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Article (2/244)
Welcome to the tri-party
Welcome to the tri-party

Welcome to the tri-party


It’s time for financial institutions to rethink old practices of collateral management and break existing silos

Tri-party collateral management

Today, due to new regulations, market participants are seeking more sophisticated and comprehensive collateral solutions that will enable them to use a wide range of securities to back their trades and mobilise their assets when and where they are needed. Increasingly, they are turning to the tri-party model. Acting as a neutral party, the tri-party agent manages the collateralisation of exposures resulting from trading activities between two counterparties.

However, how can a service, designed historically for interdealer transactions, fully meet new collateral management requirements? What are the conditions necessary for an efficient tri-party collateral management? Let’s have a look at three different collateral requirements: variation margin on uncleared over-the-counter (OTC) derivatives, initial margin on cleared OTC and securities financing transactions.

Using equities as collateral

The main characteristic of bilateral management on uncleared OTC derivatives is the almost exclusive use of cash and government bonds. There is an inherent risk in using equities as collateral due to the frequency of corporate actions. When these occur, there may be a tax risk when failing to detect such an event or substitute on time. Therefore some asset managers have had to change their investment profile to hold cash or bonds, with an impact on their returns, especially for UCITS funds which cannot "transform” their equities because of regulatory guidelines.

The tri-party model is perfectly suited to manage equities as collateral. However, this solution is viable for the buy-side only if various criteria are met.

  • Both buy-side and sell-side participants must adapt their operational processes for OTC derivatives to create a new operational path for the tri-party collateral management
  • The tri-party agent must comply with the asset segregation rules[1] imposed on some institutional investors, and these are not entirely uniform, with some local rules having to be considered[2]
  • Tri-party management must be "connected" directly to the client's main account to avoid the burden of constantly managing collateral inventory realignments

BNP Paribas Securities Services is the only global custodian with a tri-party service directly funded by the customer's current account. Too often, the customer has to manage an additional account (called a "longbox"), which reduces the benefits of the tri-party model. In a "longbox" configuration, the customer must pre-select the securities to be transferred to the "longbox", recall the surplus securities to the main account, reconcile their positions over several accounts, etc.

Initial margin on cleared OTC derivatives

In addition to the variation margin obligation, more and more of the buy-side will soon have to post the initial margin on OTC derivatives cleared by central counterparties (CCPs), as the clearing mandate enter into force progressively. Some participants are anticipating this situation because their banking counterparties have already passed on to them the capital costs associated with uncleared transactions. This is particularly true for large and directional portfolios with long-dated trades, such as the ones dealt by pension funds. Given the size of the initial margin, it is most likely that many will decide to post securities.

A tri-party service can prove to be a real benefit due to:

  • The amount of the initial margin varying - even more with new OTC derivatives trades
  • No minimum transfer amount -unlike uncleared OTC derivatives - meaning the client will be called for the first penny
  • The requirement that transfers are complete on the same day between the customer and the CCP
  • Different places of deposit between the buy-side and the CCP[3] resulting in early market cut-offs to transfer the collateral

What about tri-party securities financing?

Today, the hundreds of billions of collateral linked to securities financing transactions mainly come from inter-dealer transactions with few buy-side participants. Institutional investors are eyeing new opportunities for securities financing transactions. With quantitative easing, historically low or negative interest rates, and the requirements of Basel III, banking counterparties are seeking high quality liquid assets over the long term. Buy-side participants[4] will be able to generate additional income, which is particularly welcomed in this current environment.

Several initiatives have emerged on trading with new securities financing execution platforms.  On post-trade, it is essential to optimise the full operation chain: confirmation with the counterparty, fees calculation, portfolio accounting, monitoring funds’ ratios and collateral management, etc.

As with OTC derivatives, tri-party platforms are well positioned:

  • Basket repos can be easily managed as the cash leg settlement is synchronised with several lines of securities defined by an eligibility matrix (also known as the “basket”)
  • It  provides more velocity to the collateral giver, notably when refinancing small lines of securities
  • The type of collateral can be broader - equities or corporate bonds - enabling the buy side to obtain more attractive execution spreads.

At the turning point

It’s time financial institutions rethink the old practices of collateral management and break the existing silos. Although tri-party service was initially created for the interdealer business, it can be used more widely across financial institutions’ derivatives activities.  To make it a success, market players should have a strategic approach with the involvement of many teams to ensure that processes along the value chain, from front-office and middle- and back-office, are adapted to tri-party service.

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[1] Such as UCITS and AIFMD
[2] Same segregation rules apply to Italian pension funds, for instance
[3] The buy side uses a global custodian. Article 47.3 of EMIR requires that CCPs' initial margins be held by a Securities Settlement System
[4] Excluding UCITS funds that cannot participate in term securities financing transactions due to regulatory restrictions