Towards a central collateral utility: the value proposition of CSDs in collateral services

Central Securities Depositories (CSDs) have emerged as leading providers of tools and services for collateral management, building on their own longstanding roles in market infrastructure. This article examines the role of a major CSD – The Depository Trust Company (DTC) – in the collateral management effort, and how this extends its existing role in the industry. What is true for DTC will be true for other CSDs as well.

For collateral management to achieve its full potential, it can no longer be left to individual lines of business to separately manage their own collateral needs; anything less will result in a loss of revenue or expense management opportunity, and over time will lead to weaker returns than competitors. Firms must centralize their internal collateral management organizations but also work with central utilities, including Central Securities Depositories, to achieve maximum efficiency. What exactly constitutes internal collateral management can be different across organizations, and describe a range of diverse activities.

Creating the modern CSD

In the beginning, there was paper and lots of it. The paper, though, wasn’t the real problem. The real problem was that the paper was scattered across multiple locations, in the vaults of individual brokers and banks or in the safe deposit boxes of individual investors. Trade settlement occurred bilaterally between buying and selling brokers and their customers, based on their individual trade records and records provided by the local exchange. The inefficiencies of this market structure are obvious, and reached such a problematic state that local exchanges – for instance, the New York Stock Exchange – closed on Wednesdays from June to December in 1968 just to allow banks and brokers to catch up on settlement. In what may seem like a scene from a movie, Wall Street was once full of armies of clerks shuffling stock and bond certificates in and out of envelopes; matching them up to trade tickets; calculating cash payments; writing checks; and then sending runners from bank to bank to deliver securities and payments. Physical proximity to other dealers was critical, and this kept the financial industry in lower Manhattan.

The solution to the paperwork problem was the establishment of regional depositories associated with local exchanges. In the US, the Depository Trust Company (DTC) was formed in 1973 as a central depository for brokers trading on the NYSE. DTC became the common custody bank for the industry, storing certificates and centrally processing trade settlements. DTC has also become the main depository for corporate bonds and municipal securities, and, via a free of payment link to Fedwire, can hold US treasuries.

There were three transformational elements to the creation of DTC. The first was to establish a shared industry infrastructure to perform standardized operational tasks on behalf of all participants; this provided immediate benefits in economies of scale as well as process reliability and predictability. The second was to streamline the business process to its essentials, the transfer of securities and payments, and to eliminate unproductive peripheral activities such as stuffing envelopes and walking around lower Manhattan. The third was to eliminate redundancies in record keeping and reconciliations across the industry.

Local depositories servicing the Boston Stock Exchange, the Pacific Stock Exchange and the Midwest Stock Exchange were merged under the DTC umbrella by the end of the 20th century, creating a national market infrastructure. Brokers and banks no longer needed to process inter-depository transfers in order to meet trade settlement obligations. Participants gained a single view of all securities positions; and a unified point of control over margin segregation, delivery and receive obligations, and pledge positions against bank loans and CCP margin.

What was relevant for the historical model of trade settlement at a CSD is applicable to today’s collateral management infrastructure. The management of collateral to fund a range of underlying trading activities eventually resolves to a set of common operational tasks that are trade-type agnostic. Collateral must move from one party to another with a minimal number of steps. Participants need a common point of reconciliation and record keeping to reduce redundancy and error. And participants need the operational reliability of a common standard, as well as economies of scale of a centralized operational model.

From national to global

On the global scale, the advent of CSDs in important markets such as the Canadian Depository for Securities (CDS) and Euroclear made cross-jurisdictional activities less problematic. Working with national regulators, CSDs began to work together to virtualize a global market infrastructure by creating common standards and procedures for the movement and custody of assets, as well as the necessary controls and compliance procedures to meet regulatory needs.

Much of this has involved the digital representation of ownership and rights of rehypothecation for different types of activities. These distinctions include recognizing a transfer of possession (such as a securities loan) versus a collateral pledge (against a margin obligation) versus a transfer of ownership (such as a sale). Each jurisdiction has had its own rules and its own way of representing these differences, and this has led on occasion to legal battles and investor loss. A harmonization of global CSD standards greatly reduces the potential for risk.

For collateral optimization to realize its full potential, it must occur across the global book of business. Where collateral needs exist in different jurisdictions than the collateral availability, firms need an operationally efficient method of moving collateral. This must occur within the context of their existing inventory management and securities segregation requirements. CSDs can provide the connective infrastructure to span the geographical divide.

Evolving customer demand for collateral services

Collateral financing teams are the core of a bank’s centralized collateral management organization; for decades, they have been the firm’s primary internal sources of securities and cash liquidity. These units are concerned with the compliant and efficient utilization of securities inventories whether as brokers managing inventories of customer margin debits or as banks managing multiple customer custody inventories. Over time, they have absorbed responsibility for most firm-level functions that demand collateral liquidity.

Securities finance teams are also attuned to and reliant on the tools and controls provided by CSDs. At a broker dealer, for instance, it is most often the securities lending group that has final say over the firm’s use of free securities inventories. These teams facilitate customer trading and market making activities, and have had control over short sale authorization and compliance. Their systems have primary control over the management of intraday segregation to ensure that deliveries made for financing purposes do not result in a violation of customer securities segregation rules. For all these functions, most securities finance systems in the US are deeply integrated with DTC services and tools including Memo Seg, Bank Loan Pledge/Release and OCC Margin Pledge/Release.

Meanwhile, OTC derivatives collateral management has been on a direct path of convergence with securities finance collateral teams, the result of new rules for Initial and Variation Margin that enforce a myriad variety of internal and external calculations. From understanding who is required to post collateral and when, to internal balance sheet impacts for posting the right and wrong collateral, OTC derivatives collateral teams have become central players in acquiring systems and utility services to meet their needs. The collateral needs in this fast moving space have generated some of the biggest change in collateralized trading markets in recent years.

CSDs can integrate collateral management tools with their existing controls such that dependent systems can easily understand what is happening without regression development, or significant changes to long established processes. For the securities finance system, collateral management activities for derivatives margin pledge need to fall into normal processes and be reported consistently with all other securities movements.

The CSD as collateral infrastructure

CSDs are able to mitigate if not eliminate the inefficiencies of the multilateral collateral management processes, in which dealers and banks, custodians and investors must all separately manage their parts and hope that all the parts come together successfully when it comes to actual settlement. By virtue of their centralized position as financial markets infrastructure, CSDs provide consistency in the operational process integrated with other core services. As US domestic financial markets participants want greater access internationally, DTC can ensure that securities moving from one jurisdiction to another do so while retaining a consistent understanding of the purpose of the transfer.

The changing nature of CSD services in the collateral space creates new questions about who is the user: a custodian, a dealer, an end-investor, or a combination of all three. The use of the CSD allows pledgees of all types to exercise better control over their collateral, and in some jurisdictions this is already a legal requirement. Custodians and self-clearing brokers are the traditional users of a CSD on behalf of their clients and their own accounts. It would make the most sense for this structure to remain in place, although the growth of collateral optimization requirements means that end-investors may want access as well, which is a possibility with integrated custodial portals. An overall growth of collateral services in the market means that traditional roles of access to market infrastructure may need a reasonable review from the operations, legal and technology perspectives.

Since their creation, CSDs have served to harmonize the needs of disparate market participants with the same requirements into one standard operational practice. The same thing is happening in collateral today. CSDs link customer primary systems together through a single set of settlement instructions; and deliver margin collateral to the right sub-account of the right pledgee with the right representation of ownership and possession. Just as the business of securities finance has transformed into the business of collateral management, so too the role of the CSD is being transformed into a central collateral management utility.

This article was commissioned by DTCC-Euroclear Global Collateral.

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