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The rules governing the asset management of Swiss pension funds, including the use of derivative instruments, are set out in the Federal Act on Occupational Benefit Plans and the Federal Ordinance on Occupational Benefit Plans. Further, the Federal Social Insurance Office, as the federal supervisory authority of pension funds, published professional recommendations for the use of derivative financial instruments (October 15 1996).

In the future, pension funds which are subject to the Federal Act on Occupational Benefit Plans will also be subject to the new derivatives regulations pursuant to the proposed new Financial Market Infrastructure Act, which is expected to enter into force in the first half of 2015. The Federal Council is competent to provide for certain exemptions under the new act. Whether such exemptions shall apply to pension funds remains open.

Pension fund regulations

Permissible underlyings

Pursuant to the pension fund regulations, a pension fund may invest in derivative instruments with a value based on one or more of the following assets (underlyings):

• cash;

• debt instruments, such as bank deposits, bonds (including convertible instruments), mortgage notes debentures, term deposits or loans, irrespective of whether such debt instruments are secured or unsecured or are in certificated or uncertificated form;

• real estate; and

• equity instruments that are listed on a stock exchange or admitted to trading on a regulated market.

A pension fund may also invest in certain alternative investments if the alternative investment does not provide for an additional funding obligation and the investment in the underlying is made indirectly through the investment in a diversified collective investment scheme or structured product. The alternative investments include:

• hedge funds;

• commodities;

• private equity investments; and

• insurance linked securities.
   

Pension funds may extend this list of underlyings in their investment guidelines, provided that they can always demonstrate in their annual statements that the principles of careful asset management and risk diversification are met. Certain further obligations must be fulfilled.

Coverage obligation

Pursuant to pension fund regulations, all derivative exposure of a pension fund must be fully covered (i.e., sufficient liquidity must be available at all times). The investment in derivatives must not lead to an (uncovered) short sale of assets or have a leverage effect on the total amount of assets of the pension fund. In order to assess its coverage situation, the pension fund will convert derivatives with symmetrical risk profiles (eg futures and forwards) into the corresponding underlying positions, it being understood that the long and short position on a given underlying asset may be offset. In the case of derivatives with asymmetrical profiles (eg, options), the exposure of the pension fund on exercise is relevant.

Other obligations

Further, pension funds must also:

• select, manage and monitor their investments carefully;

• ensure that their objective of pension provision is certain to be achieved;

• take into account the creditworthiness of the counterparty and the tradability in accordance with the particularities of the applied derivative financial instrument;

• observe certain risk diversification rules, which are set out in detail in the pension funds regulations; and

• show all ongoing derivative financial instruments in their annual statements.
   

Proposed new derivatives regulations

In December 2013 the Federal Council presented a first bill for consultation (pre-draft act) for a new Financial Market Infrastructure Act that proposes a new legal framework for derivatives. The pre-draft act explicitly provides that pension funds which are subject to the Federal Act on Occupational Benefit Plans qualify as financial counterparties under the pre-draft act, and as such are subject to the proposed new derivatives regulations.

Pursuant to the pre-draft act, the Federal Council is competent to exempt certain market participants from the derivatives regulations, taking into account the principle of proportionality as well as international standards. Since pension funds are already subject to detailed pension funds regulations, which, among other things, prohibit leveraging (coverage obligation), a (partial) exemption from the new derivatives regulations may then be justified.¹

The Federal Council could either (partially) release pension funds from the derivatives obligations under the act, in particular from the clearing obligation, or provide for temporary exemptions (similar to the EU regulations, which provide for a three-year temporary exemption for pension schemes).

A pension fund will be subject to the following obligations, to the extent that no exemption applies:

• Clearing obligation – the derivative transaction must be cleared through a central counterparty.

• Reporting obligation – the details of a derivative contract must be reported to a trade repository on conclusion, modification and termination of the contract. The pension fund may delegate the reporting obligation to either its counterparty (ie, the bank) or a third party.

• Risk mitigation obligation – the pension fund must:

• • ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risks and counterparty credit risks (not applicable if the derivatives are cleared by a central counterparty);

• • mark-to-market on a daily basis the value of the outstanding contract; and

• • ensure that the parties to the derivatives contract exchange adequate collateral.
     

Further, derivatives which must be cleared by a central counterparty must also be traded over a recognised platform. However, the obligation to trade over a platform will not become effective before such an obligation has been implemented under the applicable EU regulations (for further details please see "New derivatives regulatory framework")¹. The new law is expected to enter into force in the first half of 2015.

What pension funds should consider

Pension funds which use derivatives will in future have to ensure that they satisfy the asset management requirements under the pension fund regulations and fulfill the obligations imposed on financial counterparties by the pre-draft act to the extent that they are not exempt from such obligations. In particular, they must ensure that:

• infrastructure is in place that enables them to comply with the risk mitigation obligation;

• sufficient collateral is available; and

• documentation will allow for the posting of collateral.
   

Further, their investment guidelines may need to be amended in line with the new regulations. Whether the Federal Council provides for exemptions from the new derivative regulations for pension funds remains unknown. Even though it is expected that such exemptions will apply, it is too early to make predictions.

Dr. Ansgar Schott is a partner in the Banking & Finance department of FRORIEP in Zurich. He advises Swiss and international financial institutions and corporations on all aspects of banking, financial markets and regulatory compliance. He regularly advises clients on a full range of derivatives transactions and related regulatory matters.

Founded in Zurich in 1966, FRORIEP is one of the leading law firms in Switzerland, with more than 90 lawyers and offices in Zurich, Geneva, Lausanne and Zug, as well as foreign offices in both London and Madrid, serving clients seeking Swiss law advice For more information, please visit www.froriep.com