I’ve recently been looking at booking a skiing trip. Firstly, I need to find a resort to ski in, and then I need to arrange how I’m going to get there. As I’m not that long out of university, I’ll be looking to travel as cheaply as possible! Naturally a budget airline fits the bill. Cheap headline price: check.
It is unquestionable that the initial cost of a budget airline is cheaper than their more costly rivals: but what about the hidden charges? With a budget airline you have to pay for luggage; you pay for food (and water) on the flight; even seat allocation is an extra charge! Some airlines add more to check in at the airport rather than online, and on top of that they often stick a cost on for booking and admin fees.
You soon see that booking a cheap flight isn’t as clear cut as simply looking at how much the flight costs on day one. I think there is a similar challenge when looking at the cost of cleared derivatives, which is important for a pension scheme given they are not currently forced to clear.
Generally speaking, the headline cost of trading derivatives with a bank in a cleared world is cheaper than if we weren’t clearing that trade. However, there are additional costs to clearing that need to be taken into account when working out what is more cost effective.
In a non-cleared world, we can post some of the pension schemes gilts as collateral without any material additional cost (as we hold them anyway).
In a cleared world we can only post cash as collateral.
Consider the cost of actually locating the cash to post to the banks instead of gilts. As these gilts form part of an LDI portfolio, a pension scheme would generally want to keep them. As a result, the only way to get cash for collateral is to borrow it, using the gilts as security for that borrowing – this is called a repurchase transaction (“repo”). The problem with a repo is that there is a cost to the pension scheme of borrowing that cash. This cost needs to be factored in to the cost of clearing.
Pension schemes can only clear by using a “clearing member” as an intermediary between the scheme and the clearing house. This incurs another cost in the fee paid to a clearing member for providing this service. This currently locks out some smaller schemes from even considering clearing.
I’m not saying that clearing will always be more expensive, but in many cases the additional costs may well be greater than the saving you gain from the initial charge.
This will not be the case forever as the banks charge more for not clearing, but it is important for schemes (and their LDI managers) to look beyond the lure of a cheap initial cost.