Pension funds in the U.K. will likely turn away from using credit derivatives because of a planned pension protection regulation that would levy higher charges on funds using them. Users will be forced to pay a higher levy to the protection scheme because they are not recognized as an effective risk mitigation tool. The levy is compulsory for all defined benefit pension schemes starting April.
Tim Keogh, worldwide partner at pension fund consultant Mercer Investment Consulting, said the proposed levy limits the advantage for funds to use credit default swaps. He noted some funds may continue to use credit derivatives but said most are likely to opt for alternative methods of risk management, such as bank guarantees.
The proposal is from the Pension Protection Fund, which was set up to provide compensation in the event of an employer bankruptcy. It may require pension funds to contribute up to 0.5% of their total liabilities. Funds must pay a duty based in part on the risk of the sponsoring employer becoming insolvent and the tools they use to reduce this risk. CDS have been labeled ineligible, which officials say effectively bars their use by pension funds.
The proposal has drawn criticism from the International Swaps and Derivatives Association, which has requested a meeting with the PPF and is drafting a formal response to a consultation paper. Richard Metcalfe, senior policy director at ISDA in London, said CDS are the only risk mitigation instrument not accepted for the levy. "[PPF plans to recognize] contingent assets such as guarantees, securities and letters of credit," he said. "We want to get the same relief for CDS."
In the pension protection levy consultation document released in December, the PPF wrote it has not included CDS because it feels there is a lack of universal documentation governing the instruments. Metcalfe said ISDA will aim to persuade the PPF there is sufficient market standardization in place. "At the least we want to assure them there is a tried and tested documentation history," he said, adding, "Pension funds' access to a full suite of risk mitigation techniques will be removed if the document passes as it stands."
The PPF indicated they would consider recognizing credit derivatives in future years if documentation is developed which it feels adequately reflects the "complex mechanics of their operation." At the earliest this will be 2008, which one player said is long enough to stagnate pension fund participation in the CDS market. John Lavabre, press officer at the PPF in London, said consultation of the proposal will continue until the Jan. 23 deadline, declining comment on the CDS issue.