Tri-Party VM Reuse: Scaling for Acceleration
Summary of the Article: Non-Cash variation Margin (VM) Adoption in Derivatives
This article discusses the growing trend of using non-cash collateral (like corporate bonds and gilts) for Variation Margin (VM) in over-the-counter (OTC) derivatives trading, and the challenges surrounding its wider adoption. Here’s a breakdown of the key points:
1. Increasing Appetite for Non-Cash VM:
* Strongest Demand: Insurance firms and pension funds are driving the demand for non-cash VM.
* Insurers: Already heavily invested in long-dated corporate bonds, extending VM to these assets is a natural progression and becoming standard practice. The 2020 “dash for cash” and the 2022 gilt-market turmoil accelerated this trend.
* Pension Funds: Adoption is slower, focused on gilt portfolios and repo market leverage. their move is influenced by liquidity needs post-liability-driven investment.
* Prevalence: “Almost all derivatives” are now traded with non-cash credit support annexes.
2. Challenges with Cash VM:
* Custodial Issues: post-Basel III regulations make custodians reluctant to hold overnight cash,resulting in penal interest rates for those receiving cash as VM.
3. Geographic & Market Variations:
* Local Preferences: Different European markets favor different asset types, influencing what buy-side firms are willing to post as VM.
* Harmonization Difficulties: Capital and funding rules don’t always support accepting these preferred assets, hindering cross-market standardization.
4. Dealer Constraints:
* Basel III Impact: Leverage-ratio effects, liquidity rules, and balance sheet costs influence the economic viability of accepting non-cash collateral.
* Operational Complexity: Managing a wider range of assets requires significant operational changes:
* Reworking valuation and eligibility checks.
* Aligning haircut schedules.
* Managing recalls and substitutions.
* Handling coupon payments, corporate actions, and settlement differences.
* Collateral Re-Use: Dealers need to ensure received collateral can be re-used in other business areas (repo,financing,prime brokerage).
* Infrastructure Lag: Current VM infrastructure is built around a “cash is king” mentality.
5. Potential Solution: Tri-Party infrastructure:
* Existing Capabilities: Tri-party agents already handle operational processes for Initial margin (IM) and believe they can extend these services to VM.
* Lack of mandate: Unlike IM, there’s no regulatory push for tri-party adoption in VM.
* Implementation Challenges: Supporting tri-party VM requires significant changes to legal documents and control frameworks.
In essence, the article highlights a shift towards non-cash VM driven by buy-side needs, but hampered by operational complexities and regulatory constraints on the dealer side. Tri-party infrastructure is seen as a potential solution, but its adoption is not guaranteed.