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.