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 adn⁢ 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: More⁣ cautious, as they primarily hold gilts and use the repo market for leverage. Their adoption is slower and driven by liquidity considerations.
* Prevalence: “Almost all” derivatives trades are now using ⁤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 allow acceptance of these preferred assets, hindering cross-market standardization.

4.Dealer Constraints:

* Basel III ⁣Impact: Banks face constraints due to leverage-ratio effects, liquidity rules, and the cost of using balance sheet space.
* 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 hurdles on the dealer side. Tri-party infrastructure is seen as a potential solution,but its adoption is not guaranteed.