Wednesday 28 April 2021

Types of Custodians for Regulatory Initial Margin

Regulatory initial margin (Reg IM) under margin rules for uncleared OTC derivatives requires parties to post and/or collect Reg IM on a gross basis (i.e. not netted) and it must be segregated.  This is typically achieved by putting in place arrangements with an independent custodian (i.e. the custodian is not an affiliate of either party).

There are two types of custodians:

1. Central securities depositaries (CSDs)

CSDs are specialist financial organisations that act as a central point for holding securities so that ownership can be easily transferred through a book entry system.

Examples of CSDs are Euroclear Bank SA/NV (in Belgium) and Clearstream Banking SA (in Luxembourg)

2. Bank custodians

Bank custodians are financial instructions that hold customer’s securities for safekeeping.

In both cases, a party will set up their own general custodial account with the CSD or bank custodian.  They will then create a separate segregated account for posting Reg IM with each trading counterparty.  This separate account is a tripartite arrangement between you (as collateral provider), your counterparty (as collateral receiver) and the custodian.

There are two types of custodial arrangements:-

1. Third party arrangement

This is the type of custodian arrangement that most market participants will be familiar with for non-regulatory purposes.  The relevant custodian will simply hold the securities assets in their custody.  The contracting parties are required to instruct the custodian to move individual securities, as necessary, on a daily basis to the relevant segregated account.

Depending on the custodian, instructions could be sent manually (e.g. fax), using a custodian portal or by SWIFT. 

2. Tri-party arrangements

Here the custodian provides a wider service. The pledgor/chargor will hold a general account with the custodian and will post a wide variety of securities to that account (typically referred to as a “longbox”).  In addition to this general account, separate segregated accounts will be created for regulatory initial margin for each trading pair.  Before trading of in-scope products takes place, the pledgor/chargor and secured party will have agreed the types of securities that are eligible as collateral.

On each day, the custodian will receive communications from both the pledgor/chargor and the secured party for the relevant trading relationship providing details of the full amount of collateral that should be held in the relevant segregated account.  The custodian will then allocate that amount of collateral to the segregated account. This is done by taking collateral from the longbox and moving it to the segregated account.  The custodian will move eligible collateral (or potentially substitute existing collateral) on the basis of what is the cheapest for them to deliver.  

Therefore, a triparty arrangement provides collateral optimisation and reduces the operational burden of the contracting parties as they do not need to issue individual instructions for each item of collateral.

Bank custodians may offer third party and/or triparty arrangements.  CSDs are triparty agents.

Dealers typically prefer the triparty approach as it creates significant efficiencies.  However, not all entities meet the criteria to be eligible for triparty arrangements or they may already have third party custodial arrangements in place for non-regulatory purposes and prefer to use the same custodian for their regulatory obligations too in order to reduce the potential onboarding requirements with another custodian. 

Normally each party will select their own custodian for their Reg IM posting requirements.  The parties do not need to use the same custodian.  Please bear in mind that there are some onboarding/KYC requirements for you to complete in respect of your counterparty’s custodian.  When done, this will allow you to send instructions to the custodian when necessary and to gain access to the collateral in the segregated account in a close-out situation.

Posted by Abigail Harding

Category: ISDA negotiation

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