Pension Fund Clearing Obligation Exemption (Amendment) Regulations 2025

Lord Wilson of Sedgefield Excerpts

Thursday 5th June 2025 Grand Committee

Moved by

[Lord Wilson of Sedgefield]

That the Grand Committee do consider the Pension Fund Clearing Obligation Exemption (Amendment) Regulations 2025.

Relevant document: 25th Report from the Secondary Legislation Scrutiny Committee

[Lord in Waiting/Government Whip (Lord Wilson of Sedgefield) (Lab)]

My Lords, the regulations being introduced today will remove the time limit on a temporary exemption which pension funds currently have from clearing standardised over-the-counter derivatives contracts, such as interest rate swaps, through a central counterparty. This means that the exemption will continue indefinitely, ending the need for the Government to renew it every two years if we conclude that this is necessary. The draft regulations will help UK pensioners by supporting pension funds’ ability to invest in assets which generate returns for their benefit. Maintaining the exemption is also in line with the Government’s priorities to increase productive investment by pension funds to support economic growth.

Central counterparties, or CCPs, are a type of financial market infrastructure used by firms to reduce risks when trading on financial markets. They sit between the buyers and sellers of financial instruments, providing assurance that contractual obligations will be fulfilled. They do this by collecting collateral, known as margin, from all their users that can be used to cover any shortfall if a default occurs. The process of transacting through a CCP is known as clearing. In 2009, G20 countries agreed that certain standard derivatives contracts should be cleared through CCPs to help reduce risks in the financial system. In the EU, this was implemented through legislation and is known as the clearing obligation. At the time, it was decided that pension funds should be exempted from this obligation. This was because of the particular challenges that pension funds would face in meeting CCP margin requirements.

CCPs require variation margin, collateral which covers price movements on derivatives contracts, to be posted in cash. Pension funds do not usually hold large cash reserves, as they invest the large majority of their resources in assets, such as gilts and corporate bonds, to provide returns for pension holders. This means that meeting the requirement to post variation margin in cash can be more difficult for pension funds to meet than for other firms. Requiring them to clear their derivatives could cause them to increase their cash holdings, reducing their investment in other assets and their ability to generate returns for future pensioners. The UK assimilated the clearing obligation and this exemption in UK domestic law through the European Union (Withdrawal) Act 2018. The exemption was initially designed as a temporary measure, but it has since been extended several times. The Government currently need to lay secondary legislation every two years if we conclude that it is necessary to extend the exemption.

The Government extended the exemption most recently in June 2023 and noted that it would be desirable to put in place a long-term policy approach to remove the need for future temporary extensions. That is what these draft regulations seek to achieve. The Treasury has since conducted a review of the exemption, working closely with the UK financial services regulators. The review also gathered input from industry stakeholders through a call for evidence which was launched in November 2023. The review found that requiring pension funds to clear derivatives could potentially bring financial stability benefits, such as reducing counterparty risk, and could enhance resilience to shocks by increasing pension funds’ cash buffers.

However, the review also identified concerns from some market participants that removing the exemption could increase pressure on the liquidity management of pension funds, particularly under stressed market conditions, which could increase financial stability risk. The review also found strong evidence that pension funds would need to hold more cash and reduce investment in more productive assets if the exemption were removed. This could reduce their returns, potentially impacting the retirement benefits of future pensioners. This would be inconsistent with the objectives of the Government’s wider growth reforms—including the pensions investment review, the final report of which was published last week, which seeks to unlock productive investment by pension funds to support economic growth.

--- Later in debate ---

[Baroness Neville-Rolfe (Con)]

My Lords, I thank the Minister for bringing this important debate before the Grand Committee today. While technical in nature, the debate strikes at the very heart of our pensions system. It concerns the management of risk, the generation of returns for pension schemes and the financial security of our country. Derivatives play a crucial role in the operation of pension funds. They allow for efficient exposure to asset classes without necessitating the purchase of the underlying assets. They enable tactical asset allocation decisions to be executed more swiftly and cost-effectively than physical rebalancing and, through leverage, they offer the ability to increase market exposure without tying up significant amounts of capital. I know all of this from my experience as a trustee of the Tesco pension fund some years ago. Above all, derivatives are essential because pension funds face long-term liabilities that are highly sensitive to changes in interest rates, to inflation and to currency fluctuations.

These instruments are vital in managing such risks, especially in an uncertain and volatile world. Interest rate swaps hedge against fluctuations in interest rates that affect the valuation of liabilities. Inflation swaps protect against unexpected shifts in inflation, which is especially relevant where pensions are index-linked. Currency forwards and options manage foreign exchange risk where assets or liabilities are denominated in non-sterling currencies. It is the management of risk more than anything else that justifies their inclusion in the portfolio strategies of pension funds and, as the noble Lord, Lord Davies of Brixton, said, the level of risk is materially increased by this regulation. He also rightly referred to the Pension Schemes Bill, which has only just been published. I am afraid that due to other commitments, I have not yet had time to study it.

Since the European Market Infrastructure Regulation was introduced in 2012, pension funds have been granted an exemption from the central clearing obligation, recognising their unique challenge in meeting margin requirements as central counterparties. Pension funds operate on a long-term, illiquid investment model, and this fundamentally mismatches the short-term, high-frequency liquidity demands of CCPs, particularly under stressed market conditions.

Will the Minister outline the contingency plans in place should the absence of mandatory clearing suddenly appear to increase the risk of counterparty defaults?

I have to say that the exemption from these insurance-type arrangements of a CCP carries its own risks. The Government bear a heavy responsibility to maintain confidence in a financial system upon which livelihoods depend. The government review mentioned by the Minister concluded that removing the exemption could impair the ability of pension funds to invest in productive assets. That must be weighed carefully against the imperative of effective risk management. Can the Minister clarify how bilateral arrangements will be monitored for resilience, given that derivatives are no longer subject to central clearing? He talked about keeping this under review, which I think was helpful.

Our financial markets are deeply embedded in the global system. Can the Minister explain how this move aligns with international financial regulatory frameworks and, indeed, with the EU and US, which have slightly different rules from the UK? Furthermore, has the Minister assessed the potential reputational impact on the UK’s standing in international markets, particularly in the context of post-G20 commitments to mandatory central clearing, which the Minister referred to? Finally, will the Minister publish the underlying risk analysis or cost benefit assessment that supports the decisions to go for an indefinite extension period? Without such transparency, it is difficult to understand how the Government have reached their conclusion and indeed why they have chosen this policy path.

The current impact assessment states that the measure

“mitigates the risk of disruption to the market”

that might occur if pension funds were required to restructure their investment strategies “at short notice”. This would be ahead of the exemptions expiring, which happens to be 18 June—the week after next. However, this is a narrow, short-term cost analysis. I am interested in the wider picture of longer-term cost versus the benefits of alternative systems, so I very much look forward to the Minister’s response on whether he is willing to publish his cost-benefit assessment or, perhaps, to say bit more about the detail.

I urge the Minister to engage deeply with the concerns raised and to provide reassurance that the Government’s decision rests on a sound and transparent evidential foundation. We are dealing with an important subject and a risk that, as I am sure we all agree, needs to be properly managed in the interests of UK plc.

[Lord Wilson of Sedgefield (Lab)]

I thank the noble Baroness, Lady Neville-Rolfe, and my noble friend Lord Davies of Brixton for their contributions and questions. First, to answer them both, one thing that the Government are after is growth, obviously, but the other thing is financial stability; both of their contributions referred to that. This is a key priority for the Government. However, the evidence on whether removing the exemption would generate direct financial stability benefits was mixed. For example, some responses to the call for evidence noted that removing the exemption could make stress events worse by increasing liquidity pressures on pension funds. In contrast, the Government found strong evidence that pension funds would need to hold more cash and reduce investment in productive assets if the exemption were removed.

On the other issues, such as how the underlying risk will change and how we will keep that under review, the statutory instrument provides long-term clarity for market participants, which is very important in terms of the policy position. This will help with long-term planning of investment strategies by pension funds to meet their future liabilities. As I have noted, the Government will keep this policy under review in co-ordination with the UK regulatory authorities. If there are changes to market dynamics or wider government reforms that have a material impact on the value of mandatory central clearing for pension funds, the Government may reassess this issue.

On the increased burden on pension funds, this policy maintains the status quo. Removing the exemption would have placed more strain on pension funds. This gives assurance to the pension markets around the long-term consistency in our policy approach.

Finally, on the international market, our market is different from those of the EU and the United States as far as pensions are concerned. The response to the call for evidence indicated that the UK defined benefit market is structurally different from that of other jurisdictions, such as the US and the European Union, so it is appropriate that we take a different decision on this issue. The Government are committed to maintaining our high standards of regulation and financial services, including adhering to relevant international standards, where appropriate. In the US, pension schemes tend to be of shorter duration. There is also a larger and more diverse corporate bond market, which can be used for hedging; this means that the derivatives are used less there than they are in the UK.

I hope that these answers are what noble Lords are looking for.

[Baroness Neville-Rolfe (Con)]

That is very helpful—particularly on the international side. One does need to look at this in an international context; nowadays, we are so aware of the ups and downs of global markets. However, the Minister did not answer the question about the impact assessment. It may be that he does not have an answer today, but this is something that I am often concerned about because I think that good cost-benefit analysis is vital to good government. I made the point that the cost-benefit analysis that we got was a rather short-term thing; it would be very helpful to have a response on that.

[Lord Wilson of Sedgefield (Lab)]

Basically, what we are doing is maintaining the status quo. Things have been like this for several years now; we are just ensuring that the status quo continues into the future. We will review it if we need to, such as if the dynamics in the market change, but what we are offering is consistency for the industry. That is an important aspect of this statutory instrument.

Motion agreed.