Pension funds make significant use of derivatives, mainly in order to manage the balance sheet risks arising from interest rate and exchange rate fluctuations. To a lesser extent, they also use derivatives as a vehicle for investment in certain investment categories, such as commodities. The use of derivatives hence decidedly contributes to efficient portfolio management and helps to control pension funds' investment risks. But by entering into derivatives contracts they expose themselves to counterparty risk. This risk notably depends on the following three factors:
- Credit rating: In the event of counterparty failure, the extent to which a pension fund would be able to actually realise any positive value from derivatives contracts would be uncertain. The lower the credit rating of the parties with whom pension funds do business, the higher the counterparty risk.
- Concentration: Where a pension fund depends on a small number of counterparties for its derivatives, a credit downgrade or even failure of one of these parties may have a serious impact (concentration risk). Moreover, in such cases a fund may find itself in the situation that it has no scope for replacing existing counterparties with new ones. A final form of concentration risk would arise if it emerged that one of a small number of parties dominated the market for derivatives or a certain type of derivative.
- Collateral: Insufficient collateral, or collateral that is of too low a quality, would result in a capital loss if a counterparty failed. In addition, a derived counterparty risk may arise if funds have difficulty in securely depositing the cash and other collateral received.
The main objective of DNB's research was to chart the counterparty risk run by the pension sector. A group of 32 funds, with total assets under management of approximately EUR 714 billion, responded at short notice to the survey conducted by DNB. This swift response shows that the funds have sufficient information on the extent and nature of their exposure to counterparties.
Credit ratings of pension funds' counterparties
For the funds that participated in the survey, the total market value of derivatives, repos and deposits now outstanding with counterparties amounts to EUR 89.7 billion, with interest rate swaps (66%) and deposits (21%) forming the principal part.