What’s going on in the collateral segregation market? (Premium)

We’ve done some digging into the current status of collateral segregation and opinions across the buy-side and sell-side. Segregation seems to be pretty much the same process it has always been but now a lot more people are talking about it. Below are our notes from recent conversations and research.

Collateral segregation is little more than a third party holding assets in custody to benefit a counterparty in case of default in a derivatives transaction. It sounds a lot like tri-party, but instead of tri-party holding both securities and cash, the segregated custody account holds securities and/or cash with no collateral on the other side, because there isn’t any. Its the same tools as tri-party just with different legal agreements (GMRA, GLSA, ISDA CSA) underpinning the structure. One executive at a major custodian told us that collateral management is just tri-party plus other collateralized transactions that use the tri-party mechanism.
The current conversations about segregation are regulatory-driven, mostly from OTC derivatives. There is no big community on the buy-side or sell-side that wants segregation for its own sake. Operationally for the sell-side, this is no big deal – the sell-side knows about products and shells and this is just one more account to manage. For a dealer with hundreds of outstanding repo transactions, segregation makes sense if the client wants it or regulations demand it.
On the buy-side, there are some specific points of concern. BNYM’s Ross Whitehall wrote an article last May about the impact of AIFMD on collateral segregation at the sub-custodian level; the idea is that sub-custody is typically based on an omnibus account, but new regs from ESMA mean that each UCITS client will need a segregated account. This can be onerous, and a UCITS fund lending securities on its own using tri-party (effectively a sub-custodian) would be shut out. They can still manage the process themselves bilaterally but it would be cumbersome. Here’s his argument:

The proposed segregation approach actually increases investor risk along the post trade chain. It also increases systemic risk. This is due to the substantial increase in accounts, a corresponding increase in movements of securities, and in particular the inability of AIFs to function in a tri-party environment. There will also be increased settlement and operations risk because market deliveries will be necessary, rather than intraday book entry books and records management.

Our interviews across the sell-side, buy-side and service providers suggest that buy-side usage of collateral segregation has not increased over the last year. While mutual funds have used tri-party since 1985, they are not yet on their own all that interested in segregation for OTC derivatives. Hedge funds are users of segregation services but other than that, the market is not yet where service providers think it will get to.
The big change that appears to have occurred in segregation recently is on the servicing side. Custodians are now optimizing across legal entities to help their clients deal with fractured collateral pools. This is no expectation of collateral shortages, but really just custodians helping to make dealers more efficient. This can be seen as another step in the process of banks forming Central Collateral Funding Desks, or merging equity and fixed income financing into the same business units.
Besides non-cleared derivatives, attention to collateral segregation is popping up in new places. In a 2015 proposed rule on on derivative use by fund companies, the SEC said that: “A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.” What might entail a financial commitment transaction? Anything that includes collateral at all including securities loans?
It seems that collateral segregation has the attention of regulators. What that actually means and if it is really useful are questions for another day.

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