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Bank of the Future

Tri-Party Collateral Management: Evolution and Rising Importance

June 9, 2016

Traditionally viewed as merely a middle office function, collateral management assumed importance post the 2008-09 financial crisis, when its ability to mitigate counterparty, credit, and operational risks was recognized by policymakers the world over. Recently, several regulations such as the Dodd-Frank Act, European Market Infrastructure Regulation (EMIR), and Basel III have been enacted in order to foster market stability, improve resiliency, enhance transparency, and reduce counterparty, operational, and liquidity risks. These initiatives have drastically changed the collateral management landscape.

The need for enhanced transparency and extensive reporting, as mandated by regulators, is driving industry players to carefully examine existing collateral management processes and devise ways to improve them. Additionally, financial institutions are looking to enhance processes and cost efficiencies, while ensuring timely compliance with the ever-evolving regulatory requirements. If organizations are to meet all these goals effectively, standardization and automation of collateral management processes seems like the best step forward.

So far, financial institutions have managed collateral arrangements bilaterally, with their counterparties, using not-so-sophisticated systems that require a great deal of manual intervention. Therefore, managing and administering collateral in-house has become quite burdensome over time. Driven by global regulations and cost pressures, several financial institutions are turning to tri-party collateral agents for better management of their collateral.

A tri-party collateral agent could be either the International Central Securities Depository (ICSD), CSD, a custodian, or a clearing bank that specializes in providing collateral management services, and manages the collateralization of exposures resulting from principal transactions between these counterparties such as repo, security lending, OTC derivatives transactions, and so on. These principal transactions could either be cleared bilaterally or centrally through central counterparty (CCP).

Tri-party collateral management services are an attractive option for financial institutions such as small banks, broker-dealers, and buy-side firms as the day-to-day management of collateral can be quite cumbersome. Tri-party arrangements involve two counterparties to a transaction and an entity that acts as an independent tri-party agent to manage the collateral; both these counterparties are clients of the tri-party agent. Tri-party collateral management systems perform activities such as exposure management lifecycle including validating and matching, modifications and closing of counterparty exposures, and collateral management lifecycle including validating, accepting, valuing, and allocating, as well as substituting, reuse, and withdrawal of the collateral supplied by participants. Additionally, these systems also manage the post-trade processing between participants (that is, the collateral giver and the collateral taker) like payment, settlement, custody, and asset servicing of the collateral through the life of the transaction.

Tri-party agents can enhance process standardization and transparency by implementing straight-through processing, interfacing with standard market data and reference data services providers, and more. In addition, they must also provide value-added services such as collateral transformation and optimized collateral allocation according to clients collateral optimization strategies (for example, cheapest to deliver, least funding cost, and so on), which are designed to improve process and cost efficiencies. All in all, it is clear that the tri-party collateral management system offers highly versatile, time-tested solutions for a variety of market scenarios and help financial institutions effectively meet emerging requirements.

Of key importance, when establishing a tri-party collateral management system, is the fact that it should be seamlessly integrated with an organizations existing custody and position management systems landscape to ensure real-time and accurate reporting to all stakeholders. The system should have a flexible business rules engine for complex collateral valuations, automated substitution and withdrawal, standardized message formats, and the facility to perform what-if simulations to predict future collateral requirements, among other features.

Financial firms need to be mindful of the risks that come along with tri-party collateral management systems, such as increased counterparty risk in case of collateral reuse and re-hypothecation, lesser control over collateral assets, and so on. These ultimately result in operational risks, thereby driving the need to build advanced IT systems. However, since the benefits offered by tri-party collateral management clearly outweigh the risks it poses, it is highly recommended that firms quickly adopt it in order to stay competitive in the ever so dynamic financial and regulatory landscape.

Yagneswara Sarma is a Domain Consultant with the Capital Markets Practice within the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). He has 17 years of experience in IT solutions and consulting in the capital markets domain. Sarma has successfully anchored several transformational initiatives for TCS leading clients including market infrastructure and sell-side as well as buy-side capital market firms. He holds a Masters degree in Mechanical Engineering from the Indian Institute of Technology (IIT), Chennai, India.