Politicians have queried if pension funds are legally allowed to use repos, a repurchase agreement used in liability-driven investing. Have pension funds been flouting the law? 

 

In the debate about LDI since the autumn gilts crisis, the question has been raised why pension funds used repos when they are prohibited from using borrowing. Last month, Baroness Bowles of Berkhamsted challenged the Pensions Regulator about repos, suggesting it may have allowed the use of an instrument that by law is only allowed to provide temporary liquidity.  

 

During an Industry and Regulators Committee hearing on 15 November, Baroness Bowles said she finds it “difficult to make what is happening fit either the letter or the intent of the legislation”.  

 

She said by using repos, “there is no doubt that, economically, you are borrowing... Are you happy in principle that, as a regulator, you have allowed subversion of the intent of the legislation?” 

 

The LibDem peer and former MEP added: “How confident are you that, if this went to court, the court would not make a purposive interpretation? Namely, if it looks like a duck, it is a duck, even if you have called it a chicken.” 

 

The committee chair, Lord Hollick, added that the question of whether repos are legal for pension funds has been raised “a number of times” in conversations. 

 

 

Under the the Occupational Pension Schemes (Investment) Regulations 2005, trustees and scheme managers “must not borrow money or act as a guarantor in respect of the obligations of another person where the borrowing is liable to be repaid, or liability under a guarantee is liable to be satisfied, out of the assets of the scheme”, but they are allowed to borrow where this is “only for the purpose of providing liquidity for the scheme and on a temporary basis”. 

 

What seems undisputed is that economically, repos amount to borrowing, even if they are structured as sale agreements. The International Capital Market Association notes about repos that “although repo is structured legally as a sale and repurchase of securities, it behaves economically like a collateralised or secured deposit (and the principal use of repo is in fact the secured borrowing and lending of cash)”. 

 

Matthew Cox, a banking partner at law firm Baker McKenzie, agreed with this view. Although “from a strict legal perspective” they are structured as a sale with a repurchase obligation and are therefore not traditional borrowing, they are viewed as an obligation in many contexts, including creditworthiness assessments.  

 

For example, “in a market standard loan agreement... the widely accepted contractual and commercial position is that they are treated as both financial indebtedness and borrowing,” said Cox. 

 

“My sense is the regulations would need to be interpreted strictly for a repo not to be considered borrowing and therefore not prohibited,” he said. 

 

As a repo has the effect of borrowing, he argued, it should be treated as such. “Therefore, trustees should satisfy themselves they fall within the temporary liquidity exception," he advised. 

 

 

When pressed by Baroness Bowles about the legality of pension funds using repos, Neil Bull, head of investment at TPR, responded that pension funds are allowed to use repos and swaps, referring to both as “derivative instruments” and citing the fact that derivatives are explicitly allowed in legislation.  

 

However, some experts dispute that repos are derivatives, which would make the question of whether schemes are allowed to use repos more pressing. The regulator has said it would get back to the committee about this point. The list of what is legally seen as a derivative instrument is part of an EU directive, MiFID II, which refers to “options, futures, swaps, forward rate agreements and any other derivative contracts”. 

 

For Cox, the derivatives exemption does not apply. A derivative would involve one person having an asset and the other deriving benefit from it, while repos involve a sale contract, he observed. 

 

 

The Pensions Regulator does not consider repos borrowing, and so their use does not contravene the regulations, said Penny Cogher, a partner at law firm Irwin Mitchell, but added that there is a question as to whether this is the right approach in practice after recent market events.  

 

“Are they really assets that pension trustees should use if they are investing prudently for wives and orphans, as the old case law used to say? Are we getting to a position where it is all a question of semantics?” Cogher said. 

 

“While technically repos may not be ‘borrowing' depending on whether a broad or narrow interpretation is given to the word, they have some very similar attributes and there is leverage,” she said.  

 

Even where it was argued that the borrowing occurs on a short-term basis as allowed in the law, “there can be regular rolling over of repos that lead to the conclusion that there is borrowing and that this is only a device to keep them temporary”, argued Cogher. 

  

However, the use of repos has become so widespread – and has helped schemes shore up funding levels – that it could be tricky to force schemes to change. “This has grown into a huge and important part of the pensions industry – too important to fail and too complicated for many people in the industry to fully understand,” she said. 

 

Trustee boards should be looking at the level of repo transactions engaged in by their LDI manager for their scheme and review the extent of their compliance with regulations with their legal advisers, she recommended, checking also if they have reporting obligations to TPR.  

 

LDI managers will also want to consider their legal liability, she said, noting that some of the largest have updated their terms and conditions in this area. 

 

 

Repos can also be looked at from an accounting perspective. According to IFRS, a contractual obligation to deliver cash or another financial asset to another entity would be accounted for as a financial liability. An entity would also recognise a financial liability where it had a contractual obligation to exchange financial assets or financial liabilities with another party under conditions that are potentially unfavourable to the entity. 

 

A spokesperson for the Institute of Chartered Accountants in England and Wales said: “IFRS accounting standards contain sophisticated rules to ensure that entities’ balance sheets reflect the true amount of their borrowings. Users of the accounts rely on this information to, among other things, assess the leverage of an entity and its capacity to repay debts as they are due.” 

 

How do you see it – are repos borrowing? If so, which exemption – if any – can DB schemes apply to justify their use?

Penny Cogher

Chantal Thompson