The line is drawn. For more than 300 firms, the deadline to start exchanging initial margin on non-cleared derivatives is now just seven months away. And nerves are starting to jangle.

Funds need to select custodians and negotiate new documents for their collateral arrangements. But some custodians’ reluctance to support a new model for receiving collateral – and delays in publishing new custody agreements – are stalling preparations. It’s heightening fears of a logjam as the deadline for the fifth phase of IM implementation nears.

“You can’t really start drafting documentation until you know which custodian is being used – because the choice of custodian informs the document suite you’re going to use,” says a documentation expert at a European house.  “It’s really important for those firms deciding which custodians they’re going to go with that this happens in a pretty timely way.”

As part of the new margin regime, parties must pledge collateral into a segregated custody account – in either a tri-party or third party arrangement. And despite their similar-sounding names, these alternative custody models are quite different in structure.

In a tri-party account, an agent fulfils the various collateral requirements, including automated settlement, once the transfer amounts are agreed. This typically comes with a host of additional services, including collateral valuation and optimisation.

With the cheaper, but more manually intensive, third-party model, the pledging party selects and values collateral for transfer; the custodian provides settlement into the counterparty’s segregated account, as well as some reporting services.

Buy-side firms are expected to stick with third-party custodians for purposes of posting collateral – they already use them for variation margin (VM) – rather than the costlier, full-service, tri-party providers dealers typically use. When it comes to receiving collateral, however, they are at the mercy of their dealer counterparties and may have little choice but to set up tri-party accounts.

Meanwhile, Euroclear has developed a service called the ‘pledgee representative’ model, which bridges the two options, making it easier for buy-side firms to stick with third-party custodians while accessing tri-party facilities. However, no custody bank has yet officially signed to act as sponsor for its clients.

“No-one wants to be a guinea pig,” says a margin compliance specialist. “You can’t wait around to find out if your custodian is willing to be a representative because if they’re not you might need to onboard with someone else and that’s going to take time.”

Docu-drama

Further frustrating the process is the delayed publication of new custody documents that govern the terms of collateral segregation in tri-party agreements. Buy-side firms want to see these documents and gather legal opinions before selecting a tri-party custodian.

A clutch of custodians offers tri-party services – Bank of New York Mellon, Clearstream, Euroclear and JP Morgan – while a wider range of firms will provide third-party custody. These include Citi, Northern Trust and State Street, as well as numerous local banks.

For phase five entities, BNY Mellon, the world’s largest custodian with more than $30 trillion of assets under custody and administration, has readied new standardised account control agreements (ACAs). These contracts, between a custodian and its trading counterparties, were originally expected in November. New York law documents for both tri-party and third-party structures were finalised and circulated to the first batch of clients on January 29. English and Belgian law versions should be available to clients from early February.

“We wanted to make the documents as client-friendly as possible to quicken the onboarding process, because everyone is well aware there’s a lot of clients to get onboarded this year and next,” says Dominick Falco, head of collateral segregation product at BNY Mellon. “It took a little longer than we expected, but our feeling is that the new documents will be much faster to negotiate once they’re actually out there.”

JP Morgan, which has more than $25 trillion of assets under custody, finalised its phase five ACA documents in December. It is understood to be asking clients for mandate confirmations by the end of February, with applications due by the end of March.

Some believe this timetable may too aggressive, given that a calculation period for determining in-scope entities runs from March to May. Market participants now widely expect custodians to stick with the same June application deadlines set for earlier phases, leaving little time to get the largest cohort of clients over the line.

“We were right up to the wire getting this done in phase four, so it could be a real struggle to get thousands of accounts set up on the same timetable,” says a margin manager at a second European house.

Euroclear expects to begin phase five onboarding on March 1 and aims to complete account set-ups in early August.

Last year, regulators agreed to split the fifth implementation phase of the IM rules in two, staving off a more menacing logjam. A threshold hike – from €8 billion (or $8 billion under US law) to €50 billion (or $50 billion) – and a documentation amnesty for relationships with sub-€50 million (sub-$50 million) exchange amounts, slashed the number of captive entities from 1,089 to 314. The number of relationships set to be repapered was also cut from 9,059 to 1,021 according to Isda analysis.

“Phase five has become more manageable and that’s a positive step forward, but there are still bottlenecks ahead,” says Emma Patient, senior legal counsel at HSBC.

It’s not quite the 2017 variation margin ‘big bang’, which caught tens of thousands of counterparties in one swoop, but VM preparations required only a single document to be updated. “Here, you are putting in place a large suite of brand new, complex and diverse documents; it’s not insignificant,” Patient adds.

Tara Kruse, global head of data, infrastructure and non-cleared margin at Isda, sees it as a minimum 12-month process. “If people aren’t already moving forward and haven’t started some of this work, it could be quite difficult for them to be ready to actually exchange IM come September 1,” she warns.

Pain threshold

Setting up tri-party custody accounts proved to be a primary pain point in 2016. During the first implementation phase of the IM rules, US regulators were forced to issue a temporary waiver from the collateral segregation requirement when in-scope dealers failed to complete account set-ups in time for the September go-live. The problem stemmed from the fact that each in-scope dealer had a trading relationship with every other in-scope firm; what appeared at first glance to be a 20-strong wave ultimately proved to be a repapering of hundreds of relationships, and each step needed to be heavily negotiated.

Euroclear estimates 2,000 pairs require custody set-up for phase five – or double the approximately 1,000 pairs introduced during phase four. The custodian manages around 3,000 pairs for regulatory non-cleared margin on its tri-party platform. BNY Mellon’s phase five pair-count is believed to be significantly higher, given its existing relationships with many hedge fund clients.

A phase four initiative – the multi-segregated account – eased the path for Euroclear’s 2019 implementation project. This narrows down the set-up to a single account for each entity, or pledgee of collateral. From this account, the entity can receive from several pledgors.

“If we used the old methodology, we would have opened almost 10 times more accounts than with the MultiSeg structure, but here we opened one account per pledgee entity, so it’s quicker,” says Fouad Estephan, director of product management for collateral services at Euroclear.

Custodians hope to further reduce the gridlock with ACAs that dispense with lengthy negotiation. BNY Mellon is in the process of circulating the first of its new standardised agreements to clients, after receiving the green light from an Isda-led group that is scanning through new IM documents to check for potential compliance issues.

“We reached out to buy-side and sell-side clients, as well as their legal firms, to create these documents with a view to making them largely standardised, incorporating certain non-negotiable elements, says BNY Mellon’s Falco. “From the clients’ perspective, the documents still include most of the collateral features they would have requested anyway, but with fewer negotiable sections in play, so it should enable clients to complete the papering process without an unnecessary protracted back and forth.”

“The documents incorporate a lot of standard elements that clients normally expect, plus a range of different options that enable them to customise to their specific needs. The idea is that it will be a little like selecting certain customised features when you’re buying a new car,” he adds.

A legal expert not connected to BNY Mellon, who has seen a draft of the custodian’s new account control agreements, is optimistic that the new standardised approach could help avert a documentation logjam.

“They’ve taken on board some of the previous issues and put it into a format firms are used to seeing. It’s like an Isda document, where you have a pre-printed section and a schedule where you make elections. Previously, the account control agreement could be amended in various ways and that’s been an issue in every phase,” says the legal expert.

Tri-party or third party?

When it comes to posting collateral, the more expensive tri-party model may only be suitable for a handful of buy-side entities, for example those with a diverse portfolio of assets they wish to use in the IM pledge accounts.

“On a diverse portfolio, where there’s regular trading, the ability to rapidly substitute assets and to use complex collateral sets is very well supported by tri-party, which makes it a much more efficient choice for some, but it’s likely to be a minority,” says Citi’s Pery.

For firms with a large and stable pool of assets, where the need to move collateral back and forth is limited, there may be less incentive to use the tri-party approach. Most buy-side entities are expected to stick with third-party custodians.

It’s a marked shift from previous waves, as third-party operators are largely new to IM compliance and could therefore be another source of congestion, says Chetan Joshi, managing director of Margin Reform, a margin consultancy assisting phase five and six firms with compliance.

“The third-party process is quite straightforward, but the legal documents need to be reviewed for regulatory compliance. Previously this has been completed with external legal counsel, which takes time, and that’s a potential bottleneck,” says Joshi.

On a diverse portfolio, where there’s regular trading, the ability to rapidly substitute assets and to use complex collateral sets is very well supported by tri-party

Fergus Pery, Citi

An industry forum, led by Isda, aims to smooth this process by checking custody documents for potential compliance concerns. It’s not an official endorsement of IM compliance, however, and firms are encouraged to seek their own legal opinions on account documents.

But while most phase five clients are expected to stick with third-party custodians that are already in place for posting variation margin, when it comes to receiving collateral, firms are at the mercy of sell-side dealers who stuck with tri-party providers.

Brevan Howard – the first buy-side firm to become subject to the rules – came under pressure to receive collateral at Euroclear as part of its phase three preparations. It found onboarding to be a complex and lengthy process.

“It’s a process which took around six months,” according to Yaron Katz, head of risk operations at Coremont, an FCA-regulated firm that was spun out from Brevan Howard in 2018, and now provides services – including collateral management – to investment managers.

“When we had to set up accounts and negotiate the eligible collateral schedule, there was a broad discussion with counterparties and the offers were very general. Now the market has moved more to templates, so you’re not creating everything from scratch,” says Katz.

Euroclear aims to eliminate the cumbersome onboarding process for buy-side collateral receivers with a new ‘pledgee representative’ model.

This structure allows a third-party custodian to act as the collateral receiver at Euroclear on behalf of its client – in effect stepping into the client’s shoes and becoming a principal in the tri-party agreement.

“We understand from sell-side clients that they want to continue to use the tri-party service as much as possible to allocate securities. For that reason, we have offered the pledgee representative model,” says Euroclear’s Estephan.

As yet, no custodian has officially signed up as a representative for the scheme, though Estephan says the tri-party agent is in talks with many of the largest custodians.

“When they’re ready, it’s effectively a plug-and-play for the buy side. The only thing they need to do is ask the custodian to use a dedicated account for their own benefit to receive securities in Euroclear as pledged collateral.”

Northern Trust, which has $8.5 trillion of assets under custody, is thought to be close to bringing at least one large buy-side client onboard in this manner.

Others are sceptical. “For the sponsor, it’s a huge amount of effort operationally and clients don’t want to pay them for it, so what’s the incentive?” says an industry expert.

Citi – one of the largest third-party custodians with $22.8 trillion of assets under custody – is looking closely at this type of representative model, but has some reservations. 

“While acting as pledgee representative would apparently simplify the KYC [know-your-customer] and onboarding in the short term, it does significantly complicate the legal relationship between the buy-side firm and its custodian,” says Fergus Pery, global head of collateral management at Citi.

According to HSBC’s Patient, decisions over where entities will post and receive collateral are likely to be client-driven: “Parties want to be sensible about making sure they can try and facilitate using custodians of choice wherever possible,” she says.

BNY Mellon’s Falco says the custodian has seen limited demand for the representative model from its own clients but has not ruled out acting as a sponsor in the programme.

“We’re monitoring it to see if there’s a pick-up in demand. From our perspective, there may be some risks and operational issues that we would need to work through, but we haven’t had the bandwidth to investigate that model because we’re currently focusing on capabilities that clients are demanding,” Falco says.

The third man

If tri-party comes with a high price tag, third-party comes with limitations. Citi’s Pery warns firms need to ensure they have a robust process to recall pledged collateral. “There may be challenges in getting a counterparty agreement to do that on a same-day basis, so firms need to consider how to avoid getting into difficulties. Potentially this may mean ring-fencing assets for use as IM, which they don’t plan to trade on in the short-term.”

Margin Reform’s Joshi warns the structure leaves firms open to a host of regulatory obligations around concentration limits and wrong-way risk, which are typically outsourced to the agent in the tri-party model.

“People think it’s easier to utilise a third-party custodian, but once you’re subject to uncleared margin rules, your collateral system will need to manage these daily to ensure you do not have a regulatory breach,” Joshi says.

This could change as the lines blur on the two models. Custodians themselves are introducing tri-party-style automation elements to the more familiar third-party structure. While external vendors offer a variety of automated services aiming to bridge that gap, including automated concentration limit monitoring and collateral selection tools. 

“There’s a lot of focus from a technology perspective on automating the use and selection of securities so that, if you do use a third party, it’s not a manual process and should be zero-touch wherever possible. At that point, the system is effectively doing much of the same allocation of collateral that the tri-party agent does,” says Neil Murphy, business manager at TriOptima, which automates the collateral management process via its triResolve Margin platform.  

Euroclear’s collateral portfolio service, which went live in late 2019, combines the bilateral settlement structure of a third-party model with automated collateral selection.

“It’s a full automation like tri-party, but instead of having settlement in the books of Euroclear, the messages are sent to custodians and the custodians put in place the instructions to move the securities between their accounts,” says Estephan.

While more active accounts may find the model efficient, it comes at a cost and isn’t likely to replace standard third-party services.

“If it’s just a simple allocation of one or two lines of securities, it’s easier to just move it via third-party, but this automation could be very interesting for some pension funds or other large buy-side [firms] which have dozens and dozens of lines of securities to transfer,” says Estephan.

The pace so far is slow. A margin manager at the second European dealer says some hedge fund clients are negotiating, but no asset managers as yet. “That’s a big worry,” he says.

While custody initiatives could help to smooth compliance, Coremont’s Katz warns firms not to stall preparations. “We know the phase five and six queues are going to be huge and it’s mostly done on a first-come-first-served basis, so if you can be there earlier, you should be there earlier.”

Editing by Louise Marshall