Why did UK keep the pension fund clearing exemption?

Liquidity concerns, desire for higher returns and clearing capacity all possible reasons for going its own way

UK pension funds have been on the cusp of being forced to clear their over-the-counter derivatives since 2012.

The clearing requirement was brought in as part of post-global financial crisis regulation to enhance financial stability, reduce systemic risk and increase transparency in derivatives markets.

But a series of pushbacks at European Union-level pre-Brexit and subsequent opposition from HM Treasury after the UK left the bloc has meant schemes have remained exempt from the requirement.

The latest extension of the exemption comes to an end on June 18 this year, but on January 10 HM Treasury decided to make the carve-out permanent.

What’s puzzling is why the UK has taken a different path to the EU.

One of the main reasons the clearing exemption was continually pushed back was to allow time for a solution to be found that would enable pension funds to be able to post cash variation margin to the clearing house at short notice, without impacting the scheme’s ability to generate sufficient returns for its members. Whereas with bilateral uncleared derivative trades, schemes can post their government bond assets as margin. 

The overwhelming objection to the clearing requirement was that cash collateral demands would inhibit schemes’ ability to invest in high-growth assets

Nevertheless, European pension funds were required to start clearing in June 2023 after the European Securities and Markets Authority recommended that the exemption come to an end as sponsored cleared repo models and other collateral transformation solutions were now available to pension funds to deal with cash variation margin demands.

The UK has arguably gone a step further to help ease any pension fund liquidity problems. The Bank of England will soon start accepting applications for its contingent non-bank financial intermediation repo facility, which enables schemes to borrow cash against their gilts during severe gilt market dysfunction – an attempt to avoid a repeat of the 2022 crisis.

But in peacetime, some sources argue the gilt repo market might not be able to handle all UK pension funds clearing in the same way that the European markets could.

Other clues can be found in the responses to a HM Treasury consultation that ran from November 2023 asking for feedback on the topic.

Related

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Pensions eye collateral facilities to buffer market turmoil 

Out of the 26 responses it received, the overwhelming objection to the clearing requirement was that cash collateral demands would inhibit schemes’ ability to invest in high-growth assets such as private equity and infrastructure. 

As part of her Mansion House speech in November last year, UK finance minister Rachel Reeves said that pension fund capital had not been used to invest in UK start-ups or infrastructure for a long-time. To address this, Reeves announced the introduction of Canadian and Australian-style mega funds through consolidation of defined contribution schemes and local government pension schemes.

This, Reeves said, would mean the mega funds would be able to invest at scale, which the government estimated would result in £80 billion ($90 billion) for investment in private equity, including businesses and UK infrastructure projects. 

Anecdotally, some also point to the limited number of clearing members offering clearing services to pension funds, questioning whether they would have been able to absorb the increased demand had the exemption ended.

However, given pension funds are arguably the biggest derivatives users in the UK – such that their activities can have material impacts on the government bond market as was seen in 2022 – the question some might ask is whether these are a strong enough reasons to diverge from the post-2008 Group of 20 agreement to shift as much risk into clearing houses as possible.

Editing by Lukas Becker

Update, January 27, 2025: This article was changed to state that the Bank of England’s contingent non-bank financial intermediation repo facility has not yet begun accepting applications but is expected to do so soon.