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European pension funds will soon be subject to reinforced regulatory requirements, particularly with regard to their liquidity risks and their climate policies. Securities Services at BNP Paribas provides an overview of those requirements and the solutions to comply with them.
Liquidity management and derivatives transactions for pension funds
In the wake of the recent so-called gilts crisis in the UK, supervisory authorities and central banks took steps to increase their scrutiny of pension funds. They aim at monitoring more closely the liquidity issues the latter might face in times of market stress.
Margin calls are a major feature in the derivatives transactions of pension funds. They were put in place to mitigate systemic risks in the derivatives market in the aftermath of the 2008 crisis. As highlighted in a number of analyses, “the exchange of margin in the form of high-quality collateral reduces counterparty credit risk. But the requirements also increase liquidity risk as counterparties need to meet margin calls with high-quality collateral at short notice”[i]. Due to the mandatory clearing requirements of the European Market Infrastructure Regulation (EMIR) and the effects of Basel III on counterparties, more than ever, one may consider that “cash is king” in the exchanges of variation margin. Sudden jumps in rates can entail an increase in the requirement to post margin. With this in mind, pension funds need to strengthen their preparation to deal with liquidity risks.
Pursuant to EMIR, as of June 2023, pension funds which have in their portfolios large exposures in standardised over-the-counter (OTC) derivatives (for example, more than EUR 3 billion in Interest Rates Derivatives) will have to clear them in central counterparties (CCPs). If pension funds cannot be direct members of CCPs, they will have to become clients of Clearing Members, who will clear OTC derivatives on their behalf.
As regards their exposures to other types of OTC derivatives, pension funds with large portfolios (at least EUR 8 billion) must exchange margins with their counterparties since September 2022.
Towards increased scrutiny of pension funds
The gilts crisis also led supervisory authorities to turn their attention to the investment risks borne by pension funds. As supervision is data-based, the European Insurance and Occupational Pensions Authority (EIOPA) decided in February 2023 in cooperation with national European authorities to refine its supervision strategy of pension funds[ii]. EIOPA requested national European authorities in charge of supervising pension funds to adapt their data collection processes vis-à-vis pension funds by 2025. More specifically, EIOPA:
- exempted pension funds with less than EUR 50 million in total assets from data collection,
- made the quarterly collection of derivatives and cash flows data obligatory for pension funds with more than EUR 1 billion of assets under management (on derivatives and cash calls),
- included new data (on investments in Undertakings for the Collective Investment in Transferable Securities – UCITS -, and derivatives positions) in the scope of the data to be reported.
Liquidity risk of European pension funds will increasingly become a focal point in future regulatory developments. In a consultation on its future Advice on the Institutions for Occupational Retirement Provision Directive (IORP) II Review (launched in March 2023), EIOPA invited pension funds to establish repo arrangements with banking counterparties. EIOPA also proposed to strengthen pension funds’ internal reporting (such as the Own Risk Assessment – ORA – and the Supervisory Review Process – SRP) on liquidity risk management for pension funds with material derivatives exposures.
ESG monitoring and sustainable finance for pension funds
European pension funds can play a key role in supporting the sustainable transition of the European economy. European regulators plan to introduce new requirements for pension funds in relation to climate risks and the way pension funds include sustainability in their operations.
With the entry into application of the regulatory technical standards of the Sustainable Finance Disclosure Regulation (SFDR) in January 2023, pension funds must disclose whether they consider (and if not, why) Principal Adverse Impacts (PAIs) of their investment decisions on sustainability factors. These are the negative effects on environmental, social and employee matters as well as respect for human rights, anti-corruption and anti-bribery resulting from an investment decision.
In addition to SFDR, pension funds are also subject to the Taxonomy Regulation, which requires pension funds to disclose how and to what extent their economic activity includes, promotes, or finances sustainable projects (depending on pre-established criteria). The EIOPA consultation on the IORP II Review also includes questions on the inclusion of sustainability risks in the investment decisions of pension funds.
In April 2022, EIOPA launched its first climate stress tests on European pension funds with a view to testing the resilience of the sector against a climate change scenario (sharp rise in carbon prices due to a sudden, disorderly transition to climate neutrality). One of the conclusions of the stress tests (published by EIOPA in December 2022) was that more than “90% of tested pension funds consider ESG factors when determining their investment policy’[iii] but pension funds “nonetheless still experience noteworthy hurdles to allocate investments to (climate risk-sensitive) business activities, in particular for investments via investment funds”[iv]. In cooperation with the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA), EIOPA will run another climate stress test in 2024 on the whole European financial sector to verify whether European financial actors would be able to continue financing sustainable transition in times of crisis.
ESG data and monitoring: discover our solutions and insights
[ii]Decision of the Board of Supervisors on EIOPA’s regular information request regarding provision of occupational pensions information (europa.eu)