Trends in Collateral Management: New Uses for Tri-Party Structures

Driven by global regulations, an increasingly broad range of institutions are turning to collateral to effectively mitigate risk. While historically many transactions have been collateralized bilaterally (i.e., directly between counterparties), managing and administering collateral in-house can be burdensome. The introduction of new market entrants such as central counterparties (CCPs) further complicates the market infrastructure.

According to John Rivett, global business executive for collateral management at J.P. Morgan, the complexity, resourcing and investment needed to effectively administer collateral internally is causing many institutions to turn to a third-party collateral agent. When making that choice, institutions should ensure the agent is able to support the management of their collateral globally with sophisticated solutions that help optimize the use of collateral and manage its movement with the greatest efficiency. In addition to technical support, Rivett notes that the actual tri-party collateral management structure itself offers significant benefits. "Tri-party is proving extremely versatile," he comments. "It offers an efficient solution to a whole new set of collateral management challenges, extending well beyond its historical beginnings to embrace new trends and participants, including the desire to segregate collateral with a third-party custodian."

Tri-party structures for CCPs

As a result of new legislation in both the United States and Europe, more than twothirds of current bilateral trade volume is expected to be cleared through CCPs. Swap participants who enter into a centrally cleared transaction will be required to post initial margin to be held by a CCP. Variation margin will then be passed from one counterparty to the other through the CCP, either directly or through a clearing broker. These requirements, coupled with a CCP's expected acceptance of highly liquid, high-grade collateral, will put great pressure on the supply of collateral.

According to Mike Reece, EMEA markets executive for banks and broker dealers at J.P. Morgan, the collateralization of centrally cleared transactions gives rise to two pressing issues. "First, a premium will be placed on making certain that exactly the right type, quality and amount of collateral is being deployed in the right order and for the right amount of time...and no more. Second, every CCP will need efficient systems to track, monitor and properly allocate collateral. Tri-party structures are well suited to address both of these challenges."

By engaging an independent collateral agent as part of this process, CCPs and their underlying members gain support from tri-party structures and systems that efficiently support ongoing collateral reallocation and intraday substitutions based on collateral values. Collateral is accepted and allocated based on eligibility requirements that are tailored for each counterparty pair—the collateral taker (in this case, the CCP) sets the parameters for the collateral it will accept from the collateral provider (in this case, the member). The tri-party collateral agent manages and optimizes the flow of that collateral in accordance with a pre-agreed eligibility schedule, which is particularly important in rapidly changing markets.

For variation margin, collateral is marked to market. If prices increase, collateral is released back to the collateral provider, and if prices decline, additional collateral calls can be made. As a result, members have better opportunities to optimize use of their collateral, and CCPs have effectively outsourced a complex and burdensome responsibility.

While CCPs certainly stand to realize significant benefits, Reece notes that the gains are not one-sided. "Since many clearing members already use tri-party to support their repo or lending activities, they will be able to consolidate their tri-party activity and more efficiently manage collateral and liquidity on a firmwide basis."

Increased complexity = increased demand

With the advent of Dodd-Frank, derivatives trades may be centrally cleared or bilateral. This bifurcated market is daunting to some buy-side participants. Increasingly, they are turning to tri-party solutions and engaging a collateral agent in order to simplify the management of their collateral. Tri-party agents are able to reduce operational risk and complexity, help to manage counterparty exposure and provide clients with a wide array of solutions to transform and optimize collateral—all designed to address the rapidly increasing demand for higher volumes, higher values and higher quality collateral.

Evolution—even in established markets

Even in markets where tri-party has long been employed, change is rampant. Tri-party repo has been a fixture of the U.S. fixed income market for decades, but the last 18 months have brought fundamental changes in the market infrastructure. The shift of the daily unwind from early morning to 3:30 p.m. required the development of new tools to substitute securities intraday and support market liquidity. Where dealers once unilaterally booked the terms of the trade, today the scales are more balanced. Matching trade instructions gives cash investors more control over the booking process and improves market transparency.

With the cost and complexity of collateral management almost certain to increase in the post-reform environment, tri-party could well emerge as a structure able to address a broad range of collateral management needs.

Michael Albanese
Global Head of Securities Clearance

Thought, Fall 2012