For large institutions, the process of gauging whether they need to be complicit with BCBS / IOSCO 261 has started. Other firms need to prepare to meet the demands of collateral velocity and efficiency which will be required to meet the new regulation, something that cannot be done effectively or cheaply with manual processes. With this in mind, I have become somewhat baffled as to why the market is not embracing triparty for the purpose of managing OTC collateral.
Triparty facilities offer an effective mechanism with which to manage the collateral call and substitution process that (relative to bilateral settlement) reduces settlement risk, over/under collateralisation, improves best use of assets and caters for velocity. So, why have triparty facilities struggled to be embraced?
We have recently been exploring the holistic approach to collateral management and optimisation. In our previous paper ‘Turning Up the Dial’, we spoke about this topic in great detail, expanding upon a number of themes, all interrelated to liquidity and capital management. We believe triparty facilities could be an integral part of the holistic model, enabling enhanced optimisation, settlement and control functions within the process.
When triparty agents offer and promote products that create cross-border movement of assets within their triparty frameworks, the uptake of triparty for managing collateral should in theory be much greater.
The reluctance of some firms to adopt triparty facilities needs to be reconsidered, as the regulatory environment which has become the ‘new normal’ continues to create greater challenges for collateral management.
Why triparty is becoming more important?
The drive to optimise collateral means that there is already a higher demand on settlements and collateral operations areas.
Firms that manage this today, with a manual or semi-automated bilateral process, are already straining under the demands of the collateral optimisation process, and the substitutions that this demands. Added to this, collateral processes are about to suffer further pressure with the advent of BCBS261, which aims to reduce systemic risk and equalise the margin differentiation between cleared and non-cleared OTC derivatives.
The advent of this regulation will bring with it an estimated five-fold increase in call processing arising from zero thresholds and gross initial margining. This in itself is a further constraint against HQLA liquidity. For those organisations that will be subject to the new rules, there will be a requirement that they cope with the additional call rate and an unavoidable reduction in readily available HQLA.
Additionally, we are likely to see intraday margin calls against cleared OTC derivatives. Without an automated solution, which enhances the reconciliation, call agreement and settlement processes, attempts to optimise the collateral and inventory positions will be almost impossible.
Whilst optimisation is at risk within a manual process, collateral velocity will also need to improve. Greater demand on capital means that coverage of the counterparty credit exposure will need to be delivered faster and with greater certainty. Keeping up with this new demand will be a challenge.
The benefits of adopting triparty
There are a number of advantages for firms if they adopt triparty. We’ve identified some of the most significant benefits on offer:
An established process
1. Triparty has been used in secured financing markets for many years in support of large repo and Stock Borrow/Loan transactions. If a firm has access to triparty today, it is easily adaptable to any collateral process.
Transparency of holding versus ownership at the point of default
2. Rehypothecation is possible within a triparty system. The triparty agent has complete view of where the collateral entered the triparty system, where it’s held, at any time.
Lifecycle events and management of the eligible portfolio
3. In on-going collateral management, terms of eligibility are pre-set and can be managed on behalf of their clients by the triparty agent. Eligible collateral that becomes ineligible on a downgrade will be substituted automatically. Substitution of securities due to corporate actions are also managed within the triparty service.
Managed substitution process
4. Under a bilateral arrangement, a firm that is actively managing its inventory may have to realign its positions across multiple counterparties in order to meet a substitution request from its trading desks. If undertaken manually, this can take considerable time. Under a triparty framework, substitutions would be managed automatically by the triparty agent, in line with any pre-agreed restrictions and in line with the use of sale of asset inventory on a delivery-versus-delivery basis.
Reduced fails risk
5. Using a triparty mechanism may give the pledger the opportunity to utilise positions that have not been used previously as there is less risk of those securities not being redelivered as and when required – so long as there are other eligible securities available.
Velocity and improved straight-through-processing
6. With a greater level of automation and interoperability, collateral can move faster and be delivered ‘just in time’. The triparty facility allows a reduction in the number of ‘touch points’ within the settlement of collateral, and can be delivered within an hour of the instruction being made.
Segregation is catered for
7. Under BCBS261 initial margin will need to be segregated. The forthcoming interconnectivity between triparty services should reduce custodian costs.
The triparty conundrum
With some of the benefits of triparty now highlighted, it brings us back to our original question: why is there such a low adoption rate for triparty?
Through conversations with our clients, we identified some of the most common perceived or real challenges clients have cited on why triparty isn’t being adopted. They include:
- Cost of incorporating the triparty process into a firm’s existing infrastructure may be too costly for smaller institutions
- Triparty is only applicable to non-cash
- Ceding control of one’s inventory is perceived as an additional risk
- Complex relationships between triparty providers and multiple clearing corporations / institutions
- Cross-border movement of collateral strains firm’s operational capability
Triparty and central clearing will only increase in the future. Regulations affecting liquidity and capital such as (EMIR, Dodd-Frank, LCR / NSFR, CRD IV and BCBS / IOSC0261) are major concerns for many of our clients and such regulations would appear ripe for Triparty collateral management.
Whilst it would be overly optimistic to think there is one single solution that will create the ideal holistic collateral optimisation model, triparty mechanisms offer realistic answers to many of the challenges from regulations such as BCBS261. Triparty would to some extent help in reducing the operational burden that will ensue once that regulation is enacted.
For those firms that have a triparty capability for Stock Borrow/Loan (SBL) and repo, it is a relatively small step to adjust processes to include OTC collateral. For firms without the imbedded infrastructure to support triparty, there are services that may be offered which reduce the cost burden. We suspect that, in many cases, the full cost analysis of managing a bilateral process has not as yet been undertaken.
In essence, triparty should complement the bilateral process without any great need to develop further any current collateral management platform.
When you consider the relative ease with which triparty facilities can be adopted for OTC-cleared and non-cleared collateral, the question we would ask is: what is stopping you adopting triparty?
To learn more about the benefits of triparty facilities, download our paper, The Triparty OTC collateral conundrum.
By Nick Nicholls, Business Consulting Lead, GFT.