Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act that go into effect Sept. 9 have many pension funds concerned, perhaps unnecessarily.
According to research by Northern Trust, many pension funds use interest rate swaps to synthetically increase their portfolios' lifespan while conserving capital. These swaps are widely used in liability-driven investment strategies as a hedge.
Dodd-Frank, which was passed two years ago, increased regulation of the $633 trillion over-the-counter derivative market.
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Specifically, Dodd-Frank added new capital requirements on these swaps: initial margin and variation margin. The initial margin is intended to cover the fluctuation in a contract's value over a fixed period. The variation margin mitigates credit exposure arising from daily fluctuations of a contract's market value.
The U.S. Commodity Futures Trading Commission and the SEC want financial entities to post limited asset types to cover their initial margin obligations, including cash, U.S. Treasuries and other "high-quality" liquid assets. Currently, exchanges accept "flexible collateral" for initial margin, but apply discounts to less-liquid instruments, subtracting from the market value of the instrument pledged as collateral.
The new capital requirements can seem imposing, according to Northern Trust, and many plan managers are worried about their impact.
The estimated demand of initial margin required has been quoted between $800 billion and $10 trillion. Whatever the number, many fear there could be a shortfall in available high-quality assets to meet the requirements for plans.
Northern Trust, attempting to determine the impact of Dodd-Frank on initial margin requirements on pension funds, found that the average initial margin requirement was $5.3 million, and only 18 percent of funds had an initial margin requirement larger than $10 million.
"Our analysis shows that most funds in our sample group with margin requirements of more than $1 million have ample eligible collateral, in the form of high-grade government or corporate bonds, to meet their initial margin requirements," the report stated.
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