The introduction of Uncleared Margin Rules (UMR) for Phase 5 and 6 firms presents a new challenge to the financial services market: how to meet the legal, collateral and on-boarding requirements of this new segment through cost-effective and industry-wide models. The Euroclear representative model for custodians and other service providers is our solution.
Phases 5 and 6 of UMR are bringing over 1,000 new firms into the world of Regulatory Initial Margin (Reg IM) in the OTC Derivatives space. These entities may have the resources to manage margin on their own but may not have access to triparty collateral management services that facilitate efficient operations. They will need service providers, and in particular their custodians, to support access to triparty to stay in the market.
For custodians, supporting UMR for small firms is not always an attractive business. It requires navigating a complex regulatory landscape and negotiating with smaller clients for on-boarding and management of day-to-day business. Custodians with a moderate number of UMR-eligible clients will have to invest in a new range of technology and operations, implement new legal frameworks and gather legal opinions on the compliance of their services. They may also need to partner with a technology firm or service provider. Without this investment, they risk losing their clients to bigger firms that look to aggregate the business. This can be a frustrating process for all but the largest custodians.
Likewise, for triparty agents, onboarding a high number of Phase 5 and 6 firms is not always practical. These firms require Know Your Customer (KYC) connectivity to multiple counterparties and legal documentation. They may wind up conducting just a few trades a year and hold only small balances.
The Euroclear representative model allows custodians and other providers to support their clients using the Euroclear triparty engine as the backbone of their service effort. With close to 50% of all UMR margin volumes thus far residing on our triparty collateral management platform, and with commitments from several custodians already, we are developing a broad-ranging solution that will allow any client to become a collateral taker or pledgee on our triparty platform using their existing custodian as an intermediary. This eliminates the need for multiple painful onboarding processes and will allow collateral givers or pledgors to leverage the pledge mechanism implemented during Phases 1 to 4 of UMR. It also enables Euroclear to accommodate a very large number of anticipated new relationships in a cost-effective triparty mechanism.
Introducing the representative model
The representative model allows Euroclear to be a wholesale provider of market infrastructure to custodians and other intermediaries. We help these firms enable our tools, for example online digital validation of client profiles and our MultiSeg account structure and service, for their clients. A key advantage is that the representative model allows the custodian to maintain its existing client relationships: Euroclear does not speak directly with Phase 5 or 6 firms.
Through the representative model, any sell-side firm or dealer can pledge collateral to any buy-side client on the books of Euroclear triparty and, as for all previous Phases, collateral is held in a segregated account in the name of Euroclear Bank (see Exhibit 1).
Exhibit 1: The Euroclear Collateral Pledge Model
There are multiple benefits to this model, including:
- No additional workload for the sell-side pledgor, which continues to use their existing Euroclear triparty account for UMR.
- Buy-side pledgees can gain access to Euroclear triparty services using their representative custodian or other service provider.
Euroclear will continue to perform its role as a neutral collateral agent in the representative model, while recognizing that the custodian or other service provider is itself acting on behalf of one or more underlying clients. Our multi-segregation account structure allows pledgees to maintain Reg IM from multiple counterparties in one segregated account. This model has received the necessary legal validation.
The representative model is of course not the only solution in the market. Custodians and other providers will partner with a range of firms to deliver UMR-related services. Euroclear is working with third party platforms to improve scalability and straight-through processing, especially in the collection of collateral profile information. Interoperability will be a key feature for the entire financial services industry, and Euroclear will be part of this solution.
Implications for the industry
The introduction of the representative model supports industry objectives in multiple ways. Most importantly, it enables custodians to keep their client relationships, not just in UMR but across the full range of services including core custody.
Without the appropriate infrastructure to support UMR, some service providers would be at risk of losing clients that add value throughout the firm. A substantial part of their business would be at jeopardy due to the lack of efficient operational solutions and the increased costs associated with supporting Reg IM requirements. The representative model helps them reduce this threat to their existing business.
The representative model also connects to DTCC-Euroclear GlobalCollateral’s Margin Transit Utility (MTU). The MTU consolidates a custodian-neutral and open model for managing collateralized activity, including triparty. Combining the Euroclear triparty solutions for UMR with GlobalCollateral’s MTU can offer a competitive advantage for a wide range of market participants.
UMR is a challenge for the entire industry. There will potentially be hundreds of small firms entering the market in Phases 5 and 6 that will require a new level of operational processing. By offering custodians and other service providers access to a centralized and outsourced triparty infrastructure, the representative model delivers an option for solving industry needs through a reliable and cost-effective solution.
Olivier Grimonpont is Global Head of Collateral Management and Securities Lending, Euroclear Group