks.  

It  is  unlikely  that  an  arrangement  in  which  the  central  bank  is  the  only  provider  of 
liquidity  for  repo  would  be  acceptable  to  a  central  bank  therefore  this  discussion 
assumes a solution whereby the CCP expects to use the commercial banks in ‘normal’ 
conditions and only uses the central bank in adverse market scenarios. 

The  key  consideration  then  is  whether  central  banks  will  be  prepared  to  offer  such  a 
service  to  the  CCPs  in  their  jurisdiction.    Currently  most  CCPs  do  not  have  routine 
access to central banks. Eurex and LCH.Clearnet SA are the main European exceptions 
with  special  banking  licences,  although  these  only  have  access  to  intra-day  credit 
which  is  not  suitable  for  the  repo  transactions.  For  repo  they  would  need  at  least 
overnight facilities. 

It is now clear that at least some central banks are planning to provide such facilities.  
The  Bank  of  England  Governor,  Mark  Carney  made  a  speech  in  June  201443  in  which 
he said: 

“We  all  know  that  real  markets  can  seize  up  in  crises  of  confidence,  threatening 
financial  stability  and  the  wider  economy.    Just  as  there  will  be  times  when  central 
banks  must  backstop  the  banking  system,  there  are  also  times  when  they  should 
backstop  core  markets  in  a  way  that  supports  their  contribution  to  the  real  economy 
but doesn’t encourage  excessive  risk taking. That …… is  why I  can announce that, in 
the  coming  year,  the  Bank  will  widen  access  to  our  facilities  to  include  the  largest 
broker-dealers  regulated  in  the  UK  and  to  those  central  counterparties  authorised  to 
operate in UK markets.” 

This  follows  a  speech  in  October  201344  where  he  said  that  the  bank  was  extending 
the range of collateral it accepted and the length of lending facilities it offered as well 
as reducing the cost of its facilities. 

Whilst the practical detail of these announcements is still to emerge we view them as 
very  significant  to  the  way  repo  markets  in  the  UK,  and  potentially  across  the  EU  if 
replicated by central banks elsewhere, will operate in the future.  It has the potential 
to  improve  liquidity  in  interbank  repo  markets  at  times  of  stress.    It  could  even,  at 
least in theory, provide a foundation for CCPs to offer repo, as a principal, directly to 
their participants.  Both would serve to reduce the risk of PSAs not being able to raise 
cash for variation margin when markets are stressed. 

However,  despite  these  developments  there  is  still  a  question  as  to  whether  CCPs 
could  be  equipped  to  offer  such  a  service  or  would  even  want  to.    When  we 
interviewed CCPs during this study, albeit before the Bank of England announcements 
were  made,  they  all  indicated  that  they  had  very  significant  reservations  about 
providing such a service, with the view that it would add to their risk profile (perhaps 
to an unacceptable degree).  Reasons cited were: 

(cid:131)  The competence of the CCP to become a repo market principal. They do not have, 
and may not wish to invest in, the necessary trading and treasury management 
capability (i.e. CMs and banks are best placed to offer such a service, as indeed they 
do now). 

43  Mark Carney: Speech at Lord Mayor’s Banquet, London, 12th June 2014 –  

http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech736.pdf 

44  Mark Carney: Speech as part of the Financial Times 125th anniversary celebrations, London, 24th October 2013 - 

http://www.bankofengland.co.uk/publications/Pages/speeches/2013/690.aspx 

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(cid:131)  The extra concentration of risk in the system that would be created by such 

arrangements. 

(cid:131)  The offering of such a service would put the CCP in direct competition with one of 

the business lines of its membership. 

That  said,  several  CCPs  interviewed  indicated  that,  if  another  CCP  offered  such  a 
service  and  did  it  well  then  they  would  be  forced  to  respond  due  the  competitive 
advantage conferred on the first CCP to offer this service.  

These reservations were shared by other participants.   The primary concern was the 
potentially  destabilising  effect  during  the  default  of  a  CCP  participant  of  the  CCP 
having  to  unwind  repo  transactions,  in  which  it  was  a  principal,  at  the  same  time  as 
liquidating or transferring the defaulter’s OTC derivatives contract portfolio.  Currently 
CMs  have  confidence  that  they  understand  the  CCP’s  default  procedures  and  risk 
management  policies  sufficiently  to  understand  the  potential  impact  on  the  CCP  of  a 
default and to assess the counterparty risk of the CCP.  The need to unwind a portion 
of the repo book in which the CCP was itself a principal would add a further dimension 
to this assessment.  It would increase the counterparty risk and naturally there would 
be uncertainty about how large the increase in risk would be. 

Overall  the  reaction  of  the  CMs  to  this  solution  ranged  from  lukewarm  to  complete 
rejection  of  the  concept  (including  giving  up  membership  of  a  CCP  if  it  tried  to  offer 
this service). On the other hand, if such a service existed, at least some CMs indicated 
that they would consider using it, especially if their clients wished them to, provided it 
was clear that the CCP had properly covered the increased risks. 

Even though CCPs may choose not to offer repos as a principal to participants it does 
not mean that CCPs can do nothing to improve the functioning of the repo market. As 
mentioned in section 6.3.4, Eurex is looking to enhance its existing GC Pooling service 
(in which it acts as service provider) to allow PSAs to act as principals in it, reducing 
the counterparty risk that would result from increased repo activity.  

Other CCPs are also looking at assisting the repo market and are at different stages of 
planning but, again, only on a service provider basis. LCH.Clearnet’s RepoClear service 
does not currently offer client clearing45 however Michael Davie, CEO of LCH.Clearnet, 
speaking in May 2014, discussed the possibility of giving PSAs direct access to its repo 
clearing service and said that LCH.Clearnet was discussing with the industry how this 
could work in practice. 

6.4.2 

Benefits of the solution 

The fundamental assumption of this solution is that the CCP’s central bank would offer 
liquidity in times of stress.  Consequently the main risk of the changes being imposed 
by EMIR, as perceived by PSAs (liquidity risk), would be eliminated. 

6.4.3 

Costs of the solution 

Due  to  the  minimal  amount  of  work  undertaken  by  CCPs,  CBs  and  others  on  this 
solution  it  is  difficult  to  quantify  the  costs.  If  the  CCPs  undertook  this  role  as  a  cost 
recovery  service  to  the  industry  then  it  could  potentially  be  cheaper  than  collateral 
transformation  by  CMs,  but  there  really  is  not  enough  information  available  at  this 
stage to determine that. 

45  LCH.Clearnet’s  SwapClear  service  does  offer  client  clearing,  but  the  two  services  have  separate  sets  of  rules  and  rule  changes 

involve consultation with the respective groups of current users. 

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6.4.4 

Risks of the solution 

The following are the key risks and issues impacting on this solution. 

Change in the risk profile of CCPs 

In  order  to  offer  such  services,  CCPs  would  have  to  develop  new  management, 
operational  and  risk  management  capabilities  which  they  do  not  currently  have.  
Default  procedures  would  have  to  change  significantly  and  they  would  need  to  take 
into consideration the VM funding side of clearing in addition to the current risks they 
manage.  This means that they would be increasing their risk profile and become even 
more systemically critical than they currently are. Such an increase in their risk profile 
is  likely  to  be  a  major  concern  to  regulators.  Any  such  change  in  default  procedures 
would be subject to regulatory approval, which may well not be given.   

The actual access CCPs have to central bank repo facilities in order to ensure 
liquidity in both good and distressed markets 

Currently no CCPs have such access. As mentioned above, two have intra-day liquidity 
facilities  but  we  are  not  aware  of  any  more  extensive  arrangements  being  discussed 
between  central  banks  and  CCPs.  The  key  to  making  this  solution  work  would  be  to 
ensure that the CCP has unrestricted access to liquidity against high quality collateral, 
as large volumes of VM cash may need to be available at times of market stress when 
interest rate volatility may be high. 

If  a  central  bank  were  to  provide  a  CCP  with  an  unlimited  liquidity  facility  it  is  likely 
that the terms and limitations of access to the CCP services which were supported by 
the facility would need to be very specifically and narrowly drawn – e.g. restricted to 
the  funding  of  VM  related  to  client  clearing  of  relatively  low-risk  investors,  such  as 
PSAs. 

However,  in  a  distressed  market  situation,  PSAs  may  prefer  to  obtain  funding  from 
their  existing  (non-CCP)  counterparties,  who  could  assess  them  on  their  commercial 
value and specific credit risk, meaning that they might access the necessary liquidity 
at more competitive prices than with a CCP where all clients are treated equally. 

Also, in times of market stress, it is likely that the average repo term available would 
shorten significantly. This would put greater demands on all the players in the system 
- PSAs, investment managers, CMs, CCPs and the central banks. 

Matching the maturity of a repo with the duration of the VM 

If such a solution was adopted then it could benefit from long term repo facilities being 
provided  by  the  CCP  but  would,  of  course,  increase  the  risk  to  the  CCP  if 
corresponding terms could not be sourced on the other side. Such long term facilities 
are not a feature of the existing repo market. 

Range of securities that would be accepted 

In  order  for  this  solution  to  operate  it  would,  as  for  collateral  transformation  by  CMs 
described  above,  be  essential  for  PSAs  to  have  enough  high  quality  assets 
(government  debt  or  supranational  paper)  to  be  used  for  such  a  repo  service.  As 
indicated  above,  there  probably  is  enough  high  quality  collateral  available  generally 
and our fieldwork suggests that PSAs are holding significant quantities of high quality 
collateral.  

The  CCP  would  be  likely  to  specify  a  general  collateral46  basket  of  securities  any 
mixture of which would be eligible as collateral for such a service as this.  This would 

46  General collateral or GC is the range of assets that are accepted, at any particular moment, as collateral in the repo market by 

the majority of market intermediaries and at a very similar repo rate. 

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mirror the collateralisation approach of central banks when providing liquidity to credit 
institutions. 

Ensuring  the  return  of  assets  to  PSAs  that  meet  the  same  characteristics  as 
those posted 

A  consequence  of  a  collateral  pooling  approach  would  be  that  PSAs  would  not  be 
guaranteed  to  receive  back  the  exact  securities  they  originally  posted.  The 
acceptability  to  PSAs  of  this  would  depend  on  the  collateral  basket  specified  by  the 
CCP and the investment and asset management policies of the PSA. However, the loss 
of control over assets could be an issue in some Member States.  For example, under 
Danish  regulations  pension  funds  must  keep  an  asset  register,  and  therefore  require 
the exact assets put up for VM to be returned to them.   

The acceptance by central banks of unlimited amounts of repo exposure over 
long periods at a fixed price 

A difference between this solution and collateral transformation by CMs is that it would 
involve  the  central  banks  potentially  providing  funding  for  the  duration  of  a  market 
disruption for a specific part of the financial market community. There is precedent for 
this,  as  such  long  term  funding  by  central  banks  to  commercial  banks  was  crucial  to 
the  efforts  to  resolve  the  recent  financial  crisis.    However,  if  a  central  bank-backed 
repo  service  was  only  offered  to  PSAs  there  could  be  opposition  from  other  financial 
market participants (or the request for an extension of such facilities to themselves). 
Also,  the  provision  of  such  funding  does  not  come  without  cost  to  the  central  banks, 
and such support would probably be construed as a subsidy from the tax-payer to the 
PSAs. This could make it politically difficult to implement.  

Differential access of CCPs to central bank liquidity 

The  provision  of  central  bank  liquidity  to  PSAs  would,  in  itself,  be  unprecedented.  
Also,  there  is  a  very  real  risk  that  this  arrangement  could  give  rise  to  competitive 
distortions  in  the  market  unless  all  relevant  CCPs  had  similar  access  to  central  bank 
liquidity resources.  If only one or a few of the CCPs could provide such a solution, it 
would distort the market, potentially disadvantaging other CCPs. 

6.5  Direct  acceptance  of  non-cash  assets  with  pass  through  to 

receivers of VM  

6.5.1 

Description of solution 

The  fundamental  proposition  of  this  solution  would  be  that  CCPs  would  allow 
participants  to  post  and  receive  variation  margin  in  either  cash  or  securities.    Our 
working assumption is that the securities which the CCP deemed eligible to be used for 
this  purpose  would  be  government  bonds  with  high  credit  ratings.    A  PSA  which  had 
elected  to  pay  and  receive  VM  in  securities  would,  on  being  notified  of  a  variation 
margin  call  by  the  CCP  via  its  clearing  member,  instruct  its  custodian  to  transfer 
securities  to  the  value  required  by  the  CCP  into  the  name  of  the  CCP.    When  a  PSA 
which  had  elected  to  pay  and  receive  in  securities  was  due  to  receive  VM  the  CCP 
would  be  instructed  by  the  CM  to  transfer  securities  into  the  name  of  the  PSA  at  its 
custodian.  The basic flow would therefore be as shown in the following diagram: 

Figure 6.5: Direct acceptance of non-cash assets 

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There are two potential variants on this basic concept: 

a) The  securities  could  be  passed  through  to  the  VM  receiver  with  the  right  for  the 

receiver to reuse the securities and hence to be able to realise their value. 

b) The  securities  could  be  passed  to  the  receiver  with  a  contractual  requirement  to 
return  them  should  the  receiver  become  a  payer  of  VM,  so  that  they  can  be 
returned  to  the  PSA  that  originally  posted  them  if  and  when  the  original  poster 
became a receiver of VM.  The legal form of this could be as title transfer to the VM 
receiver  or as a pledge which would be in place until the expiry  of the contract or 
some predetermined earlier date at which time a title transfer would be triggered. 

Consequences of uncertainty over collateral form 

Under  existing  bilateral  CSAs  it  is  common  for  the  parties  to  be  able  to  pay  VM  in 
either  cash  or  securities  but  the  industry  has  increasingly  recognised  that  the 
valuation of the swap has to be related to the nature of the collateral and that, if there 
is  uncertainty  about  the  collateral  which  will  be  received,  there  will  be  uncertainty 
about the valuation of the swap. 

In  the  case  of  bilaterally  settled  contracts  there  is  the  possibility  for  the  parties  to 
negotiate how the swap should be valued in order to take account of the variability of 
collateral allowed under the CSA.  In a multilateral clearing situation, where, once the 
trade has been novated, the direct connection between the trading parties is broken, 
there is no possibility for this type of negotiation and the valuation method has to be 
standardised. 

Even  for  bilaterally  settled  contracts  there  has  been  a  significant  move  towards 
reducing  valuation  uncertainty  with  the  introduction  in  June  2013  of  the  ISDA 
Standard Credit Support Annex (SCSA)47 in which only cash, in the same currency as 
the swap, is eligible for VM.  Whilst the original ISDA CSA can still be used the SCSA is 
a demonstration of the direction in which the industry is moving. 

We  conclude,  therefore,  that  the  market  would  not  accept  a  cleared  contract  where 
the form in which VM was to be received was uncertain and a contract in which non-
cash  VM  was  the  only  option  would  also  be  unacceptable  to  a  large  portion  of  the 
market.  Consequently, for this solution to be acceptable to the market, a CCP would 
have  to  offer  for  clearing  two  parallel  sets  of  products  with  the  same  fundamental 
economic terms – one for which VM would be paid and received in cash and the other 
for  which  it  would  be  posted  and  received  in  specified  eligible  securities.    This  is  for 
the following reasons: 

(cid:131)  Most counterparties require cash collateral to contribute to the funding of the swap 

and related hedges. 

(cid:131)  If the parties to the swap were uncertain whether they would receive cash or 

securities as VM it would mean that the valuation of the swap would be less certain 
and the spread for the product would widen.  This is discussed further in section 
6.6. 

(cid:131)  It is not feasible in a multilateral clearing service for the CCP to offer a product 

which allows participants the option of choosing the form in which they post and 
receive VM.  This is also discussed further in 6.6. 

There would be a significant difference in the conceptual basis of VM between the cash 
and non-cash VM products.  VM payments and receipts for the cash products would be 
treated as a settlement and the receiver would be able to use the cash as it saw fit – 

47  http://www.fpml.org/wgroup/scsawg/First-Draft-Annotated-SCSA.pdf  

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conceptually  similar  to  the  way  VM  is  treated  in  futures  markets  and  in  current  OTC 
clearing  services.    Securities  received  as  VM  for  the  non-cash  products  would  be 
considered as collateral which the receiver had a duty to preserve and return over the 
course  of  the  contract  –  conceptually  similar  to  the  way  VM  is  treated  for  bilaterally 
settled OTC derivatives contracts. 

In order to reduce pricing uncertainty, the specifications of cleared contracts with non-
cash VM would need to allow a much narrower range of acceptable collateral than that 
currently seen with OTC CSAs.  This would reduce market liquidity. 

Securities posted as VM would not be subject to a haircut.  If a haircut were applied it 
would protect the receiver of VM against a fall in the value of the securities during the 
settlement  cycle  but  it  would  be  a  consistent  additional  cost  to  payers  of  VM  and 
windfall  income  to  the  VM  receiver  in  the  event  that  the  market  price  did  not  fall 
during settlement or, indeed, rose. 

6.5.2 

Benefits of the solution 

This  solution  is  attractive  prima  facie  because  it  would  allow  securities  held  in  the 
PSA’s  investment  portfolio  to  be  posted  as  VM  without  them  having  to  be  liquidated 
and  the  PSA  thereby  losing  investment  return.    Unlike  the  solutions  described  in  6.3 
and  6.4,  it  does  not  rely  on  cash  liquidity  being  available  from  other  parties  and 
therefore would be more robust during stressed markets, when liquidity may be tight. 

6.5.3 

Costs of the solution 

The  consequences  of  the  CCP  offering  parallel  sets  of  cash  and  non-cash  contracts 
would be: 

(cid:131)  Separate market prices for the parallel sets of cash and non-cash contracts to 

reflect: 

− 

− 

− 

− 

the impact on counterparty bank’s swap funding of the different collateral; 

the different reference rates used for valuing the swaps; 

the lower liquidity of securities compared to cash; and 

the credit risk of the securities and the uncertainty in assessing the risk for 
receivers of VM, since they cannot predict exactly what security they will 
receive. 

(cid:131)  Less liquidity in each contract with the probability of wider trading spreads. 

(cid:131)  Less flexibility in porting or liquidating the positions of a defaulting participant. 

Operational costs related specifically to the use of securities for VM would be: 

(cid:131)  The costs of modifications to CCP, CM, Custodian, asset manager and PSA systems. 

Systems would need functionality added to do the following: 

−  The CCP’s system would, in the case of variation (b) described in section 6.5.1 
need to maintain a trace of the specific securities received as VM, the CM they 
were received from and the CM they were paid out to. 

−  The CM’s, PSA’s and custodian’s systems would, in the case of variation (b) 
have to record securities received as VM in a segregated way so that those 
same securities can be used to satisfy future repayments of VM. 

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−  On expiry of a contract the CCP’s, CM’s, PSA’s and custodian’s systems would 
have to record the fact that securities received as VM against the expiring 
contract no longer need to be held against possible VM repayment. 

−  The CCP’s, CM’s and PSA’s systems would have to account for differences 

between the value of the securities posted and the VM value called for and to 
process the settlement of  the differences in cash. 

−  The CCP’s, CM’s and PSA’s systems would have to account for income earned 
on the securities posted and received as VM.  In the case of variant (b), if the 
securities were received under pledge the income would have to be paid to the 
originator of the securities, via the CCP and respective CMs. 

These would run into many millions of euros for the industry as a whole.   

(cid:131)  Direct custodian and Central Securities Depositary (CSD) fees related to movements 

of securities to and from the CCP. 

(cid:131)  Increased back office staff costs for asset managers, CMs and CCPs to handle the 

additional operational complexity. 

(cid:131)  A level of over-collateralisation created by participants wanting to reduce the 

number of securities movements and therefore leaving collateral with the CCP until 
a headroom threshold has been attained.  This would be a particular concern in the 
case of some CCPs such as CME Clearing where excess collateral is included in the 
default waterfall.  Currently there is no concept of excess VM under current clearing 
models and this would therefore require further legal work on segregation and 
default rules. 

6.5.4 

Risks of the solution 

Acceptability to in-the-money counterparties of VM paid in non-cash assets 

For the reasons discussed in 6.5.1 above we would expect that choice over the form of 
collateral  posted  and  received  would  be  provided  by  having  two  distinct  contracts 
forms available for trading.  Therefore non-cash VM would be acceptable to the in-the-
money  counterparty  since  they  had  chosen  to  trade  a  specifically  non-cash  VM 
contract. 

However, this solution has a number of serious disadvantages: 

(cid:131)  A two tiered market would make trade reporting confusing as prices would be 
weighted in some cases by the VM terms and therefore create noise in market 
transparency. 

(cid:131)  It would result in a divergence of pricing between the cash and non-cash VM 
contracts which in turn would lead to the non-cash contract being used by a 
minority of market participants and therefore having low liquidity. 

(cid:131)  Since there would almost certainly be a range of securities eligible for VM it would 

be difficult to value the non-cash VM swap. 

(cid:131)  It would be operationally complex and create practical difficulties due to the short 
term nature of VM – both the need to meet VM obligations at short notice and the 
two-way variability of VM. 

(cid:131)  Passing securities through to the receiver of VM would not meet some PSAs’ 

requirement to keep control of their assets.   

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Our view is that these issues are so serious that it would make the solution unusable 
by  the  majority  of  the  market.    This  view  was  borne  out  by  our  fieldwork.    All  the 
clearing members and CCPs which commented on this solution were negative to it. Of 
the PSA fund managers interviewed all the UK firms said that they had concerns that 
their fiduciary duty to  maintain control of the  assets would be difficult to satisfy with 
this solution.  Some Dutch firms, however, said that they would prefer to pass bonds 
as VM. 

Scope for the return of assets to PSAs that meet the same characteristics as 
those posted  

Initial margin will be returned to participants by the CCP at the expiry of the contract 
to  which  the  IM  relates.    Variation  Margin,  however,  has  different  characteristics.    It 
reflects  the  increase  or  decrease  in  the  value  of  the  contract  since  trade  date  and  is 
payable  or  receivable  each  day  depending  on  the  contract’s  value  on  that  day,  the 
extent to which the contract is in or out of the money compared to its initial value and 
the aggregate amount of VM paid or received to date.  VM will not be repaid on expiry 
of  the  contract  as  it  is  a  settlement  payment,  although  a  counterparty  which  has 
received VM in relation to a particular contract may, at any point during the life of the 
contract find that it has to pay VM because the contract’s value moves against it. 

A PSA therefore could not expect to have returned to it all the VM it posted against a 
particular  swap.    We  can,  however,  examine  whether  it  would  be  possible,  as  and 
when VM is repaid, for it to be in the securities originally posted.  In order to achieve 
this,  the  cleared  contract  would  need  to  be  similar  to  variant  (b),  outlined  in  6.5.1 
above.  This has some important differences to variant (a): 

(cid:131)  A receiver of VM would be required to hold on to the collateral so that it could be 

returned in the event that the receiver becomes a payer of VM.  The receiver would 
therefore not be able to use the VM to fund the swap. 

(cid:131)  If a receiver of VM was later required to pay VM the volume of securities required to 
cover the VM call would be calculated at the price of the securities on the call date.  
This means that, even if the original VM payer received back the same securities it 
could have effectively made a gain or loss on them because of the difference in the 
market price of the securities when it paid VM to the price when it received VM. 

(cid:131)  In order for the trace between VM payer and receiver to be maintained as far as 

possible the VM payments calculated by the CCP for a particular participant would 
have to be made gross to and from the CCP rather than inward payments being 
netted with receipts as would be conventional for cash VM derivatives.  

If  it  was  acceptable  to  PSAs  to  receive  back  VM  securities  “with  the  same 
characteristics”  as  those  it  originally  posted  rather  than  the  exact  same  securities 
variant (a) described in 6.5.1 could go some way to satisfying the requirement.  The 
CCP  would  specify  a  general  collateral  basket  of  securities  any  of  which  would  be 
eligible  to  be  posted  as  VM.  This  would  involve  consultation  with  PSAs  and  their 
counterparties 
to  determine  a  group  of  securities  with  sufficiently  similar 
characteristics that the PSAs would be comfortable posting and receiving any of them 
without  the  variability  of  collateral  having  an  impact  on  the  valuation  of  the  swap.  
There  is,  of  course  the  possibility  that  PSAs  would  not  be  able  to  agree  or  that  they 
agreed  on  such  a  narrow  set  of  securities  that  the  bundle  would  not  meet  the  CCP’s 
liquidity risk or concentration risk policies. 

Our  understanding  is  that  no  CCP  currently  has  the  systems  capable  of  managing 
securities collateral used for a VM arrangement in which it is paid out to in-the-money 
counterparties.    Indeed,  we  have  no  evidence  that  they  have  put  much  thought  into 

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the  cost  of  developing  such  systems.    However,  we  have  set  out  some  of  the 
additional functionality which we consider would be required in section 6.5.3 

Measurement and monitoring of the value of non-cash assets by CCPs 

The  type  of  non-cash  assets  which  CCPs  would  accept  as  collateral  is  likely  to  be 
highly rated and liquid government bonds for which real time prices are available.  It 
is  quite  possible  that  this  would  be  a  subset  of  the  securities  eligible  as  collateral 
under  existing  CSAs  precisely  because  the  CCP  needs  to  be  confident  in  the  liquidity 
and valuation of the collateral. 

The CCP should, therefore, be able to maintain a real time view of the current value of 
the collateral it is passing to and from participants (the CCP would already have to do 
this because it would hold similar securities as IM). 

Operational issues 

Participants posting non-cash VM would have to be able to transfer the securities into 
the  name  of  the  CCP  on  the  same  day  as  the  collateral  call  is  made.    However,  this 
would  be  difficult  to  achieve  in  practice  since  most  CSD  settlement  systems  work  on 
too  long  a  settlement  cycle.    If  the  PSA  were  to  hold  its  securities  with  a  custodian 
with which the CCP also has an account the transfer could then be internalised within 
the  custodian  and  not  be  subject  to  the  settlement  timetables  of  external  CSDs,  but 
PSAs may not want to choose their custodians on this basis. However, they may need 
to for this model to work. 

One further difficulty is that securities can only be exchanged in transferable units.  In 
the  case  of  bonds  these  units  can  be  quite  large.    Since  the  VM  amounts  payable  or 
receivable will be calculated by the CCP in monetary values the CCP would need to set 
a  market  convention  for  how  these  values  are  to  be  converted  into  the  deliverable 
quantity  of  whatever  security  the  VM  payer  chooses  to  post.    This  would  inevitably 
result  in  rounding  differences  which,  depending  on  the  securities  involved,  could  be 
considerable.  

These  rounding  differences  would  have  to  be  accounted  for  and  cash  adjustments 
made  between  the  CCP  and  the  clearing  members  and  would  need  to  be  covered  by 
changes to the CCP’s rules.  

If  the  solution  conformed  to  variant  (b),  outlined  in  section  6.5.1  above,  and  the 
securities  were  moved  to  the  VM  receiver  under  a  pledge,  any  interest  payments 
received  on  the  securities  would  be  due  to  the  beneficial  owner,  i.e.  the  original  VM 
poster,  under  current  conventions  relating  to  pledged  collateral.    This  would  cause 
considerable operational complications: 

(cid:131)  Firstly the CCP would have to monitor coupon events on all the securities eligible for 

VM and demand payments from VM receivers and pay it out to VM posters on 
coupon dates. 

(cid:131)  Secondly it would distort the economic impact of the contract since interest would 
be paid to the original VM poster and yet the securities may never be returned. 

The  question  of  how  coupon  payments  would  be  treated  under  this  solution  would 
therefore need legal determination in order for the idea to be developed further. 

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6.6  Acceptance  of  non-cash  assets  with  security  interest  passed 

through to receivers of VM  

6.6.1 

Description of solution 

In this solution the CCP would allow participants to post variation margin in securities.  
In  order  to  meet  a  variation  margin  call  the  PSA  would  instruct  its  custodian  to 
transfer  securities  to  the  account  of  the  CCP.    Unlike  the  solution  described  in  6.5 
above,  the  CCP,  instead  of  passing  on  the  securities  to  the  counterparties  due  to 
receive VM, would create a security interest over the posted securities, in favour of the 
VM receiver. 

Figure 6.6: Acceptance of securities with security interest passed through  

Since the receiver of VM only receives value for the security interest in the event of a 
default, this solution is less a way of managing VM, more a fundamental alternative to 
VM.  The overall purpose of a derivatives contract with daily mark to market and cash 
settlement  between  those  out  of  the  money  and  those  in  the  money  is  that  it  resets 
the risk between the participants and the CCP to that of the close-out risk in the event 
of default of one of the participants. The solution described here could, perhaps, better 
be described as a “variable IM” model in which out-of-the-money parties are required 
to post additional collateral on top  of the initial level of  IM but the  collateral remains 
within the CCP’s ambit in normal operation even though some of it is earmarked to in-
the-money  parties.    This  contract  form  is  not  unknown  but  it  does  have  a  different 
economic  content  to  the  current  norm  in  the  OTC  swaps  market.    As  mentioned 
earlier, the economic impact of a cash settled VM contract is to erase on a daily basis 
the  counterparty  exposure  arising  from  market  moves:  in  the  case  of  a  variable  IM 
contract,  a  security  interest  or  a  claim  on  a  security  would  not  erase  but  merely 
mitigate  the  counterparty  risk  of  the  daily  exposure  and  expose  the  receiver  to  the 
market  risk  and  credit risk  related  to  the  value  of  the  claim.  In  the  event  of  default, 
the recipient of the claim would be subject to a loss (or a gain) and to the uncertainty 
of the value of his claim until its liquidation. This additional risk borne would imply that 
contracts  in  which  VM  is  not  cash  settled  should  be  priced  differently  and  be  more 
expensive than regular cash settled ones. 

Many of the issues outlined in the discussion in section 6.5 above result from the fact 
that  the  value  of  the  securities  used  for  collateral  have  a  varying  relationship  to  the 
cash  flows  in  the  underlying  swap.    Those  issues  would  consequently  also  affect  this 
solution. We assume that a contract with security interest passed through would also 
have  to  be  offered  in  addition  to,  and  not  in  replacement  of,  a  parallel  contract  with 
cash VM. 

The securities posted by VM payers would be subject to a haircut, set by the CCP, to 
cover  the  market  risk  relating  to  the  securities  the  security  interest  held  for  the  VM 
receiver would be over the same volume of securities as was posted by the VM payer. 

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6.6.2 

Benefits of the solution 

Similarly to the model described in section 6.5, this solution is also attractive because 
it would allow securities held in the PSA’s investment portfolio to be used, in this case 
to  cover  the  variable  IM,  without  them  having  to  be  liquidated  and  the  PSA  thereby 
losing  investment  return.    Again,  unlike  the  solutions  described  in  sections  6.3  and 
6.4, it does not rely on cash liquidity being available from other parties and therefore 
would be more robust during stressed markets, when liquidity may be tight. 

6.6.3 

Costs of the solution  

Legal risk 

A  crucial  open  question  at  present  is  whether  the  security  interest  would  have  a 
consistent  legal  basis  across  the  EU.    The  complexities  and  differences  in  the  law  on 
security interests in the different member state jurisdictions would make the concept 
very  uncertain  in  a  default  situation,  which  is  exactly  when  it  needs  to  work 
predictably. 

One  CCP  said  that it  was  interested  in  the  concept  and  it  was  being investigated  but 
that  they  had  not  yet  addressed  the  legal  aspects  and  they  had  doubts  about  the 
solution working in practice. 

Overall,  the  great  majority  of  CMs  expressed  the  view  that  this  option  was  not 
feasible.  Two PSAs said that they would prefer this option as long as the assets were 
held at their custodian with the CCP having a charge over them - this would be similar 
to the quad-party model discussed in section 6.8 below.  One PSA fund manager said 
that,  if  technically  feasible,  this  would  be  their  preferred  option  but  recognised  the 
probability  that  the  market  would  be  bifurcated  (see  discussion  below),  with  two 
different swap prices, and the likelihood of over-collateralisation might also make this 
solution problematic. 

Counterparty  appetite  to  accept  a  cash  claim  on  the  CCP  instead  of  an 
immediate receipt of cash 

As  discussed  in  section  6.5,  our  view  is  that  many  market  participants  would  not 
accept a claim instead of actual cash since the cash collateral is an important element 
in  funding  the  swap.    As  far  as  this  solution  is  concerned  we  have  therefore  also 
concluded that, if a product with security interest as receivable VM were to be offered, 
it  would  have  to  be  in  addition  to,  not  replacing,  the  conventional  cash  VM  product.  
Hence  this  solution  would  have  many  of  the  same  consequences  as  that  involving 
securities pass through, such as: 

(cid:131)  Separate market prices for the parallel sets of cash VM and non-cash VM contracts. 

(cid:131)  Less liquidity in each contract with a possibility of wider trading spreads. 

(cid:131)  Less flexibility in porting or liquidating the positions of a defaulting participant. 

Operational costs 

PSAs would face custody and settlement costs related to the posting of VM securities 
to  the  CCP.    There  may  also  be  some  inefficiency  as  a  result  of  over-collateralisation 
created by posters of VM wanting to reduce the number of securities movements. 

CCP reuse of the posted securities 

Unlike  the  solution  in  described  in  section  6.5,  the  CCP  would  not  need  to  reuse  the 
posted  securities.  However,  it  would  need  to  be  able  to  create  a  charge  over  the 
securities  in  order  to  pass  on  the  security  interest  to  the  receiver  of  VM.    The 
securities posted by givers of VM would have to be unencumbered and the PSA would 

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have to allow a security interest, to the benefit of any receivers of VM the CCP should 
choose,  to  be  created  over  them.    Most  PSAs  have  rigorous  policies  to  ensure  that 
they maintain proper control of their assets, particularly when they outsource some of 
their responsibilities to fund managers and/or custodians.  This solution would require 
some  PSAs  to  alter  their  asset  management  policies  in  order  to  allow  a  security 
interest  to  be  created  over  assets  posted  as  VM.    It  would  also  require  CCPs  to  take 
new  powers  in  their  risk  management  and  treasury  policies  and  their  participation 
agreements.  We would expect these issues to be solvable. 

Application of ‘haircuts’ on the value of the collateral  

Haircuts on the securities posted by VM givers would be set by the CCP and the same 
haircuts would, in effect, be applied to the value of the security interest passed on to 
VM  receivers.    The  CCP  would  need  to  determine  the  haircut  by  taking  into  account 
the additional risks associated with dealing with securities collateral and the securities 
interest held by VM receivers in the event of default. 

The  respective  policy  of  the  CCP  would  be  published  to  participants  and  be  open  to 
scrutiny by its regulator. 

6.7  Quad-party collateral for VM security interest   

6.7.1 

Description of solution 

This solution is a variation on the one described in section 6.6.  It would allow the PSA 
to  use  securities  for  VM  without  transforming  them  into  cash,  the  collateral  being 
provided  in  the  form  of  a  securities  interest.    The  PSA  would  outsource  its  collateral 
management  to  a  custodian  in  an  arrangement  formalised  between  the  four  parties 
involved - the PSA, the CM, the CCP and the Custodian. 

Figure 6.7: Quad-party collateral for VM security interest 

The  PSA  would  transfer  securities  to  be  used  for  collateral  into  an  account  to  be 
controlled under the quad party agreement.  It would be a segregated account in the 
name  of  the  PSA.    On  receiving  a  VM  call  from  the  CCP  the  CM  would  instruct  the 
Custodian  to  move  the  required  value  of  securities  from  the  PSA’s  account  into  a 
collateral account in the name of the CCP.  The CCP would then allocate the collateral 
received  from  VM  payers  to  VM  receivers  by  recording  a  security  interest  over  the 
securities held to its name by the Custodian in favour of each VM receiver. 

The  solution  would  build  on  existing  tri-party  collateral  management  services  and 
would  be  similar  in  most  respects  to  quad-party  collateral  services  already  proposed 
by  some  custodians  to  meet  the  needs  some  buy-side  firms  have  for  segregation  of 
their assets from their service banks. 

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6.7.2 

Benefits of the solution 

This solution has similar benefits to the solutions described in sections 6.5 and 6.6 in 
not  requiring  PSAs  to  liquidate  securities  to  meet  VM  calls.  In  addition,  as  the 
collateral is not being passed to the CCP via the CM it would be possible for the CCP to 
obtain value against the security interest in the event of the default of the CM without 
it being delayed by the liquidator of the CM. 

6.7.3 

Costs of the solution  

Swap pricing 

The market costs of there being parallel sets of cash and non-cash contracts would be 
similar to those for solutions described in sections 6.5 and 6.6. 

Operational efficiency 

The solution could build on efficient existing tri-party collateral systems.  It would not 
involve  the  frequent  movement  of  securities  or  cash  between  systems  and  it  would 
lend  itself  to  STP  integration  with  the  CMs’  and  CCPs’  systems.    However,  we  would 
expect  the  current  collateral  management  systems  of  custodians  to  require  some 
development in order to provide a quad-party service. 

Costs of the solution 

There would be service charges - both annual charges and per transaction fees - to be 
borne by the PSA but it is difficult at this point to estimate what these would be. 

6.7.4 

Risks of the solution  

Many of the characteristics of the previous solution would also apply here: 

(cid:131)  It is a “variable IM” concept rather than a daily settled VM concept. 

(cid:131)  Counterparty credit risk against the CCP could build up significantly over the life of 

the contract. 

(cid:131)  It would probably result in a split market between a cash VM contract and a non-

cash contract. 

(cid:131)  The legal treatment of securities interests varies across the EU. 

(cid:131)  CCP-determined haircuts would apply. 

(cid:131)  The PSA trustees would have to agree to a certain portion of the portfolio being 

under the control of the quad-party arrangement. 

The general view of the firms interviewed was that, because the nature of the security 
interests  over  the  collateral  securities  is  complex,  this  solution  would  present  too 
many legal difficulties in a default situation. 

Discussion amongst participants of this option as a potential solution to the challenges 
of buy-side clearing seems to have diminished recently, having been largely overtaken 
by the individual segregation opportunities offered by CMs. 

6.8  Agency stock lending 

6.8.1 

Description of solution 

This  solution  is  not  a  way  of  posting  non-cash  collateral  but  another  form  of 
transformation in which a PSA raises the necessary cash for meeting VM calls.  Stock 

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lending  is  similar  to  repo  but,  in  this  case,  the  PSA  would  lend  securities  from  its 
portfolio (mediated by an agent) to other market players who actually have a need for 
that security (such as to meet a delivery obligation where they are short of the stock, 
due  to  operational  difficulties  or  deliberate  short  selling).  Collateral  is  taken  by  the 
PSA to ensure the return of the assets lent and, if this collateral is taken in the form of 
cash, that cash could be used for VM purposes. 

Although banks could arrange the stock loans, they would be acting as agents and the 
repos would, therefore, not be on their balance sheets. 

As  a  component  of  their  investment  strategy,  stock  lending is  already  used  by  many 
PSAs as a way of enhancing portfolio returns. However, as the ability to lend depends 
on the needs of other players to cover short trading positions and on the state of the 
market, stock lending cannot be viewed as a consistent source of funding and certainly 
not a complete solution to the problem. 

Figure 6.8: Agency stock lending 

A  PSA  could,  however,  adopt  a  strategy  of  being  more  active  in  the  stock  lending 
market and using any cash raised to reduce the amount that is needed to be raised by 
other means.  In this way it may be able to reduce the extra cash requirement which 
comes with mandatory clearing. 

6.8.2 

Benefits of the solution 

This solution is a continuation and enhancement of an existing common practice. PSAs 
are  very  familiar  with  it,  the  supporting  legal  agreements  are  mature  and  well 
understood and custodians have established infrastructure to support it. It, thus, does 
not  require  any  new  systems,  legal  work  or  operational  procedures.    The  loans  also 
generate income from the borrower and therefore enhance investment returns. 

6.8.3 

Costs of the solution  

PSAs  do  not  pay  directly  to  use  such  a  service  but  are,  in  fact,  paid  a  fee  by  the 
borrower. However, most loans are mediated through the PSA’s asset manager and an 
agent  who  together  charge  up  to  40  per  cent  of  the  income  received  from  the 
borrower. 

6.8.4 

Risks with the solution 

Availability of sufficient liquidity 

The key issue is that the stock lending market can give little certainty of the amount 
of cash that can be raised. Whether counterparties actually want to borrow stock (and 
it  is  usually  primarily  equities)  and  for  what  duration  (and  most  loans  are  of  short 
duration)  is  outside  the  control  of  the  PSAs.  In  times  of  market  stress,  when  short 
selling may actually be banned for some security types and other market participants 
also have liquidity squeezes, the market may dry up completely.  Finally, the volume 
of  stock  lending  tends  to  be  very  seasonal,  varying  with  the  dividend  seasons  of 
European markets. 

Some interviewees commented that the stock lending market is actually becoming less 
attractive  than  it  was.  Reasons  cited  were  the  possible  introduction  of  a  Financial 
Transaction  Tax  on  such  transactions  and  counterparty  risk  issues.  The  former  is 
outside  the  scope  of  this  report.  The  latter,  however,  could  clearly  be  helped  by 

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increased  use  of  cleared  stock  lending  services,  such  as  those  currently  offered  by 
Eurex  and  SIX.  Such  arrangements  are  not  heavily  used  yet,  but  may  eventually 
become  attractive  to  the  whole  industry  as  securities  lending  falls  into  in  the  same 
category  as  OTC  derivatives  and  repo  in  terms  of  capital  requirements.    From  a 
regulatory perspective, therefore, a CCP cleared solution would have the same impact 
on the capital requirements for securities lending transactions as it does on repos. 

6.9  Secured lending by cash-rich corporations   

6.9.1 

Description of solution 

During  the  course  of  the  study  a  further  potential  solution  was  identified  -  the 
possibility that non-traditional sources of cash could be tapped to help provide liquidity 
for  VM  payments  by  well  capitalised  OTC  derivatives  parties  such  as  PSAs.    In 
particular many large corporate entities presently have very  significant cash reserves 
and some have become concerned about depositing their cash, without security, with 
the  banking  sector.    If  the  need  of  cash-rich  corporates  to  lend  securely  could  be 
brought together with the need of PSAs to have a source of cash to allow them to pay 
VM without liquidating securities there could be a solution which is attractive to both. 

We  believe  that  at  least  one  of  the  organisations  interviewed  has  put  considerable 
thought  into  how  such  a  service  could  be  arranged  but  there  are  not  yet  indications 
that it would definitely be launched. 

 Figure 6.9: Secured lending by corporations  

The  solution  would  involve  essentially  a  repo  mechanism  with  a  PSA  repo-ing 
securities  and  receiving  cash  from  the  corporate  entity  as  collateral  against  the 
repurchase.    The  service  would  be  operated  by  a  third  party  or  parties.  The  main 
characteristics of the arrangement would be as follows: 

(cid:131)  The service would be similar to tri-party repo facilities currently offered by custodian 

banks and ICSDs such as Euroclear and Clearstream. 

(cid:131)  The corporate entity and the PSA would be the principals to the repo contract. 

(cid:131)  The service operator would hold securities and cash accounts for the participants 

and would administer the cash and securities flows related to each repo contract on 
behalf of the principals. 

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(cid:131)  Corporate entities and PSAs would be direct participants in the service. 

(cid:131)  Although banks could arrange the repo deals they would be acting as agents and 

the repos would therefore not be on their balance sheets. 

(cid:131)  The service operator could define standardised repos for particular bundles of 

eligible securities, which would maximise liquidity and the ease with which repos 
could be arranged and which would allow securities to be substituted during the life 
of the repo.  It could also administer the repo-ing of specific securities, which would 
ensure that the PSA received back the original security on the return date. 

(cid:131)  In order to ensure that repos could be executed with immediate effect the securities 
involved would need to be held within the service.  This in turn would mean that, for 
it to be efficient the service would need to have a critical mass of lenders and PSAs. 

(cid:131)  In order to be able to draw on cash held across the globe the operational hours of 

the service would need to be extensive. 

Operational efficiency 

This  solution  would  be  based  on  existing  tri-party  models  which,  once  the  tri-party 
agreement is in place, allow for transactions to be administered through their lifetime 
by the service provider with little effort from the counterparties. 

6.9.2 

Benefits of the solution 

The primary benefit of this solution would be that it provides for a new source of cash 
to  be  brought  into  the  system,  potentially  alleviating  the  liquidity  squeeze  that  a 
reduction in traditional repo activity may cause (particularly in times of stress). 

It would also offer benefits to corporations which want to lend to highly creditworthy 
counterparties; want to spread risk by having a broader group of borrowers; or want 
to lend to borrowers other than credit institutions. 

6.9.3 

Costs of the solution  

It  is  difficult  to  forecast  the  cost  of  a  service  when  it  is  at  the  stage  of  a  broad 
concept.  In general we would expect it to be competitive with the cost to a PSA of a 
conventional tri-party repo. 

It is likely that some new systems infrastructure would need to be developed and legal 
and regulatory work would be required to establish the service.  Therefore the service 
provider  would  incur  up-front  costs  which  would  need  to  be  recovered  during  the 
operation of the service. 

6.9.4 

Risks with the solution  

Service Provider 

One of the prime issues would be how to bring together a sufficiently large community 
of  lenders  and  PSAs  to  make  the  liquidity  available  sufficiently  attractive  and  the 
service cost efficient.  This “critical mass” challenge is the crux of many new financial 
market  initiatives  but  in  this  case  it  has  an  additional  dimension.    The  central 
participants  -  corporates  and  PSAs  -  are  clients  of  the  banks.    Setting  up  an 
infrastructure  service  in  which  the  principals  are  bank  clients  could  be  seen  as 
disintermediation, which has traditionally been viewed negatively by banks. 

In order to keep the repo transactions off bank balance sheets the service really needs 
to  be  operated  through  a  CSD-like  body  and  the  major  International  CSDs  would  be 

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the  natural  providers  of  this  service.    Euroclear  Bank,  for  example,  already  allows 
corporates  to  be  participants  but  only  as  liquidity  providers.    However,  PSAs  are  not 
eligible  to  be  participants.    A  group  of  banks  effectively  control  Euroclear’s 
participation criteria and moves in the past to change the criteria to include investing 
institutions  have  not  been  successful.    Even  if  PSA  participation  were  limited  to  tri-
party  repo  services  this  could  be  seen  by  the  bank  participants  to  be  the  start  of  a 
slippery  slope  to  broader  scale  disintermediation.    If  regulators  thought  it  was 
desirable  for  PSAs  to  have  direct  access  in  order  to  secure  liquidity  and  reduce 
systemic risk, they could, conceivably, force the issue but this seems unlikely. 

One  custodian  bank  (BNY  Mellon)  already  operates  a  CSD  in  Belgium  which  provides 
securities  issuing  services  and  has  ambitions  to  provide  services  for  investors.    The 
London  Stock  Exchange  Group  will  establish  a  new  CSD  in  Luxembourg  during  2014 
and  JP  Morgan  has  announced  that  it  will  use  it  as  part  of  its  international  collateral 
management  service.    It  is  unlikely,  however,  that  this  solution  would  reach  critical 
mass  if  the  service  were  operated  by  a  single  bank.    In  order  to  get  wide  usage  the 
customers of multiple banks would need to participate.  

A  neutral  CSD,  with  open  access  for  corporates  and  PSAs  located  in  a  wide  range  of 
countries,  could  be  the  appropriate  vehicle  to  operate  the  service.    This  could, 
conceivably, be provided by the LSE’s Luxembourg venture provided it has sufficiently 
open  membership  criteria  and  could  attract  multiple  banks  to  support  it.    A  CSD 
owned by a consortium of banks could also be a possibility. 

Form of contract 

We  have  described  this  solution  as  a  vehicle  for  facilitating  repos  but  that  would  not 
have to be the form of the contract between the parties.  It would be possible to use a 
similar structure for handling secured loans between corporates and PSAs.  A secured 
loan transaction may be more acceptable than a repo for some participants because: 

(cid:131)  Some corporates may not be familiar with repos and not have the administrative 

resources to deal with them. 

(cid:131)  The loan terms could be more flexible, making it possible to repay the loan when 

the PSA chooses rather than having to specify a repo return date. 

Availability of sufficient liquidity 

The  motivation  for  the  cash-rich  corporations  is  seeking  additional  return  on  their 
cash. This suggests several issues.  Firstly, the cash is on balance sheets because of a 
lack  of  suitably  attractive  investment  opportunities  and  has  not  been  returned  to 
investors due to a mix of faith in future opportunities and perhaps also the associated 
tax  effects  of  returning  cash  to  investors.   These  motivations  may  not  be  maintained 
indefinitely. 

Secondly, the demand from PSAs is likely to be volatile – if the cash-rich corporations 
have the appetite for the additional treasury management implied by that, it would be 
priced into the offering.  

Therefore  this  solution  would  have  to  be  seen  as  a  potential  additional  source  of  VM 
cash for PSAs not the complete solution to their needs. 

One  potential  benefit  of  this  solution,  though,  is  that  corporates  and  other  cash  rich 
bodies may not be so negatively impacted by adverse market conditions as CMs which 
have  many  other  market  activities  to  fund.    Therefore,  they  may  actually  be  a  more 
stable source of funds in these circumstances. 

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Additional sources of cash 

CCPs themselves hold significant quantities of cash - principally IM - which they have 
to  invest.    If  CCPs  were  able  to  reverse  repo  this  cash  to  PSAs  it  could  provide  an 
additional source of liquidity.  

However,  under  the  EMIR  Technical  Standards  CCPs  have  restrictions  on  where  they 
can invest cash.  On the face of it these appear to allow CCPs only to deposit cash with 
banks with a low credit risk.  We understand that CCPs have been seeking clarification 
on this restriction and some believe that the legislation may permit lending by CCPs to 
PSAs.  This  may  need  to  be  the  subject  of  future  clarification  by  regulators.    If  CCPs 
were allowed to reverse repo cash to PSAs it would not only provide a further source 
of  liquidity  for  the  PSAs  but  it  would  also  provide  CCPs  with  an  opportunity  to  lend, 
with good quality collateral, to a more diversified range of counterparties and hence to 
reduce their concentration risk. 

Interestingly, one CCP told us that, in their experience, in times of market stress when 
VM calls are likely to be higher, the proportion of margin that they collect which is in 
cash rises.  

6.10  Summary of analysis of technical solutions 

All  of  the  models  described  above  are  theoretically  possible  but  most  have  technical, 
cost,  risk,  market  impact  and  practicality  issues  which  would  have  to  be  resolved 
before they before they could be available to PSAs to meet their VM needs.   

Below  we  summarise  the  key  benefits,  costs,  risks  and  market  capacity  of  each 
potential solution.  In order to compare the solutions, we have assessed and charted 
the impact each solution would have on the following factors: 

(cid:131)  Market Capacity (i.e. the ability of the market to provide the necessary VM, both in 

normal market conditions and in times of stress). 

(cid:131)  Impact on Investment Performance (i.e. the direct investment returns of the PSAs). 

(cid:131)  Impact on Swap Market (i.e. market liquidity and pricing). 

(cid:131)  Legal & regulatory complexity and risk. 

(cid:131)  Operational Cost (in normal market conditions). 

(cid:131)  Operational complexity and risk (in normal market conditions). 

(cid:131)  Investment required (in people, systems, legal work, etc.). 

(cid:131)  Counterparty Risk. 

The radar charts below represent our assessment of these factors.  The more positive 
the assessment the further the plotted point is from the centre of the chart. 

6.10.1 

Collateral transformation by CMs 

Benefits of the solution 

(cid:131)  It is close to current market practice.  Most CMs are able to offer repo facilities to 
their clients and many PSAs and their investment managers already use repos. 

(cid:131)  Most PSAs hold high quality bonds which would be readily acceptable collateral for 

repo transactions. 

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(cid:131)  The PSA would also retain its exposure to the securities it repos, thereby meeting 

one of their key objectives. 

(cid:131)  The solution uses existing legal and regulatory structures and would not require new 

ground to be broken in this area. 

(cid:131)  It would not have any impact on the pricing of the cleared swaps. 

Costs and risk factors 

(cid:131)  PSAs and their investment managers would need to develop their treasury and risk 

management capabilities in order to deal with larger volumes of repos and the short 
operational deadlines by which VM must be posted.  For this some additional system 
support may be required. 

(cid:131)  PSAs would pay the transaction costs of the repos. 

(cid:131)  If PSAs required a repo facility guaranteeing a certain level of capacity from its CM 

there would be an ongoing cost for it. 

(cid:131)  The interest paid on the repo cash would be an additional operational cost. 

(cid:131)  For CMs this should be a revenue earning service but the profit margin for this 
business is expected to be squeezed by an increase in their cost of regulatory 
capital. 

(cid:131)  It would not be possible to match the maturity of the repo with the duration of the 

VM requirement.  The PSA would therefore incur continuing roll costs and attendant 
risk. 

Capacity of the solution 

(cid:131)  In normal market conditions we would expect the market to have sufficient euro and 

sterling repo capacity to meet the needs of the European PSAs. 

(cid:131)  In a severely stressed market the total PSA VM requirement would exceed the 

apparent daily capacity of the UK gilt repo market and would probably exceed the 
relevant parts of the euro government bond repo market. 

(cid:131)  In the event of an imminent CM default caused by a PSA not being able to obtain 
sufficient repo liquidity to meet its VM call we consider it likely that the respective 
central bank would step in to provide short term liquidity to bridge the crisis, but 
this would not be a prior commitment.   

(cid:131)  Market capacity may reduce as banks reduce their involvement in response to 

capital adequacy regulatory changes. 

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Figure 6.10: Summary of collateral transformation by CMs 

6.10.2 

Collateral transformation by CCPs 

Benefits of the solution 

(cid:131)  Access to central bank liquidity would remove the possibility of a shortage of repo 

capacity at times of market stress leading to a PSA not being able to fund its VM call 
and causing the default of its CM. 

(cid:131)  The service would be available to all PSA client clearing participants of the CCP. 

(cid:131)  The PSA would retain its exposure to the securities it repos. 

Crucial assumption on which this solution depends 

(cid:131)  That the CCP would have access to overnight central bank liquidity to fund its repo 
book in the event that it was not able to obtain it from commercial banks.  While at 
least one central bank is probably going to provide CCPs with some form of access 
to its lending facilities, the terms and conditions to be applied have yet to emerge 
and we cannot, therefore, judge whether it will adequately fit the needs of this 
solution. 

Costs and risk factors 

(cid:131)  CCPs would be entering into a line of business which is out of character.  They 

would become a trading participant in the repo markets.  The CCP would be taking 
on new and additional risk.  This would affect the assessment their CMs make of 
them as a counterparty credit risk. 

(cid:131)  The CCP would need to invest in the development of the service involving new 

contractual arrangements, new rules, system changes and regulatory clearance. The 
CCP would also need to develop new trading and risk management capabilities to 
cover the operation of the repo business. 

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(cid:131)  PSAs and their investment managers would need to develop their treasury and risk 

management capabilities and infrastructure in a similar way to the Collateral 
transformation by CMs solution. 

(cid:131)  PSAs would be less likely to receive back exactly the same securities on maturity of 

the repo since the service would specify a general collateral basket. 

(cid:131)  PSAs would pay the transaction costs of the repos.  These would be likely to be a 
higher than those of the Collateral transformation by CMs solution since the CCP’s 
costs would need to be covered and a tri-party repo service would probably be 
involved. 

(cid:131)  The interest paid on the repo cash would be an additional operational cost. 

Capacity of the solution 

(cid:131)  In normal market conditions would be similar to Collateral transformation by CMs. 

(cid:131)  In stressed markets it would continue to meet the requirements of PSAs since it 

could call on central bank liquidity. 

Figure 6.11: Summary of collateral transformation by CCPs 

6.10.3 

Acceptance of non-cash assets with pass through to receivers of 
VM 

Benefits of the solution 

(cid:131)  It would allow securities held in the PSA’s investment portfolio to be posted as VM 

without them having to be liquidated. 

(cid:131)  The variation of the solution described in section 6.3.1(b) would ensure that the PSA 
posting securities as VM would receive back securities that it had previously posted 
should it become a VM receiver. 

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Costs and risk factors 

(cid:131)  Contracts with securities VM would have to be priced differently to those with cash 

VM. This would result in a bifurcation of the market for any particular OTC 
derivatives contract, split liquidity and worse pricing for the non-cash product.  That 
would impair the PSA’s investment return. 

(cid:131)  There would be significant legal issues to resolve relating amongst others to: the 

legal form of the transfer of VM securities; the point at which the ownership of the 
securities is transferred; the segregation of over collateralised assets and the rights 
to income deriving from the securities. 

(cid:131)  PSAs would have to hold securities they wish to use for VM in a custodian or CSD in 
which the CCP also has an account and which could process a same day transfer to 
the CCP’s account before the deadline for posting VM. 

(cid:131)  PSAs would pay custodian and CSD fees related to the movements of securities to 

and from the CCP. 

(cid:131)  CCPs, CMs, PSAs custodians and asset managers would need to keep track of 

securities which had been used for VM which may need to be repaid.  There would 
need to be a considerable systems investment to support this. 

(cid:131)  Systems and operational procedures would also have to be able to manage and 

account for the rounding differences resulting from the securities having minimum 
transferrable units. 

(cid:131)  There would be increased staff and management costs for PSAs, asset managers, 

CMs and CCPs to handle the additional operational complexity. 

Capacity of the solution 

(cid:131)  In both normal conditions and in times of market stress the solution should perform 

satisfactorily. 

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Figure 6.12: Summary of pass-through of non-cash assets 

6.10.4 

Acceptance of securities with security interest passed through to 
receivers of VM 

Benefits of the solution 

(cid:131)  It would allow securities held in the PSA’s investment portfolio to be posted as VM 

without them having to be liquidated. 

(cid:131)  Since this is not a conventional VM arrangement and VM is not passed through to 

receivers, it would ensure that the PSA posting securities as VM would receive back, 
by the maturity date of the OTC derivatives contract, the securities that it had 
previously posted. 

Costs and risk factors 

(cid:131)  Contracts operating to this model would have to be priced differently to those with 
cash VM. This would result in a bifurcation of the market for any particular OTC 
derivatives contract, split liquidity and worse pricing for the non-cash product.  That 
would impair the PSA’s investment return. 

(cid:131)  The complexities and differences in the law on security interests in the different 
member state jurisdictions would make the concept very uncertain in a default 
situation, which is exactly when it needs to work predictably. 

(cid:131)  PSAs would be subject to additional custodian and CSD costs related to moving 

securities to and from the CCP. 

(cid:131)  PSAs would have to modify their asset management policies to allow a security 

interest to be created over the securities they post to the CCP. 

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(cid:131)  CCPs would have to invest in determining the legal basis for the contracts using this 
model so as to minimise legal risk during a CM default.  They would have to obtain 
regulatory clearance for it and to modify their systems so as to be able to account 
for the security interests and to manage defaults where this type of contact was 
involved. 

(cid:131)  CMs would probably also have to modify their systems in order to handle this model 

of contract. 

Capacity of the solution 

(cid:131)  In both normal conditions and in times of market stress the solution should perform 

satisfactorily. 

Figure 6.13: Summary of pass-through of security interest 

6.10.5  Quad-party collateral for VM security interest 

Benefits of the solution 

(cid:131)  It would allow securities held in the PSA’s investment portfolio to be posted as VM 

without them having to be liquidated. 

(cid:131)  Since this is not a conventional VM arrangement and VM is not passed through to 

receivers, it would ensure that the PSA posting securities as VM would receive back, 
by the maturity date of the OTC derivatives contract, the securities that it had 
previously posted. 

Costs and risk factors 

(cid:131)  Contracts operating to this model would have to be priced differently to those with 
cash VM. This would result in a bifurcation of the market for any particular OTC 
derivatives contract, split liquidity and worse pricing for the non-cash product.  That 
would impair the PSA’s investment return. 

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(cid:131)  The complexities and differences in the law on security interests in the different 
member state jurisdictions would make the concept very uncertain in a default 
situation. 

(cid:131)  PSAs would have to keep the securities they intended to use for VM with a custodian 

which operated this service for the CCP concerned. 

(cid:131)  PSAs would be subject to additional custodian and CSD costs related to moving 

securities to and from the CCP.  These would be likely to be higher than the costs of 
the solution described in 6.4.1. 

(cid:131)  PSAs would have to modify their asset management policies to allow a security 

interest to be created over the securities they post to the CCP. 

(cid:131)  CCPs would have to invest in determining the legal basis for the contracts using this 
model so as to minimise legal risk during a CM default.  They would have to obtain 
regulatory clearance for it and to modify their systems so as to be able to account 
for the security interests and to manage defaults where this type of contact was 
involved. 

(cid:131)  The custodian operating the quad party service would have to invest in the systems 

to manage it. 

(cid:131)  CMs would probably also have to modify their systems in order to handle this model 

of contract. 

Capacity of the solution 

(cid:131)  In both normal conditions and in times of market stress the solution should perform 

satisfactorily. 

Figure 6.14: Summary of quad-party collateral 

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6.10.6 

Agency stock lending 

Benefits of the solution 

(cid:131)  It follows current market practice.  Most CMs are able to offer repo facilities to their 

clients and many PSAs and their investment managers already use repos. 

(cid:131)  The PSA would also retain its exposure to the securities it lends, thereby meeting 

one of their key objectives. 

(cid:131)  Stock lending can enhance investment returns. 

(cid:131)  The solution uses existing legal and regulatory structures and would not require new 

ground to be broken in this area. 

(cid:131)  It would not have any impact on the pricing of the cleared swaps. 

Costs and risk factors 

(cid:131)  PSAs would not pay directly to use such a service but would, in fact, be paid a rate 
of return by the borrower. However, since this solution assumes the loans would be 
mediated through an agent - often the custodian of the PSA they would incur fees. 

Capacity of the solution 

(cid:131)  The capacity available to a PSA would depend on the level of demand from 

borrowers of stock at the time for the securities the PSA holds in its portfolio.  This 
demand tends to be seasonal, being related to dividend dates.  Capacity can 
therefore not be relied upon. 

(cid:131)  In times of market stress, when short selling may actually be banned for some 

security types and other market participants may also have liquidity squeezes, the 
market may dry up completely.   

Figure 6.15: Summary of agency stock lending 

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6.10.7 

Secured lending by cash-rich corporations 

Benefits of the solution 

(cid:131)  It provides for a new source of cash to be available to PSAs, potentially alleviating 

the liquidity squeeze that a reduction in traditional repo activity may cause. 

(cid:131)  Corporate lenders would have ready access to a class of very creditworthy 

borrowers. 

(cid:131)  Although banks could arrange the repo deals they would be acting as agents and 

the repos would therefore not be on their balance sheets. 

Costs and risk factors 

(cid:131)  In order to be effective the service would need a critical mass of lenders and 

borrowers and preferably global reach so that it could draw on cash held around the 
world.  Current infrastructure providers may not be able to achieve this.  Any one 
custodian may not have a sufficiently wide customer base to make it effective.  The 
ICSDs should be good candidates to offer this type of service but have restrictions 
on PSAs being able to directly participate in their services. 

(cid:131)  PSAs would need the securities they intended to repo to provide VM cash to be held 

by the custodian or CSD operating the service. 

(cid:131)  It is likely that some new systems infrastructure would need to be developed and 

legal and regulatory work would be required to establish the service. 

(cid:131)  Probably both parties to the transactions would be charged a fee for the services.  
We would expect it to be competitive with the cost to a PSA of a conventional tri-
party repo. 

Capacity of the solution 

(cid:131)  The capacity of the solution would depend on the number of lenders which decide to 
participate and the total volume of cash they decide to lend through the service.  
Therefore this would have to be seen as a potential additional source of VM cash for 
PSAs not the complete solution to their needs. 

(cid:131)  In times of market stress corporates and other cash rich bodies may not be so 

negatively impacted by adverse market conditions as CMs which have many other 
market activities to fund and therefore they may be a more stable source of funds. 

Potential variant of the solution 

(cid:131)  It would be possible to use a similar structure for handling secured loans between 

corporates and PSAs in addition to repos.  A secured loan transaction may be more 
acceptable than a repo for some participants because corporates may be more 
familiar with secured loans than repos and the loan terms could be more flexible, 
making it possible to repay the loan when the PSA chooses rather than having to 
specify a repo return date. 

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Figure 6.16: Summary of secured lending by cash-rich corporations 

6.11  Conclusions on the relative merits of the technical solutions 

It  is  clear  that,  despite  many  industry  players  being  very  aware  of  the  negative 
impacts of mandatory clearing on PSAs none of the models assessed stands out as the 
obvious  solution  to  the  issue.    Perhaps  partly  for  this  reason,  there  is  currently  little 
hard  evidence  that  the  industry  is  investing  in  innovative  solutions  to  the  core 
problem.  This is due in part to the whole clearing industry having been preoccupied in 
making  sure  they  themselves  can  meet  the  impacts  of  EMIR  and  other  regulatory 
changes introduced over the last few years, combined with a general assumption that 
the exemption to PSAs from mandatory clearing will be extended.  It can certainly be 
said  with  confidence,  at  this  stage,  “that  the  necessary  effort  to  develop  appropriate 
technical solutions has not been made and that the adverse effect of centrally clearing 
derivative  contracts  on  the  retirement  benefits  of  future  pensioners  remain 
unchanged”48. 

The  table  below  summarises  our  assessment  of  each  of  the  solutions  in  terms  of  its 
impact on the cost and risk factors we have discussed above.  Against each factor in 
the table we have assessed the relative appeal of each of the solutions. 

48  See EMIR 85(2). 

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Table 6.1: Summary of assessment of impact on cost and risk factors  

Collateral 
trans-
formation 
by CMs 

Collateral 
trans-
formation 
by CCPs 

Direct 
pass-
through of 
non-cash 
assets to 
receivers 
of VM 

Security 
interest in 
non-cash 
assets 
passed 
through to 
receivers 
of VM 

Quad-
party 
collateral 
for VM 
security 
interest 

Secured 
lending by 
cash-rich 
corpora-
tions 

Agency 
stock 
lending 

Impact on 
Investment 
Performance 

Impact on 
Swap Market 

Legal & 
regulatory 
complexity 
and risk 
Operational 
Cost 

PSAs 
CCPs 
CMs 

Operational 
complexity 
and risk 
PSAs 
CCPs 
CMs 

Investment 
Required 

PSAs (inc. 
custodians) 

CCPs 
CMs 

Counterparty 
Risk 

PSAs 
CCPs 
CMs 

0 

0 

0 

-1
0 
0 

-1
0 
-1

-1 
0 
0 

0 
0 
0 

0 

0 

-2 

-1 
-2 
1 

-1 
-2 
1 

-1 
-2 
0 

0 
-1 
-2 

0

-2 

-2

-2
-2
-2

-2
-1
-1

-1 
-2
-2

0
0
0

0

-2 

-2

-1
0
0

-1
0
-1

-1 
-2
-1

-1
0
0

0

-2 

-2

-1
0
0

-1
0
-1

-1 
-2
-1

-1
-1
0

1 

0 

0 

0 
0 
0 

0 
0 
0 

0 
0 
0 

0 
0 
0 

0 

0 

-1 

-1 
0 
0 

-1 
0 
0 

-2 
0 
0 

1 
0 
1 

Key: Relative Appeal 
Best 

Worst 

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The table below summarises our assessment of the capacity of the solutions – i.e. the 
extent  to  which  each  solution  would  meet  the  full  requirement  of  the  PSAs  in  both 
normal and stressed market conditions.  

Table 6.2: Summary of assessment of capacity of the solutions 

Collateral 
trans-
formation 
by CMs 

Collateral 
trans-
formation 
by CCPs 

Market Capacity 
(Normal Conditions) 

Market Capacity 
(Stressed Conditions) 

1 

-1 

1 

2 

Security 
interest 
in non-
cash 
assets 
passed 
through 
to 
receivers 
of VM 

2 

2 

Direct 
pass-
through 
of non-
cash 
assets to 
receivers 
of VM 

2 

2 

Quad-
party 
collateral 
for VM 
security 
interest 

2 

2 

Agency 
stock 
lending 

-1 

-2 

Secured 
lending 
by cash-
rich 
corpora-
tions 

-1 

-1 

Key: Capacity to meet PSAs VM requirement
 Would fully meet requirement 

Would meet a small part of requirement 

Three  of  the  solutions  –  Direct  acceptance  of  non-cash  assets  with  pass-through  to 
receivers of VM, Acceptance of non-cash assets with security interest passed through 
to  receivers  of  VM  and  Quad-party  collateral  for  VM  security  interest  –  would  allow 
PSAs to use securities to cover VM calls, without having to transform them into cash.  
However,  all  of  them  have  significant  drawbacks.    All  of  them  would  entail  non-cash 
VM  contracts  being  offered  as  separate  product  lines  to  cash  VM  products.  The 
resulting low liquidity of the non-cash VM products would mean that they would trade 
at  wider  spreads.    In  addition  we  consider  direct  acceptance  of  non-cash  assets  with 
pass-through to receivers of VM to involve so much operational complexity as to rule it 
out.   

The two solutions involving security interest would be easier to implement technically 
but  differences  in  the  law  on  security  interests  in  the  different  member  state 
jurisdictions  would  mean  they  have  higher  legal  risk.    Even  if  the  legal  uncertainty 
could  be  resolved,  we  would  expect  that  the  split  of liquidity  between  cash  and  non-
cash  products  would  be  enough  to  prevent  the  non-cash  products  from  gaining 
traction. 

Two  of  the  solutions  –  Collateral  transformation  by  CMs  and  Agency  stock  lending  – 
are already  available to PSAs.   Questions about their applicability revolve around the 
capacity  of  the  market  to  meet  the  full  needs  of  the  European  PSAs,  whether  that 
capacity may reduce as a result of changes in capital adequacy regulation and whether 
capacity would hold up in times of market stress. 

Agency  stock  lending  can  be  attractive  to  PSAs  -  because  it  can  enhance  investment 
returns - in the event that there is demand from borrowers at the time the PSA needs 
to raise VM cash.   However,  since this cannot be relied on, stock lending can at best 
form a small part of the solution to the PSAs need for VM cash. 

Collateral transformation by CCPs appears to be an attractive solution, particularly in 
times  of  stressed  markets.  However,  there  are  two  main  challenges.    First,  whether 
the conditions under which central banks would be prepared to offer liquidity to CCPs 
would,  in  practice,  be  compatible  with  the  solution.    Second,  the  lack  of  appetite 
amongst  CCPs  to  take  on  and  manage  the  resulting  increased  risk  (and  even  with  a 

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changed  appetite  by  CCPs  it  would  be  subject  to  regulatory  approval)  and  likely 
concern about the ability of CCPs to maintain current levels of systemic security. 

Secured lending from cash-rich corporations is an interesting concept and could allow 
PSAs to tap into an additional pool of cash to which they currently have limited access.  
For it to be a significant part of the solution PSAs need custodians or CSDs would have 
to  invest  in  creating  a  service  with  sufficient  scale  and  ease  of  use.    In  addition,  the 
cash  is  on  balance  sheets  because  of  a  lack  of  suitably  attractive  investment 
opportunities  and  has  not  been  returned  to  investors  due  to  a  mix  of  faith  in  future 
opportunities  and  perhaps  also  the  associated  tax  effects  of  returning  cash  to 
investors.  These motivations may not be maintained indefinitely 

The  only  substantial  solution  with  any  expectation  of  traction  at  present  is  collateral 
transformation  by  CMs.    A  PSA’s  appetite  for  reliance  on  this  solution  will  depend  on 
how  the  cost  of  repo  (both  at  business-as-usual  and  at  stressed  repo  rates  and 
haircuts) compares to the opportunity cost of maintaining a larger cash buffer instead.  
Critically, it will also depend on its view of the capacity of the repo market to  satisfy 
its likely needs.  As indicated in section 6 above, there are serious concerns that the 
repo  market,  as  presently  constructed,  could  not  meet  the  liquidity  demands  of  the 
PSAs in times of stress.  

It therefore follows that UK PSAs as a group would not be able to rely fully on the gilt 
repo market in the UK, and most likely other PSAs would not be able to rely on euro 
government bond repo markets in the rest of Europe.  Whilst the repo of other assets 
could  increase  the  potential  capacity  available  these  other  repo  markets  are  much 
more  susceptible  to  losses  of  liquidity  in  a  crisis  situation.    As  such,  reliance  upon 
them is not likely to be seen as a prudent approach.  

Therefore,  absent  any  change  in  the  size  of  the  repo  market  or  very  substantial 
progress on some other technical solution (with the sourcing of liquidity from cash-rich 
corporations  being  the  most  promising),  PSAs  would  need  to  create  a  cash  buffer  to 
cover the shortfall over and above the capacity that they judge the repo market would 
be likely to be able to provide.  

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7.  Appendix  1:  Risk  Management  of  OTC  Derivative 

Contracts 

This explanation is provided to assist readers  with some of the concepts discussed in 
this paper. 

The trading of an OTC  derivative contract  creates  obligations between the parties  for 
what can be a very long period of time (up to 50 years).  Changes to the values of the 
variables underlying the contract during this period (e.g. interest rates in the case of 
interest rate swap contracts) result in changes in the value of the derivative contract, 
resulting in turn in one party making a profit on the contract and the other making a 
loss.  Under  EMIR,  every  OTC  contract  now  needs  to  be  valued  at  least  once  per  day 
(known  as  marking-to-market)49.    Once  the  contract  is  marked-to-market,  the  profit 
or loss of each of the parties to the contract can be calculated.  

Rather  than  allowing  the  profit  and  loss  to  build  up,  and  running  the  risk  that  the 
losing  counterparty  will  not  be  able  to  pay  when  the  loss  is  settled,  regular  action  is 
taken to manage this risk.  The methods used have some differences depending upon 
whether  the  contract  is  settled  bilaterally  between  the  trading  parties  or  they  submit 
the contract to a CCP for clearing. 

Bilateral settlement 

OTC  derivatives  contracts  which  are  to  be  bilaterally  settled  are  covered  by  an  ISDA 
Master Agreement, agreed between the trading parties.  Almost all Master Agreements 
include  a  CSA  which  governs  how  the  credit  risk  is  to  be  covered  for  all  OTC  trades 
done between the parties.  The CSA requires that the entire portfolio of trades covered 
by  the  Master  Agreement  is  marked-to-market  to  arrive  at  a  single  net  valuation  for 
the portfolio.  The valuation is carried out by the Valuation Agent specified in the CSA, 
which in  most  cases  of  OTC  derivatives  contracts  between  a  PSA  and a  bank,  will  be 
the  bank  or  its  nominated  agent.    The  Valuation  Agent  calculates  the  portfolio  value 
and  the  change  in  the  value  since  the  last  valuation  and  notifies  both  parties  of  the 
results.  

Figure 7.1: Role of Valuation Agent  

Collateral in the form of Variation Margin can then be required by the gainer from the 
loser to protect the former in the event that the loser is not able to pay the difference 
at  the  subsequent  payments.  The  process  is  not  automatic,  however.    The  party 
entitled to receive VM must notify the other party that a transfer of VM is required and 
CSAs can specify a threshold amount below which a transfer is not required. 

This  process  basically  avoids  any  build-up  of  uncollateralised  losses.    Hence  at  any 
point in time the party for whom the bilateral portfolio has a positive value is holding 

49  EMIR clause 11.2 refers. 

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collateral  equivalent  to  that  value  and  at  each  valuation  the  amount  of  collateral  is 
adjusted. 

Figure 7.2: Calculation of daily variation margin  

Who  pays  and  who  receives  is  determined  by  whether  this  calculation  is  positive  or 
negative. 

Traditionally  CSAs  have  allowed  variation  margin  to  be  provided  in  the  form  of 
securities,  or  in  cash.    In  order  to  cover  the  risk  of  securities  transferred  as  VM 
changing  in  value,  each  security  eligible  for  VM  under  the  CSA  has  an  associated 
“valuation  percentage”  by  which  the  value  of  securities  transferred  must  exceed  the 
calculated  figure  of  VM  due.    There  is,  however,  a  trend  towards  bilateral  VM  being 
paid in cash rather than securities (though no regulation mandates this). 

VM  does  not,  however,  cover  all  the  risks  the  parties  face  in  relation  to  the  bilateral 
portfolio.    In  the  event  of  the  default  of  one  of  the  parties  the  other  party  would 
probably  have  to  replace  the  portfolio  with  an  equivalent,  traded  with  one  or  more 
new  counterparties.    The  potential  costs  of  the  replacement  are  not  covered  by  the 
bilateral  transfer  of  VM.  In  the  past,  this  risk  was  either  accepted  by  the  parties  or 
managed  by  tools  such  as  position  limits.    However,  EMIR  now  requires  these  risks, 
once they get beyond a certain threshold, to be managed through the taking of initial 
margin (IM). This is margin taken to cover the potential loss which would be incurred 
in the event of the default of counterparty.  

CCP clearing 

With  CCP  clearing  the  relationships  between  the  parties  to  a  particular  contract  are 
different  to  those  for  bilateral  settlement.  In  general  buy-side  organisations,  such  as 
PSAs,  will  not  be  direct  participants  of  a  CCP.    Any  contract  they  wish  to  be  cleared 
must go through a clearing member (CM) of the CCP.  This CM could be the firm that 
arranged the trade, or was the counterparty of the trade, but it does not have to be. 

Figure 7.3: CCP clearing  

The CM becomes the party to the trade as far as the CCP is concerned and, once the 
trade has been matched (i.e. both parties have formally agreed  on the details of the 
trade)  and  has  been  received  by  the  CCP,  it  is  then  ‘novated’.    Novation  means  that 
the CCP breaks the original trade into two trades - the buying CM becomes the buyer 
to  the  CCP  and  the  selling  CM  becomes  the  seller  to  the  CCP.  The  CCP  therefore 
becomes  the  buyer  to  every  seller  and  the  seller  to  every  buyer.  This  results  in  the 
CCP having a completely flat position, as for every buy it makes, it makes an identical 
sell. 

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Figure 7.4: Novation  

Novation  breaks  the  relationship  between  the  parties  to  the  original  trade  and,  from 
the point of novation onwards, the CCP’s systems and processes make no reference to 
a  connection  between  New  Trade  1  and  New  Trade  2.    The  CCP  applies  its  risk 
management  processes  to  the  portfolio  of  trades  it  holds  against  each  of  its 
counterparties,  i.e.  against  each  CM.    This  results  in  important  differences  compared 
to bilateral settlement: 

(cid:131)  Each CM’s portfolio includes trades done originally with multiple counterparties, 

hence CCP clearing is sometimes referred to as “multilateral”. 

(cid:131)  Each CM’s portfolio contains trades in multiple products, including those not traded 

OTC. 

(cid:131)  The CCP will split the total portfolio by product in order to calculate its exposure to 
each CM although, where products are closely correlated, they may be grouped 
together in order to take account of the correlation in the exposure calculations. 

As with bilateral contracts under EMIR, a CCP marks-to-market all CM portfolios on at 
least  a  daily  basis,  and  calculates  the  variation  margin  due  to  the  CCP  and  the 
variation margin that the CCP has to pay out.   

CCPs  differ  in  their  treatment  of  the  market  risk  from  that  employed  in  bilaterally 
settled  contracts.  Instead  of  collateralising  the  differences  in  market  value  as 
described  above  for  bilaterally  settled  contracts,  CCPs  actually  crystallise  the  profits 
and losses, resulting in the VM actually being a settlement payment from the loser to 
the gainer. This is the reason that CCPs only accept VM in cash and pay out the same 
in cash, cash being the most negotiable instrument.   

The CM is responsible for paying the VM to the CCP and it, in turn, collects the same 
from the PSA or other counterparty. Operationally, most CCPs undertake the mark-to-
market  and  variation  margin  calculations  overnight  and  make  the  resulting  cash 
exchanges between themselves and the CMs the next morning.  

A CCP is not a risk taking organisation. Therefore, it seeks to remove as much risk as 
possible. It does this by also taking IM to cover the risk of the CM defaulting50.   

IM is calculated at the end of each day (but can be more often in periods of volatility) 
and calls to top up any IM are made to CMs.   

Summary of margin taken by a CPP: 

50  If  a  CM  defaults,  the  clearing  house  aims  to  crystallise  any  losses  as  soon  as  possible,  usually  by  closing  out  the  derivative 
positions of the defaulting CM or transferring them to another CM.  However, it can take time to do this and the price may move 

against the clearing  house,  especially in a default  which happens at  a time of increased market volatility.  In such  a case, the 

value of the positions may have moved a long way since the last mark-to-market and settlement of the related variation margin.  
Initial margin is taken to cover any such potential losses, in at least the vast majority of envisaged scenarios. 

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(cid:131)  VM is the daily profit and loss on a derivative contract since the last mark-to-market 

and is exchanged daily in cash. 

(cid:131)  IM is an amount to cover the risk of having to close out or transfer a defaulting CMs 

position. It is recalculated at least daily and any shortfalls have to be made up 
immediately. IM can be provided in the form of cash or securities (the latter subject 
to haircuts). 

Differences between bilateral and CCP clearing for the purposes of this study 

Under  EMIR,  the  risk  management  for  both  bilateral  and  CCP  cleared  contracts 
requires  the  taking  of  both  IM  and  VM.  The  key  difference  is  that,  for  bilateral 
contracts,  the  VM  provided  is  actually  collateral  to  protect  the  gainer  from  the 
potential  loss  of  profits  accumulated  under  the  contract  whereas,  for  CCP  cleared 
contracts, the VM is actually settlement of the profits gained on the contract. Another 
way  of  looking  at it is  that  profits  gained  on  a contract  are  paid  out  daily in  the  CCP 
environment  (in  the  form  of  VM),  but  are  accumulated  in  the  bilateral  environment 
until the next payment date, with the risk of loss of the profits being covered by VM. 

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8.  Appendix 2: Detailed Modelling Results 

8.1.1 

Regulatory regime 

The  tables  below  presents  the  derivative  usage  regimes  used  to  calculate  the  scaling 
factors  to  account  for  differing  intensity  of  derivative  usage  across  the  EU28.    This 
feeds directly into the VM modelling results. These regimes were developed based on 
information received from our fieldwork and industry data where available.  Where no 
information was available (those Member States marked with an asterisk in the table) 
have assumed that derivative usage is no higher than ‘medium’, and assigned scores 
scoring to the following methodology. 

Table 8.1: Methodology to assign derivative use intensity scores  

Category   

Derivative use intensity score 

Defined contribution, Large 

Defined contribution benefit, Small 

Defined benefit, Large 

Defined benefit, Small 

Low  

Ultra low  

 Medium 

 Low 

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Table 8.2: Derivative usage intensity scores 

Member 
State 

Derv usage 
Large DC 

Derv usage 
Small DC 

Derv usage 
Large DB 

Derv usage 
Small DB 

AT* 

BE* 

BG* 

CY* 

CZ 

DE 

DK 

EE 
EL 
ES* 

FI* 

FR* 

HR* 

HU* 

IE 
IT 
LT* 

LU* 

LV* 

Low 

Low 

Low 

Low 

Medium 

Medium 

High 

Low 
Low 
Low 

Low 

Low 

Low 

Low 

Medium 
Low 
Low 

Low 

Low 

Ultra Low 

Ultra Low 

Ultra Low 

Ultra Low 

Ultra Low 

Low 

Medium 

Ultra Low 
Ultra Low 
Ultra Low 

Ultra Low 

Ultra Low 

Ultra Low 

Ultra Low 

Ultra Low 
Ultra Low 
Ultra Low 

Ultra Low 

Ultra Low 

Medium 

Medium 

Medium 

Medium 

N/A 

High 

High 

N/A 
N/A 
Medium 

Medium 

Medium 

Medium 

Medium 

High 
Medium 
Medium 

Medium 

Medium 

MT* 
NL 
PL 
PT 
RO 
SE 
SI* 
SK 
UK - LDI 
UK - non-LDI 
Note: N/A applies where Member States have no AUM in defined benefit.  
* indicates those Member States where we used default as set out at Table 8.1 

Ultra Low 
Medium 
Ultra Low 
Ultra Low 
Ultra Low 
Low 
Ultra Low 
Low 
Low 
Low 

Low 
High 
Low 
Low 
Low 
Medium 
Low 
Medium 
Medium 
Medium 

Medium 
High 
Medium 
Medium 
Medium 
High 
Medium 
N/A 
Ultra high 
High 

Low 

Low 

Low 

Low 

N/A 

Medium 

Medium 

N/A 
N/A 
Low 

Low 

Low 

Low 

Low 

Medium 
Low 
Low 

Low 

Low 

Low 
High 
Low 
Low 
Low 
Medium 
Low 
N/A 
High 
Medium 

8.1.2 

Historic scenario 

The  amount  of  cash  that  PSAs  across  the  EU28  would  need  to  hold  to  meet  VM 
requirements  is  presented  in  the  table  below.    This  represents  a  proportion  of  the 
maximum VM collateral need based upon the simulations run, being: 100 per cent, 90 
per cent and 80 per cent of the maximum five-day VM call from 2007 to 2012. 

At  the  100  per  cent  cash  buffer  there  is  significant  variation  in  the  size  of  the  cash 
buffer, from €730,000 for Greece to €37 billion for the UK when only IRS is clearable.  
This variation reflects differences in the intensity of derivative use and the size of the 
pension industry in each Member State.   

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Table  8.3  Total  cash  VM  requirement  to  be  held  under  the  IRS  clearable-
historic scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
190 

90% of maximum 
calculated VM call 
171 

80% of maximum 
calculated VM call 
152 

1,280 

29 

0.07 

215 

10,349 

19,166 

17 

0.73 

2,057 

3,159 

1,590 

67 

28 

2,087 

1,291 

2.5 

17 

1.85 

4.89 

42,550 

573 

292 

24 

9,156 

19 

141 

37,160 

131,469 

1,152 

27 

0.06 

193 

9,314 

17,250 

15 

0.66 

1,851 

2,843 

1,431 

60 

25 

1,878 

1,162 

2.25 

15 

1.67 

4.4 

38,295 

516 

263 

22 

8,241 

17 

127 

33,444 

118,322 

1,024 

24 

0.05 

172 

8,280 

15,333 

13 

0.58 

1,645 

2,527 

1,272 

53 

22 

1,670 

1,033 

2. 

13 

1.48 

3.91 

34,040 

459 

233 

19 

7,325 

15 

113 

29,728 

105,175 

Source: Europe Economics and Bourse Consult analysis. 

When inflation clearing is incorporated into the model, the cash buffer for the majority 
of Member States falls.  Inflation shocks typically provide some offset for interest rate 
shocks,  which  enables  some  netting  of  daily  VM  calls  by  the  CCP.    This  in  turn 
translates  into  a lower  cash  buffer  requirement.    The  exception  is  the  UK,  where  the 
cash  buffer  requirement  increases  where  inflation  and  interest  rates  are  both 
clearable.    The  UK  on  average  makes  a  greater  use  of  inflation  swaps  and  thus  the 
netting  of  VM  calls  during  clearing  is  not  sufficient  to  offset  the  increase  in  VM 
resulting from clearing inflation as well as interest rate.   

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Table  8.4  Total  cash  VM  requirement  to  be  held  under  the  IRS  and  inflation 
clearable-historic scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
180 

90% of maximum 
calculated VM call 
162 

80% of maximum 
calculated VM call 
144 

1,212 

28 

0.06 

203 

9,795 

18,139 

16 

0.69 

1,946 

2,990 

1,505 

63 

26 

1,975 

1,222 

2.37 

16 

1.75 

4.63 

40,270 

543 

276 

23 

8,666 

18 

134 

47,814 

137,069 

1,090 

25 

0.06 

183 

8,815 

16,325 

14 

0.62 

1,752 

2,691 

1,355 

57 

24 

1,778 

1,100 

2.13 

14 

1.58 

4.16 

36,243 

488 

249 

21 

7,799 

16 

120 

43,033 

123,362 

969 

22 

0.05 

163 

7,836 

14,511 

13 

0.55 

1,557 

2,392 

1,204 

50 

21 

1,580 

978 

1.9 

13 

1.4 

3.7 

32,216 

434 

221 

18 

6,933 

15 

107 

38,252 

109,655 

Source: Europe Economics and Bourse Consult analysis. 

The table below presents the annual (2012) opportunity cost across the EU of holding 
this amount of cash. As can be seen the opportunity costs vary significantly across the 
EU28,  from  just  over  €4,500  in  Greece  to  over  €500  million  in  the  Netherlands.  The 
costs  represent  between  around  0.01  and  0.05  per  cent  of  total  AUM.    The  weighted 
average opportunity cost across Member States is around 0.03 per cent of AUM. 

The  opportunity  costs  to  PSAs  across  Member  States  of  holding  this  amount  of  cash 
depends  on  a  number  of  factors,  such  as  how  much  cash  they  already  have  and  can 
use to create the cash buffer; what assets they need to sell to create the remainder of 
the buffer; the foregone yield on these assets; and the yield that can be made on the 
cash held.  For example, despite the NL having only a slightly higher aggregate  cash 
buffer  requirement  than  the  UK,  Dutch  PSAs  would  incur  a  much  greater  overall 

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opportunity  cost  due  largely  to  the  higher  average  return  on  SONIA  compared  with 
EONIA. 

Table  8.5:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS 
clearable-historic scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,212 

90% of maximum 
calculated VM call 
1,091 

80% of maximum 
calculated VM call 
970 

8,153 

188 

0.43 

1,368 

131,818 

244,116 

106 

4.64 

13,098 

40,239 

10,128 

849 

234 

26,582 

16,446 

16 

106 

12 

91 

7,338 

169 

0.39 

1,232 

118,637 

219,704 

95 

4.18 

11,788 

36,215 

9,115 

764 

216 

23,924 

14,801 

14 

96 

11 

82 

541,951 

487,756 

3,651 

1,858 

393 

3,285 

1,672 

362 

116,622 

104,960 

123 

899 

354,784 

1,515,048 

110 

809 

319,305 

1,363,558 

6,522 

150 

0.34 

1,095 

105,455 

195,292 

85 

3.71 

10,478 

32,191 

8,102 

679 

199 

21,266 

13,157 

13 

85 

9.43 

73 

433,561 

2,920 

1,487 

331 

93,298 

98 

719 

283,827 

1,212,067 

Source: Europe Economics and Bourse Consult analysis. 

The  ability  to  clear  inflation  swaps  and  the  scope  of  netting  between  these  and  IRS 
reduces  the  size  of  the  cash  buffer,  with  a  resulting  smaller  opportunity  cost,  for  all 
Member  States  except  the  UK.    The  UK’s  opportunity  cost  of  holding  a  cash  buffer 
under  the  combined  scenario  is  greater  than  under  the  scenario  where  only  IRS  are 
clearable.  

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Table  8.6:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS  and 
inflation clearable-historic scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,147 

90% of maximum 
calculated VM call 
1,032 

80% of maximum 
calculated VM call 
918 

7,716 

178 

0.41 

1,295 

124,754 

231,033 

100 

4.39 

12,396 

38,082 

9,585 

804 

224 

25,158 

15,564 

15 

100 

11 

86 

512,908 

3,455 

1,759 

377 

110,372 

116 

851 

456,501 

1,554,594 

6,945 

160 

0.36 

1,166 

112,279 

207,930 

90 

3.95 

11,156 

34,274 

8,627 

723 

208 

22,642 

14,008 

14 

90 

10 

78 

461,617 

3,109 

1,583 

347 

99,335 

104 

766 

410,851 

1,399,149 

6,173 

142 

0.32 

1,036 

99,803 

184,827 

80 

3.51 

9,917 

30,466 

7,668 

643 

191 

20,126 

12,452 

12 

80 

8.92 

69 

410,326 

2,764 

1,407 

318 

88,298 

93 

681 

365,201 

1,243,704 

Source: Europe Economics and Bourse Consult analysis. 

Since more cash is held as the buffer size increases, the opportunity cost of the cash 
buffer will always increase with it, whereas any costs associated with conducting repo 
operations when there is a shortfall in the cash buffer will decrease as the cash buffer 
increases. 

At the cash buffer levels analysed here, in the historic simulation there is no additional 
cost incurred by conducting repo operations to meet excess VM requirements, i.e. the 
cash buffer is always sufficient.  This result arises because the maximum five-day VM 
call  over  the  2007  to  2012  period  is  sufficiently  greater  than  the  maximum  five-day 
VM call for the year of analysis, i.e. 2012.  This result reflects the relative stability of 
interest  rates  over  2012  compared  with the initial  financial  crisis  and the  subsequent 
Eurozone crisis. 

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Since  there  are  no  requirements  for  repo  operations,  the  total  cost  over  one  year  is 
unchanged relative to the opportunity cost of holding an additional cash buffer. 

8.1.3 

100bps scenario 

Here we assume that in forming the cash buffer PSAs would consider the highest five-
day VM call over the past five years as well as the expected VM call in the event of a 
100bps  move  in interest  rates.    This  change  would  be  right  across  the  curve.    Again 
we analyse three different levels of cash buffer. 

For  Member  States  other  than  the  UK,  the  size  of  cash  buffer  required  under  this 
model  is  140  per  cent  of  the  cash  buffer  under  the  normal  scenario.    In  the  UK  the 
increase is far more substantial, at 330 per cent. 

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Table  8.7  Total  cash  VM  requirement  to  be  held  under  the  IRS  clearable-
100bps scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
267 

90% of maximum 
calculated VM call 
241 

80% of maximum 
calculated VM call 
214 

1,799 

41 

0.09 

302 

14,540 

26,926 

23 

1.02 

2,889 

4,438 

2,234 

94 

39 

2,932 

1,814 

3.52 

23 

2.6 

6.87 

1,619 

37 

0.09 

272 

13,086 

24,233 

21 

0.92 

2,600 

3,994 

2,011 

84 

35 

2,639 

1,633 

3.17 

21 

2.34 

6.18 

1,439 

33 

0.08 

242 

11,632 

21,541 

19 

0.82 

2,311 

3,551 

1,787 

75 

31 

2,346 

1,451 

2.81 

19 

2.08 

5.5 

59,777 

53,800 

47,822 

805 

410 

34 

12,863 

27 

198 

122,901 

255,393 

725 

369 

31 

11,577 

24 

179 

110,611 

229,854 

644 

328 

27 

10,291 

22 

159 

98,321 

204,315 

Source: Europe Economics and Bourse Consult analysis. 

Due  to  the  nature  of  the  model,  except  when  a  marginal  increase  in  the  cash  buffer 
results in PSAs within a Member State selling assets with a higher excess return, the 
change in the opportunity cost is linear to the change in the cash buffer. 

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Table 8.8: Annual opportunity cost of holding cash buffer under IRS clearable 
- 100bp scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,703 

90% of maximum 
calculated VM call 
1,533 

80% of maximum 
calculated VM call 
1,362 

11,454 

264 

0.6 

1,922 

185,188 

342,951 

149 

6.52 

18,401 

56,530 

14,229 

1,193 

305 

37,345 

23,104 

22 

149 

17 

148 

10,309 

237 

0.54 

1,730 

166,669 

308,656 

134 

5.87 

16,560 

50,877 

12,806 

1,074 

280 

33,610 

20,794 

20 

134 

15 

124 

9,163 

211 

0.48 

1,538 

148,150 

274,361 

119 

5.22 

14,720 

45,224 

11,383 

955 

256 

29,876 

18,483 

18 

119 

13 

103 

761,372 

685,235 

609,098 

5,129 

2,611 

518 

163,839 

172 

1,263 

1,173,383 

2,803,369 

4,616 

2,349 

475 

147,455 

155 

1,137 

1,056,045 

2,523,037 

4,103 

2,088 

431 

131,071 

138 

1,011 

938,707 

2,242,708 

Source: Europe Economics and Bourse Consult analysis. 

In this scenario, the simulated VM calls for 2012 are supplemented by the excess VM 
call  when  considering  the  requirements  for  repo  operations  to  cover  any  excess  VM 
calls that exceed the cash buffer.  As a result, other than in the case  where 100 per 
cent of the VM call is held as the cash buffer, there are some costs of conducting repo 
operations for all Member States.  These are presented in Table 8.9 below. 

Since  the  size  of  required  repos  increases  with  a  lower  cash  buffer,  the  costs  are 
decreasing  with  the  level  of  the  cash  buffer.    The  model  assumes  that  the  stress 
scenario  only  happens  once  every  twenty  years,  and  thus  we  report  an  average  cost 
for 2012. 

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Table 8.9 Annual cost of repo under IRS clearable - 100bp scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
0.00 

90% of maximum 
calculated VM call 
6.97 

80% of maximum 
calculated VM call 
14 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

47 

1.08 

0.00 

7.87 

379 

702 

0.61 

0.03 

75 

116 

58 

2.44 

1.01 

76 

47 

0.09 

0.61 

0.07 

0.31 

1,558 

21 

11 

0.89 

335 

0.7 

5.17 

3,191 

6,643 

94 

2.16 

0.00 

16 

758 

1,403 

1.22 

0.05 

151 

231 

116 

4.88 

2.02 

153 

95 

0.18 

1.22 

0.14 

0.61 

3,115 

42 

21 

1.77 

670 

1.41 

10 

6,382 

13,287 

Source: Europe Economics and Bourse Consult analysis. 

The  table  below  presents  the  total  costs  to  PSAs  across  the  EU28.    For  funds  with  a 
relatively  high  initial  cash  holding,  the  additional  cost  of  conducting  larger  repo 
operations  as  the  cash  buffer  decreases  could  outweigh  the  saving  from  a  reduced 
opportunity  cost.    However  typically  in  our  model  the  opportunity  cost  change 
outweighs substantially the repo cost, i.e. at face value the lowest possible cost would 
appear to be at the lower cash buffer – but this does not mean this approach would be 
adopted, e.g. if there are concerns over the ability to repo in the levels implied. 

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Table  8.10  Annual  total  cost  (opportunity  cost  and  repo  cost)  under  IRS 
clearable - 100bp scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,703 

90% of maximum 
calculated VM call 
1,540 

80% of maximum 
calculated VM call 
1,376 

11,454 

264 

0.6 

1,922 

185,188 

342,951 

149 

6.52 

18,401 

56,530 

14,229 

1,193 

305 

37,345 

23,104 

22 

149 

17 

148 

10,356 

238 

0.54 

1,738 

167,048 

309,358 

135 

5.89 

16,636 

50,993 

12,864 

1,076 

281 

33,687 

20,841 

20 

135 

15 

124 

9,257 

213 

0.49 

1,554 

148,908 

275,764 

120 

5.27 

14,871 

45,455 

11,499 

959 

258 

30,029 

18,578 

18 

120 

13 

103 

761,372 

686,793 

612,213 

5,129 

2,611 

518 

163,839 

172 

1,263 

1,173,383 

2,803,369 

4,637 

2,360 

476 

147,791 

156 

1,142 

1,059,236 

2,529,680 

4,145 

2,110 

433 

131,742 

139 

1,021 

945,089 

2,255,994 

Source: Europe Economics and Bourse Consult analysis. 

8.1.4 

EBA stress scenario 

Costs here mimic the situation where PSAs used as a reference point the impact of the 
parameters contained within the EBA’s adverse stress tests.   

The  total  cash  VM  requirement  to  be  held  under  a  stress  scenario  where  IRS  only  is 
cleared ranges from €235 billion to €294 billion across the EU28.  This increases to a 
range of €301 billion to €377 billion where both IRS and inflation swaps are clearable. 

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Table 8.11 Total cash VM requirement to be held under the IRS clearable-EBA 
adverse stress scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
308 

90% of maximum 
calculated VM call 
278 

80% of maximum 
calculated VM call 
247 

2,074 

48 

0.11 

348 

16,770 

31,056 

27 

1.18 

3,332 

5,119 

2,577 

108 

45 

3,382 

2,092 

4.06 

27 

3 

7.92 

68,945 

929 

473 

39 

14,836 

31 

229 

141,464 

294,276 

1,867 

43 

0.1 

313 

15,093 

27,950 

24 

1.06 

2,999 

4,607 

2,319 

97 

40 

3,044 

1,883 

3.65 

24 

2.7 

7.13 

1,660 

38 

0.09 

279 

13,416 

24,844 

22 

0.94 

2,666 

4,095 

2,062 

86 

36 

2,705 

1,674 

3.24 

22 

2.4 

6.34 

62,051 

55,156 

836 

426 

35 

13,353 

28 

206 

127,318 

264,848 

743 

378 

31 

11,869 

25 

183 

113,171 

235,421 

Source: Europe Economics and Bourse Consult analysis. 

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Table 8.12 Total cash VM requirement to be held under the IRS and inflation 
clearable-EBA adverse stress scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
370 

90% of maximum 
calculated VM call 
333 

80% of maximum 
calculated VM call 
296 

2,487 

57 

0.13 

417 

20,104 

37,231 

32 

1.42 

3,995 

6,137 

3,089 

130 

54 

4,054 

2,508 

4.86 

32 

3.6 

9.5 

82,655 

1,114 

567 

47 

17,787 

37 

274 

193,432 

376,631 

2,238 

51 

0.12 

376 

18,094 

33,508 

29 

1.27 

3,596 

5,523 

2,780 

117 

48 

3,649 

2,257 

4.38 

29 

3.24 

8.55 

74,390 

1,002 

510 

42 

16,008 

34 

247 

174,089 

338,968 

1,990 

46 

0.1 

334 

16,083 

29,785 

26 

1.13 

3,196 

4,910 

2,471 

104 

43 

3,243 

2,007 

3.89 

26 

2.88 

7.6 

66,124 

891 

453 

38 

14,229 

30 

219 

154,746 

301,305 

Source: Europe Economics and Bourse Consult analysis. 

The tables below present the annual opportunity costs of holding different proportions 
of  the  total  VM  cash  buffer.    Costs  across  the  EU28  range  from  €2.6  billion  to  €3.2 
billion  for  the  IRS-only  scenario,  and  between  €3.3  billion  and  €4.1  billion  for  the 
inflation and IRS scenario.    

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Table  8.13:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS 
clearable-EBA adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,964 

90% of maximum 
calculated VM call 
1,768 

80% of maximum 
calculated VM call 
1,571 

13,211 

304 

0.69 

2,217 

213,590 

395,549 

172 

7.52 

21,223 

65,200 

16,411 

1,376 

343 

43,072 

26,648 

26 

172 

19 

186 

11,890 

274 

0.62 

1,996 

192,231 

355,994 

155 

6.77 

19,100 

58,680 

14,770 

1,239 

314 

38,765 

23,983 

23 

155 

17 

158 

10,569 

243 

0.56 

1,774 

170,872 

316,439 

138 

6.02 

16,978 

52,160 

13,129 

1,101 

286 

34,458 

21,318 

21 

138 

15 

130 

878,142 

790,328 

702,514 

5,915 

3,011 

584 

188,967 

199 

1,457 

1,350,611 

3,230,576 

5,324 

2,710 

534 

170,070 

179 

1,311 

1,215,550 

2,907,523 

4,732 

2,409 

484 

151,174 

159 

1,166 

1,080,489 

2,584,470 

Source: Europe Economics and Bourse Consult analysis. 

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Table  8.14:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS  and 
inflation clearable-EBA adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
2,355 

90% of maximum 
calculated VM call 
2,119 

80% of maximum 
calculated VM call 
1,884 

15,838 

364 

0.83 

2,658 

256,063 

474,204 

206 

9.02 

25,443 

78,165 

19,674 

1,650 

400 

51,637 

31,947 

31 

206 

23 

242 

14,254 

328 

0.75 

2,392 

230,457 

426,784 

185 

8.11 

22,898 

70,348 

17,707 

1,485 

365 

46,474 

28,752 

28 

186 

21 

208 

12,670 

291 

0.67 

2,127 

204,850 

379,364 

165 

7.21 

20,354 

62,532 

15,739 

1,320 

331 

41,310 

25,557 

25 

165 

18 

174 

1,052,763 

947,487 

842,210 

7,091 

3,610 

684 

226,544 

238 

1,747 

1,846,767 

4,100,558 

6,382 

3,249 

624 

203,889 

214 

1,572 

1,662,090 

3,690,507 

5,673 

2,888 

564 

181,235 

190 

1,398 

1,477,413 

3,280,456 

Source: Europe Economics and Bourse Consult analysis. 

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Table  8.15  Annual  cost  of  repo  under  IRS  clearable-EBA  adverse  stress 
scenario, €000s 

100% of maximum 
calculated VM call 
0.00 

90% of maximum 
calculated VM call 
8.04 

80% of maximum 
calculated VM call 
16 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

54 

1.24 

0.00 

9.07 

437 

809 

0.7 

0.03 

87 

133 

67 

2.82 

1.17 

88 

55 

0.11 

0.7 

0.08 

0.35 

1,796 

24 

12 

1.02 

387 

0.81 

5.96 

3,673 

7,655 

Source: Europe Economics and Bourse Consult analysis. 

108 

2.49 

0.01 

18 

874 

1,618 

1.41 

0.06 

174 

267 

134 

5.63 

2.33 

176 

109 

0.21 

1.41 

0.16 

0.71 

3,593 

48 

25 

2.04 

773 

1.62 

12 

7,346 

15,310 

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Table 8.16 Annual cost of repo under IRS and inflation clearable-EBA adverse 
stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
0.00 

90% of maximum 
calculated VM call 
9.63 

80% of maximum 
calculated VM call 
19 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

65 

1.49 

0.00 

11 

524 

970 

0.84 

0.04 

104 

160 

80 

3.38 

1.4 

106 

65 

0.13 

0.84 

0.09 

0.43 

2,154 

29 

15 

1.23 

463 

0.97 

7.15 

5,022 

9,796 

130 

2.98 

0.01 

22 

1,048 

1,940 

1.69 

0.07 

208 

320 

161 

6.75 

2.8 

211 

131 

0.25 

1.69 

0.19 

0.85 

4,307 

58 

30 

2.45 

927 

1.95 

14 

10,045 

19,592 

Source: Europe Economics and Bourse Consult analysis. 

The most significant driver of the total costs over one year, shown in the table below, 
is the opportunity cost of holding additional cash.   

Once again, whilst the cost may be minimised at the 80 per cent buffer, concerns over 
the repo market does not mean this (or, indeed, an even lower cash buffer) would be 
adopted. 

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Table  8.17  Annual  total  cost  (opportunity  cost  and  repo  cost)  under  IRS 
clearable-EBA adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
1,964 

90% of maximum 
calculated VM call 
1,776 

80% of maximum 
calculated VM call 
1,587 

13,211 

304 

0.69 

2,217 

213,590 

395,549 

172 

7.52 

21,223 

65,200 

16,411 

1,376 

343 

43,072 

26,648 

26 

172 

19 

186 

11,944 

275 

0.63 

2,005 

192,668 

356,803 

155 

6.8 

19,187 

58,813 

14,837 

1,241 

316 

38,853 

24,037 

23 

155 

17 

158 

10,677 

246 

0.56 

1,792 

171,746 

318,057 

139 

6.08 

17,152 

52,427 

13,263 

1,107 

288 

34,634 

21,427 

21 

139 

15 

130 

878,142 

792,124 

706,106 

5,915 

3,011 

584 

188,967 

199 

1,457 

1,350,611 

3,230,576 

5,348 

2,722 

535 

170,457 

179 

1,317 

1,219,223 

2,915,178 

4,780 

2,433 

486 

151,947 

160 

1,178 

1,087,835 

2,599,780 

Source: Europe Economics and Bourse Consult analysis. 

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Table 8.18  Annual total cost (opportunity  cost and repo cost) under  IRS  and 
inflation clearable-EBA adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
2,355 

90% of maximum 
calculated VM call 
2,129 

80% of maximum 
calculated VM call 
1,903 

15,838 

364 

0.83 

2,658 

256,063 

474,204 

206 

9.02 

25,443 

78,165 

19,674 

1,650 

400 

51,637 

31,947 

31 

206 

23 

242 

14,319 

329 

0.75 

2,403 

230,980 

427,754 

186 

8.15 

23,003 

70,508 

17,787 

1,488 

367 

46,579 

28,817 

28 

186 

21 

208 

12,800 

294 

0.67 

2,148 

205,898 

381,304 

167 

7.29 

20,562 

62,852 

15,900 

1,327 

334 

41,521 

25,688 

25 

167 

19 

175 

1,052,763 

949,640 

846,517 

7,091 

3,610 

684 

226,544 

238 

1,747 

1,846,767 

4,100,558 

6,411 

3,263 

625 

204,353 

215 

1,579 

1,667,113 

3,700,303 

5,731 

2,917 

566 

182,162 

192 

1,412 

1,487,458 

3,300,048 

Source: Europe Economics and Bourse Consult analysis. 

8.1.5 

Adverse stress scenario 

Costs here mimic the situation where PSAs used as a reference point the impact of the 
parameters  contained  within  the  Federal  Reserve’s  adverse  stress  tests.    These  are 
somewhat akin to a crisis laid upon a crisis – i.e. very unlikely events. 

Since the cash buffer is directly proportional to the size of the maximum VM call, the 
cash buffer held by all Member States other than the UK is 2.6 times greater than in 
the normal scenario for the IRS model.  In the case of the UK, this multiple increases 
to 6.8. 

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Table  8.19  Total  cash  VM  requirement  to  be  held  under  the  IRS  clearable-
adverse stress scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
499 

90% of maximum 
calculated VM call 
449 

80% of maximum 
calculated VM call 
399 

3,358 

77 

0.18 

564 

27,142 

50,265 

44 

1.91 

5,394 

8,285 

4,171 

175 

72 

5,474 

3,386 

6.56 

44 

4.85 

13 

111,592 

1,503 

765 

63 

24,013 

50 

370 

254,282 

501,616 

3,022 

70 

0.16 

507 

24,428 

45,239 

39 

1.72 

4,854 

7,457 

3,754 

157 

65 

4,926 

3,048 

5.91 

39 

4.37 

12 

100,433 

1,353 

689 

57 

21,612 

45 

333 

228,854 

451,455 

2,686 

62 

0.14 

451 

21,714 

40,212 

35 

1.53 

4,315 

6,628 

3,337 

140 

58 

4,379 

2,709 

5.25 

35 

3.88 

10 

89,274 

1,203 

612 

51 

19,211 

40 

296 

203,425 

401,293 

Source: Europe Economics and Bourse Consult analysis. 

The  VM  requirement  for  the  UK  is  higher  under  the  IRS-only  case  in  the  FED  stress 
scenario.    This  is  different  to  the  other  simulations  (i.e.  historic  data  and  the  EBA 
stress scenario) in which the VM requirement for the UK is greater when both IRS and 
inflation  swaps  are  clearable.    This  is  because  inflation  for  the  UK  is  assumed  to 
increase  under  the  Fed  adverse  scenario,  while  it  decreases  in  the  EBA  scenario  and 
during the worst 5-day period in the historic scenario. 

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Table 8.20 Total cash VM requirement to be held under the IRS and inflation 
clearable-adverse stress scenario, €millions 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
438 

90% of maximum 
calculated VM call 
394 

80% of maximum 
calculated VM call 
350 

2,945 

68 

0.15 

494 

23,808 

44,090 

38 

1.68 

4,731 

7,267 

3,658 

153 

64 

4,801 

2,970 

5.76 

38 

4.26 

11 

97,882 

1,319 

671 

56 

21,063 

44 

325 

203,313 

420,261 

2,651 

61 

0.14 

445 

21,427 

39,681 

34 

1.51 

4,258 

6,541 

3,293 

138 

57 

4,321 

2,673 

5.18 

34 

3.83 

10 

88,094 

1,187 

604 

50 

18,957 

40 

292 

182,982 

378,235 

2,356 

54 

0.12 

395 

19,046 

35,272 

31 

1.34 

3,785 

5,814 

2,927 

123 

51 

3,841 

2,376 

4.61 

31 

3.41 

9. 

78,306 

1,055 

537 

45 

16,851 

35 

260 

162,651 

336,209 

Source: Europe Economics and Bourse Consult analysis. 

In  line  with  the  increased  cash  buffer  requirements  under  this  scenario,  there  is  an 
increased  opportunity  cost  of  holding  cash.    This  is  typically  of  the  same  magnitude, 
except in cases where the cash buffer eats sufficiently into the initial cash holding that 
there  is  a  requirement  to  sell  a  higher  than  proportional  level  of  assets  to  meet  the 
desired cash buffer. 

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Table  8.21:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS 
clearable-adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
3,179 

90% of maximum 
calculated VM call 
2,861 

80% of maximum 
calculated VM call 
2,543 

21,382 

492 

1.12 

3,589 

345,707 

640,218 

278 

12 

34,350 

105,530 

26,562 

2,228 

562 

69,715 

43,131 

42 

278 

31 

359 

19,244 

443 

1.01 

3,230 

311,137 

576,196 

250 

11 

30,915 

94,977 

23,906 

2,005 

473 

62,743 

38,818 

38 

250 

28 

314 

17,106 

394 

0.9 

2,871 

276,566 

512,174 

223 

9.74 

27,480 

84,424 

21,249 

1,782 

427 

55,772 

34,505 

33 

223 

25 

269 

1,421,322 

1,279,190 

1,137,058 

9,574 

4,873 

893 

305,854 

321 

2,358 

2,427,721 

5,470,563 

8,617 

4,386 

813 

275,268 

289 

2,123 

2,184,949 

4,923,473 

7,659 

3,899 

732 

244,683 

257 

1,887 

1,942,177 

4,376,426 

Source: Europe Economics and Bourse Consult analysis. 

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Table  8.22:  Annual  opportunity  cost  of  holding  cash  buffer  under  IRS  and 
inflation clearable-adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
2,788 

90% of maximum 
calculated VM call 
2,510 

80% of maximum 
calculated VM call 
2,231 

18,755 

431 

0.99 

3,148 

303,234 

561,562 

244 

11 

30,130 

92,564 

23,298 

1,954 

463 

61,150 

37,832 

37 

244 

27 

304 

16,880 

388 

0.89 

2,833 

272,911 

505,406 

220 

9.61 

27,117 

83,308 

20,969 

1,758 

422 

55,035 

34,049 

33 

220 

24 

264 

15,004 

345 

0.79 

2,518 

242,588 

449,249 

195 

8.54 

24,104 

74,052 

18,639 

1,563 

382 

48,920 

30,265 

29 

195 

22 

224 

1,246,702 

1,122,031 

997,361 

8,398 

4,275 

794 

268,277 

282 

2,069 

1,941,107 

4,610,080 

7,558 

3,847 

723 

241,449 

254 

1,862 

1,746,997 

4,149,077 

6,718 

3,420 

652 

214,622 

225 

1,655 

1,552,886 

3,688,074 

Source: Europe Economics and Bourse Consult analysis. 

As with all the stress scenarios, there is a requirement to conduct repos when the cash 
buffer  is  less  than  100  per  cent  of  the  expected  maximum  VM  call.    The  cost  across 
the  IRS  clearing  model  and  the  model  where  both  IRS  and  inflation  are  cleared  is 
similar across both models for most Member States.  However in the case of the UK, 
there  is  a  significantly  greater  cost  associated  with  conducting  repo  operations  when 
inflation is not cleared. 

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Table  8.23  Annual  cost  of  repo  under  IRS  clearable-adverse  stress  scenario, 
€000s 

Member State 

100% of maximum 
calculated VM call 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

90% of maximum 
calculated VM call 
of maximum 
calculated VM call 
13 

87 

2.01 

0.00 

15 

707 

1,310 

1.14 

0.05 

141 

216 

109 

4.56 

1.89 

143 

88 

0.17 

1.14 

0.13 

0.57 

2,908 

39 

20 

1.65 

626 

1.31 

9.65 

6,602 

13,047 

80% of maximum 
calculated VM call 

26 

175 

4.03 

0.01 

29 

1,414 

2,619 

2.28 

0.1 

281 

432 

217 

9.11 

3.77 

285 

176 

0.34 

2.28 

0.25 

1.15 

5,815 

78 

40 

3.31 

1,251 

2.63 

19 

13,205 

26,094 

Source: Europe Economics and Bourse Consult analysis. 

July 2014    136

 
 
European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

Table  8.24  Annual  cost  of  repo  under  IRS  and  inflation  clearable-adverse 
stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
0.00 

90% of maximum 
calculated VM call 
11 

80% of maximum 
calculated VM call 
23 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

0.00 

77 

1.77 

0.00 

13 

620 

1,149 

1. 

0.04 

123 

189 

95 

4. 

1.66 

125 

77 

0.15 

1. 

0.11 

0.5 

2,550 

34 

17 

1.45 

549 

1.15 

8.46 

5,279 

10,932 

153 

3.53 

0.01 

26 

1,241 

2,298 

2. 

0.09 

247 

379 

191 

7.99 

3.31 

250 

155 

0.3 

2. 

0.22 

1.01 

5,101 

69 

35 

2.9 

1,098 

2.31 

17 

10,558 

21,864 

Source: Europe Economics and Bourse Consult analysis. 

The  most  significant  driver  of  the  total  costs  over  one  year,  presented  in  the  table 
below, is the opportunity cost of holding additional cash.   

Once again, whilst the cost may be minimised at the 80 per cent buffer, concerns over 
the repo market does not mean this (or, indeed, an even lower cash buffer) would be 
adopted. 

July 2014    137

 
 
European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

Table  8.25  Annual  total  cost  (opportunity  cost  and  repo  cost)  under  IRS 
clearable-adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
3,179 

90% of maximum 
calculated VM call 
2,874 

80% of maximum 
calculated VM call 
2,569 

21,382 

492 

1.12 

3,589 

345,707 

640,218 

278 

12 

34,350 

105,530 

26,562 

2,228 

562 

69,715 

43,131 

42 

278 

31 

359 

19,332 

445 

1.02 

3,245 

311,844 

577,506 

252 

11 

31,055 

95,192 

24,014 

2,009 

475 

62,886 

38,906 

38 

252 

28 

315 

17,281 

398 

0.91 

2,900 

277,980 

514,793 

225 

9.84 

27,761 

84,855 

21,467 

1,791 

431 

56,057 

34,681 

34 

225 

25 

270 

1,421,322 

1,282,098 

1,142,873 

9,574 

4,873 

893 

305,854 

321 

2,358 

2,427,721 

5,470,563 

8,656 

4,406 

814 

275,894 

291 

2,132 

2,191,552 

4,936,520 

7,737 

3,939 

735 

245,934 

260 

1,906 

1,955,382 

4,402,520 

Source: Europe Economics and Bourse Consult analysis. 

July 2014    138

 
 
European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

Table 8.26  Annual total cost (opportunity  cost and repo cost) under  IRS  and 
inflation clearable-adverse stress scenario, €000s 

Member State 

AT 

BE 

BG 

CY 

CZ 

DE 

DK 

EE 

EL 

ES 

FI 

FR 

HR 

HU 

IE 

IT 

LT 

LU 

LV 

MT 

NL 

PL 

PT 

RO 

SE 

SI 

SK 

UK 

Total 

100% of maximum 
calculated VM call 
2,788 

90% of maximum 
calculated VM call 
2,521 

80% of maximum 
calculated VM call 
2,254 

18,755 

431 

0.99 

3,148 

303,234 

561,562 

244 

11 

30,130 

92,564 

23,298 

1,954 

463 

61,150 

37,832 

37 

244 

27 

304 

16,957 

390 

0.89 

2,846 

273,531 

506,554 

221 

9.65 

27,240 

83,497 

21,064 

1,762 

424 

55,160 

34,126 

33 

221 

25 

264 

15,158 

349 

0.8 

2,544 

243,828 

451,547 

197 

8.63 

24,350 

74,430 

18,829 

1,571 

385 

49,170 

30,420 

30 

197 

22 

225 

1,246,702 

1,124,582 

1,002,462 

8,398 

4,275 

794 

268,277 

282 

2,069 

1,941,107 

4,610,080 

7,592 

3,865 

725 

241,998 

255 

1,870 

1,752,276 

4,160,009 

6,787 

3,455 

655 

215,719 

228 

1,672 

1,563,444 

3,709,938 

Source: Europe Economics and Bourse Consult analysis. 

July 2014    139

 
 
 
 
 
 
 
 
 
 
 
 
European Commission 
 Baseline report on solutions for the posting of non-cash collateral to CCPs by PSAs 

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ISBN -978-92-79-33042-1 
DOI 10.2780/17409 

July 2014    140