Tri-Party Collateral Management

Tri-party collateral management is a service in which a neutral third party, the tri-party agent, takes over the operational handling of collateral between two parties to a secured transaction. The party giving collateral and the party receiving it agree the amount to be secured and the kinds of assets that are acceptable; the agent then chooses suitable securities from the giver's account, moves them to the receiver's account, values them every day and adjusts or replaces them as needed until the transaction ends.

The agent is typically a large custodian bank or an international central securities depository, with which both parties hold accounts. It acts as an administrator and does not take on the credit risk of either party: if one side defaults, the loss or gain belongs to the other. The service is an outsourced form of collateral management, used above all for the repurchase agreement market, securities lending and the posting of margin.

The relationship rests on a three-way contract between the agent and the two parties, alongside the bilateral agreement that governs the underlying trade. The parties also complete an eligibility schedule, sometimes called a collateral basket or profile, which lists the acceptable asset types, issuers, ratings and currencies, the collateral haircut applied to each, and concentration limits that cap exposure to any one issuer or security.

A transaction then proceeds as follows:

1. The two parties agree a trade, for example a cash loan of 100 million against collateral, and each notifies the agent of the amount, dates and basket.
2. The agent matches the two notifications.
3. Its allocation system selects securities from the collateral giver's account that satisfy the schedule and have a value, after haircuts, at least equal to the required amount.
4. The securities are transferred to an account held for the receiver, against the movement of cash where the agent also handles the cash leg.
5. Each day, and often several times a day, the agent revalues the collateral, tops up any shortfall and returns any excess.
6. At maturity the collateral is released and the cash repaid.

The agent's tasks cover the main operational burdens of secured financing. It tests each security against the parties' collateral eligibility rules; carries out collateral valuation using current market prices; and makes substitutions automatically when the giver needs a pledged security back, for instance to deliver against a sale, replacing it with another eligible asset without involving the receiver. It processes income and corporate actions on securities held as collateral, usually passing the benefit back to the giver, and reports positions to both sides.

Agents also offer collateral optimisation: algorithms that allocate the giver's assets across all its counterparties so that the lowest-quality securities each receiver will accept are used first and more valuable assets are kept free. Where the receiver is permitted to reuse the collateral, the agent can track that reuse within its system.

• Repo. Cash investors such as money market funds lend to dealers against baskets of securities without needing the systems to select and value individual bonds. In the United States the tri-party segment is a central part of the repo market and of short-term dollar funding.
• Securities lending. Borrowers of shares and bonds post non-cash collateral to lenders through an agent.
• Margin for uncleared derivatives. Rules requiring the two-way exchange of initial margin, held in segregated accounts and protected from the receiver's insolvency, led many firms to use tri-party agents to hold and administer it.
• Central bank and clearing house collateral. Some central banks accept collateral for their credit operations through tri-party services, and a central counterparty may accept margin from members in the same way.

For the collateral receiver, the arrangement provides independent custody, daily valuation and the assurance that only eligible assets are held, without building its own infrastructure. For the giver, automatic selection and substitution allow a large and changing inventory to be financed efficiently. Compared with a bilateral collateral agreement, where each party must instruct every movement, the number of manual settlement instructions and the risk of failed deliveries are much lower.

The model concentrates activity in a small number of agents, whose continuous operation is important to funding markets. The receiver also depends on being able to sell the collateral quickly if the giver defaults, which is harder when baskets contain less liquid assets.

The 2008 financial crisis exposed a specific weakness in US tri-party repo. Trades were unwound each morning and rewound in the afternoon, and in between the clearing banks extended very large amounts of intraday credit to dealers. When confidence in a dealer fell, both the cash lenders and the clearing bank had reason to withdraw, and funding could disappear within days, as it did for Bear Stearns and Lehman Brothers. A reform programme led by the Federal Reserve Bank of New York in the following years sharply reduced the use of intraday credit and improved the settlement process. Authorities have continued to watch the market because of its reliance on few providers and its links to money market funds, a subject treated under shadow banking.

• Federal Reserve Bank of New York: Tri-Party Repo data
• International Capital Market Association (ICMA)