On 8 June 2020, the Financial Sector Conduct Authority ("FSCA") published a draft conduct standard titled "Conditions for Investment in Derivative Instruments for Pension Funds" (the "Draft Conditions"), by which the FSCA would regulate the parameters for pension funds to enter into derivative transactions. The Draft Conditions are an improvement over the first attempt at this regulation, which was released by then Financial Services Board in 2010.
The Draft Conditions apply to pension funds registered under the Pension Funds Act, 1956. In summary, they outline the ways in which pension funds may use derivatives. As to be expected, pension funds may only use derivatives for hedging and effective portfolio management, but not for speculative or leveraging purposes. In using derivatives for hedging and portfolio management, pension funds must, among other things:
- stick within set value limits (not greater than 25% of the pension fund's assets)
- only enter into derivatives allowed in the fund's investment policy statement
- hold assets at least equal the effective economic derivative exposure (which is defined in the Draft Conditions as being the exposure, taking into account the delta(s) of the derivative)
Risk management policy
The pension fund's board must adopt and implement a risk management policy, ensure risk monitoring in the derivatives, and obtain legal and technical advice in areas where the board itself lacks necessary expertise. The Draft Conditions provide detailed instructions for calculating exposure for purposes of Regulation 28 and the netting of the effective economic derivative exposure against effective economic exposure of the assets of the pension fund.
In relation to collateral, the Draft Conditions include paragraph 7, stating that the collateral must consist of assets or instruments prescribed as eligible collateral in the FSRA Joint Standard 1 of 2020 (Margin requirements for non-centrally cleared OTC derivative transactions) ("Joint Standard 1"). At present, cash and gold are the only such prescribed assets for eligible collateral, and OTC derivative providers are not required to exchange collateral with pension funds in terms of Joint Standard 1. The collateral paragraph does allow for outright transfers or pledges of collateral, though the provisions of the paragraph are unclear at various points whether it is referring to collateral posted to or by the pension fund.
Finally, paragraph 8 stipulates the information that the pension fund must receive from its financial services providers or OTC derivatives provider with reference to the FMA Conduct Standard 2 of 2018, which is the Conduct Standard for Authorised OTC Derivative Providers (the "ODP Conduct Standard"). Interestingly, paragraph 4 of the Draft Conditions contains a list of allowable counterparties, which includes a number of types of entities that may not be OTC derivative providers such as foreign banks, foreign insurers, insurers and authorised users.
Reason to comment
There are a few provisions on which industry may find reason to comment. For example, paragraph 2(5) of the Draft Conditions requires that derivative transactions must be capable of being sold, liquidated or closed out at the fund's initiative. For a pension fund to require this sort of optional early termination in a hedge will, in most cases, significantly increase pricing for the pension fund of the hedge.
Paragraph 2(6) of the Draft Conditions goes on to require that the derivative transaction must have a consistent, transparent and verifiable methodology for valuing, which must be done by third party independent valuers. Joint Standard 1 recognises that in many cases, valuation of a derivative will involve proprietary methodologies specific to an OTC derivative provider and does not require their disclosure. It is not clear in the Draft Conditions why the FSCA will expect the OTC derivative providers to disclose those proprietary methodologies.
Finally, paragraph 5(2)(d) of the Draft Conditions requires that a pension fund may net its exposures under multiple derivatives with the same counterparty, provided that an agreement recognised by section 35B of the Insolvency Act, 1936 (for derivatives, essentially the ISDA Master Agreement) is in place and that on a default by the counterparty, the fund must only pay the net sum of the positive and negative mark-to-market values of the underlying transactions. Section 35B, however, does not mandate the statutory netting of the mark-to-market values of the transactions; rather it mandates the statutory netting of market values of unperformed obligations.
The Draft Conditions can be found at this link. Comments to the Draft Conditions are due to the FSCA, using the submission template available with the Draft Conditions, on or before 31 July 2020 at FSCA.RFDStandards@fsca.co.za.
Originally published 09 June 2020
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