Introduction

For the purpose of argument I’ll take paradox to be defined as: “A statement or proposition that seems self-contradictory or absurd but in reality expresses a possible truth”, or “An opinion or statement contrary to commonly accepted opinion”

…and not “a self-contradictory and false proposition” (insert smiley winky emogi here- Ed).

The use of Triparty facilities should play a more important role for OTC collateral as firms seek to establish a more holistic approach to their collateral management practices.

At GFT we have been investigating how adopting a holistic approach to collateral management and optimisation will improve this process. Triparty facilities look set to become an integral part of the holistic model, enabling enhanced optimisation, settlement and control functions within the process, against a centralised inventory portfolio.

It will come as no surprise to many that regulation is the key driving force in the need to begin reviewing how collateral is managed. In particular, collateral processes will face further demands with the advent of regulations such as BCBS261.

BCBS261 aims to reduce systemic risk and equalise the margin differentiation between cleared and non-cleared OTC derivatives. The volume of margin calls in the OTC derivatives market is expected to increase substantially in the near future. An estimated 5-fold increase. The main weight of BCBS/IOSCO  leans against all non-cleared derivatives counterparties who will be required to post initial margin gross (IM) to a segregated account, and all will need to post variation margin (VM) against zero thresholds, with a cap of $500k minimum transfer amount.

It would seem an ideal time to adopt an available and ready-made collateral solution which, to a large degree, assists in meeting the demands of velocity whilst maintaining optimisation and containing or even reducing inclement risks endemic within the collateral process, without requiring a huge increase in staffing to meet those business demands. Triparty is such a solution and, rather puzzlingly, has yet to be used to any great extent for managing OTC collateral. 

The view from the market?

We have been closely following market views and opinion and it’s clear that firms understand and recognise that Triparty is going to play a much greater role in the management of collateral.

A recent survey by the DTCC (Depository Trust and Clearing Corporation) suggests that the industry currently finds itself in a tricky situation.

• In their recent paper, the DTCC surveyed fund managers. 66% of participants said that non-cleared OTC derivatives were either ‘crucial’ or ‘very important’ to their investment strategies and asset allocations.

• In the same survey, only 1 fund manager in 8 believed they were ready for the increased margining requirements for non-cleared OTC derivatives, with no distinction between large and small firms.

• DTCC-Euroclear Global Collateral Ltd / PWC’s published a white paper In February 2016 ‘Implications of Collateral Settlement Fails: An Industry Perspective on Bilateral OTC Derivatives.’  It announced that the market expects a 407% increase in trade ‘fails’ - an additional average cost of $3.6 million for each buyside firm and and 377% to $2.4 million for each sellside firms.

Euroclear survey

To understand views within the market further, we examined the survey commissioned by Euroclear, entitled Collateral Management in Europe, published in May 2015. The survey attempted to establish the market-wide willingness or ability of clients to transact collateral through Triparty mechanisms.

Based on interviews with respondents from 20 firms, comprising brokers, banks, asset managers, pension funds and corporates, the research showcases several major areas for industry action as the markets continue to grapple with the impact of quantitative easing, amongst other things, on the available supply of high-quality liquid assets.

The survey cites macro-economic uncertainty, and concern over the potential for more government debt downgrades, plus concerns over the potential UK exit from the EU as macro-economic factors that may cause concern with regards to activity in the process, all of which may mean greater volatility in the market and a likely increase in call activity.

The expectation from survey participants that both Triparty and central clearing will increase over the next few years, and points to regulation affecting liquidity and capital (EMIR, Dodd Frank, LCR / NSFR, CRD IV, and BCBS / IOSCO261) as major concerns, all of which seem positive for Triparty collateral management.

Deliberating on the paradox

The consensus view within the market suggests that in principle, Triparty facilities offer an effective mechanism within which to manage the collateral call and substitution process, that (relative to bilateral settlement) reduces settlement risk and over-collateralisation or under-collateralisation, and improves best use of assets.

In speaking with clients, we see themes of perceived or real challenges the cited as reasons for a slow adoption of triparty for OTC collateral:

Cost of incorporating Triparty into a firms existing infrastructure may be costly for smaller institutions. We believe this probably means an underutilisation of inventory by those institutions currently, and almost certainly no investigation of services provided by their agents, custodians or larger counterparties, all of which may make the business case for Triparty.

For firms already utilising Triparty facilities for repo or SBL, there are few additional costs

Constrained Rehypothecation is seen as an issue within the triparty mechanism. This isn’t strictly true and is possible, it happens today. Moreover, control over assets within the triparty pool can be maintained by the owner/holder of collateral, and can/will be returned to custody accounts as required, within the several batch runs during a day.

Risk of fails is reduced. Counterparty credit risk is also reduced as substitutions are made delivery-versus-delivery.

Triparty offers an effective outsourcing of settlement process for OTC derivative collateral, which extends to a managed optimisation, and provides clear assistance at the point of default in understanding ownership and offset of collateral, simplifying any wind-up of an administrated firm.

From paradox to paradigm?

It seems inevitable that the future of collateral optimisation will involve more use of Triparty. Despite the awareness of this within market, it’s strange that Triparty has not been fully embraced for the purposes of managing collateral.

Some of the perceived challenges of incorporating Triparty processes need to be re-evaluated. How can firms develop a full business case and organise their operating models to deal with the challenges and concerns of adopting a Triparty process?

We believe Triparty mechanisms offer some of the best answers to many of the challenges thrown up by BCBS261. With the demand for higher quality collateral rapidly increasing, Triparty will help in the reduction of operational risk and complexity as well as helping to manage counterparty exposure more effectively.

The market needs all the assistance it can muster to meet the demands of BCBS261 and other liquidity and capital constraining regulation. Speaking to some Triparty agents recently, they have begun to see larger institutions initiating triparty arrangements for OTC collateral, but many still struggle to make the connection of Triparty repo/SBL and OTC collateral. Moreover, those that realise the potential for Triparty will require its buy-side counterparties to move with them. It seems time to move these facilities to the forefront of the collateral process.