Lancashire explores derivatives for risk mitigation
1Lancashire County Council is exploring how it could use derivatives to hedge against its pension fund liabilities and to help risk manage its treasury positions, Room151 has learnt.
Until recently, the use of financial derivatives had been considered illegal for local authorities after a House of Lords ruling in 1991 that the products were beyond the powers (ultra vires) of UK councils.
Mike Jensen, chief investment officer at the council, said the council is currently taking advice on how such an arrangement might be managed by its in-house investment team.
He said: “We have had a conversation with lawyers that concluded that the perceived issues around vires apply to councils and pension funds taking speculative positions rather than risk mitigation positions.
“We are comfortable that if we can demonstrate that using derivatives fulfils a risk management position then we would be acting legitimately. I would go so far as to say that we have a duty to manage those pension fund liabilities and treasury risks.”
He said that the affirmation of a strong credit rating would help the proposal in terms of both pricing and limits.
But he said that a major challenge was getting counterparties comfortable with the idea of councils using derivatives once more.
Jensen said that a number of fund managers have recently taken legal advice which has reached a similar conclusion to that received by Lancashire.
He also said that the sums could change in 2018 – the current expiration date for an exemption for pension funds from European rules relating to derivatives.
Unless the exemption is extended, the rules would then require pension funds and counterparties to deal through exchanges and deposit collateral into a clearing house in cases where the gap between the contracts and the market interest rate increases.
Jensen said: “If you operate through exchanges then things become more expensive, and we might also be forced to look at using external fund managers but the costs would be outweighed by the hedging benefits.”
Jensen said that he would be asking the Treasury and DCLG whether it wanted to introduce new prudential regulation of derivatives hedging by councils – similar to an existing regime for housing associations overseen by regulator the Homes and Communities Agency.
“There is a definite risk here,” he said. “Housing associations have to demonstrate they have the experience or have undertaken the appropriate advice before they can transact this type of deal,” he said.
It is understood that a handful of local government pension funds have mandates for similar arrangements, although these are run by external fund managers.
Photo (cropped): Tristan Martin, Flickr
I am surprised by this legal advice. Basildon had four or five interest rate swaps, as I remember it, and each of these was linked specifically to mirror the variable interest rates on our deferred purchase schemes, current at that time. We were heavily exposed to variable interest rates as a proportion of our budget and, in the face of capping, we needed certainty, but the banks would not offer us fixed rates on our DP schemes. The lawyers were all over this at the time, and I would be amazed if they had not asked this same question. Along with everyone else, we had to unwind each of our swaps on the grounds what they WERE ultra vires.