BNP Paribas Securities Services, the custody and fund administration arm of the French bank, has launched a tri-party collateral management service. In a market dominated for 20 years in Europe by Clearstream and Euroclear, and in the United States for even longer by BNY Mellon and J.P. Morgan Chase, it is bold move. So why make it?

A large part of the answer lies in the decision by the French bank to support asset managers wrestling with the challenge of paying initial and variation margin for the first time. “The buy-side needs access to the repo markets to raise cash to meet obligations under the European Market Infrastructure Regulation (EMIR),” says Emmanuel Denis, global head of tri-party collateral at BNP Paribas Securities Services. “It is a new regulatory paradigm for the buy-side. It is a new thing for most of the buy-side players to put up securities as collateral, and then manage it afterwards. Doing it in the bi-lateral repo market creates operational risk, particularly in terms of substitution and asset servicing. A tri-party agent in the middle doing all the work is a much safer option for them.”

Tri-party is, in other words, a natural extension of global custody: an outsourced operational service for the buy-side. While asset managers could access both the repo and the stock loan markets directly – either via digital platforms or bi-laterally, with investment banks as counterparties – they would always struggle to manage the middle and back office aspects of managing the collateral. “We are the only global custodian tri-party agent to connect directly to the trading account of buy side clients booked in global custody,” adds Denis. “We do not ask our clients to open a long-box which creates an operational burden, and additional cost.”

Managers with swap portfolios have long relied on custodian banks to integrate the sourcing, allocation and servicing of collateral with fund accounting (assets posted as collateral affect Net Asset Value (NAV) calculations), custody (assets belonging to funds are scattered across sub-custodians and global custodians) and the depositary that must be appointed by any managers of a fund regulated under the Undertakings for Collective Investment in Transferable Securities (UCITS) or the Alternative Investment Fund Managers Directive (AIFMD). Depositary banks in particular are required to monitor assets posted as collateral to third parties.

Of course, it is a short step from appreciating these complexities to entrusting as many of the services as possible (fund accounting, custody, collateral management and depositary) to a single custodian bank. In this sense, tri-party collateral management is another useful lever to persuade asset managers to concentrate their business with BNP Paribas.

“If you are not a custodian, you cannot offer tri-party services,” asserts Hélène Virello, global head of collateral and OTC valuation services at BNP Paribas Securities Services.

“A tri-party collateral manager is necessarily an agent, who remains neutral between the two parties to the transaction, which are typically an asset manager and an investment bank. As an agent, we are not a party to the trade but completely neutral.”

The fact that collateral management leaves no impression on the balance sheet of the bank is one of its attractions. “That is the beauty of it,” says Patrick Colle, general manager of BNP Paribas Securities Services. “The only risk we bear is operational.” Bearing that risk is of course the value that the bank is offering to asset managers through its tri-party service. “How can I retrieve these assets from our trading account to use in tri-party?” asks Denis. “Is this collateral eligible at this counterparty? When is the settlement cut-off time for posting this collateral? These are all questions which we can answer for asset managers.”

But it is EMIR which has made answering them so urgent. The regulatory obligation to margin cleared and non-cleared OTC derivative activity in Europe may have taken longer than expected to come into effect, but is now a reality, and it has provided BNP Paribas with the opportunity to fulfil a longstanding aspiration. “We have been thinking about this for ten years,” says Patrick Colle.

Why has it taken so long for the bank to fully commit to the tri-party markets? After all, the logic of entering them was always impeccable. BNP Paribas Securities Services settles trades for all of the major sell-side counterparties in all the major markets where the investment banks choose not to self-clear. Giving those clients access to the cash and securities available on the buy-side – to cover short positions and obtain stock to on-lend – is a service they would have appreciated 20 years ago, let alone ten.

Again, it is a regulatory driver that helps to explain the timing of the launch of the service. “The sell-side wants to borrow high quality liquid assets (HQLAs), including cash, against less liquid assets, to upgrade what they hold in order to manage their balance sheets to the liquidity coverage ratio (LCR),” explains Emmanuel Denis. “We see ourselves supporting these so-called collateral swap transactions.”

Without the LCR and the Net Stable Funding Ratio (NSFR) prescribed by the Basel III capital adequacy regime, and EMIR, BNP Paribas would have faced the enormous challenge of taking market share off two pairs of longstanding duopolists on both sides of the Atlantic – BNY Mellon and J.P. Morgan Chase in the United States, and Clearstream and Euroclear in Europe – without any regulatory impetus to help.

Worse, the bank would have found itself competing for business in a market that was static at best. The classic tri-party transaction – in which cash-rich private and universal banks fund cash-poor investment banks – has never really recovered from the financial crisis. Since 2008, when the central banks stepped in to replace a repo market no longer open to the investment banks in the aftermath of the collapse of Bear Stearns and Lehman Brothers, central bank money has effectively stalled the growth of commercial bank money funding of the sell-side.

In Europe, according to the survey by the European Repo Council, the overall value of the European repo market at the end of last year (€5,656 billion) was still 12 per cent lower than in December 2006 (€6,430 billion), immediately prior to the start of the financial crisis. Throughout that time, the share taken by tri-party has remained steady, at around 10-12 per cent. In the United States, the value of collateral financed in the tri-party repo market was 18 per cent lower at the end of last year ($1.9 trillion) than it was at its peak in 2008 ($2.4 trillion).

Emmanuel Denis thinks the stasis in the tri-party markets is temporary. “We believe it is due to three things,” he says. “Quantitative easing, the current negative interest environment, and the impact of Basel III in forcing investment banks to reorganise their trading desks. We think this is not a structural issue, and it is likely to change in the future, with the repo market growing over the next few years.”

Nevertheless, BNP Paribas is launching its service now rather than later. So it was crucial to the decision that regulation, long expected to increase the use of tri-party collateral management, is starting to bite. But regulation is not the only factor that has encouraged BNP Paribas to make its move now. Building an effective collateral management technology platform is difficult and expensive, which is why Clearstream has had such success selling its established system to third parties around the world. Understandably, BNP Paribas was reluctant to become a customer of a competitor. It has instead built its own collateral management system.

Patrick Colle says it was not as risky a decision as it sounds. “Building a tri-party platform used to take years and carried a high risk of failure,” says Colle. “But with the latest technology we can do things we would not have dreamed even of attempting as recently as five years ago. Thanks to improvements to the ease, power and speed of technology, we were able to build our new platform in only 18 months. We also believe using the latest technology has enabled us to take a big leap ahead of our competitors, and offer tech-driven competitive advantages to our users as well, in the shape of more sophisticated collateral management algorithms and data visualisation tools.”

The algorithms have to be sophisticated because every user has a unique portfolio and both they and their counterparties set their own parameters in terms of collateral eligibility, acceptable counterparties, concentration ratios and haircuts, vastly complicating the necessary net exposure, valuation, optimisation and allocation calculations. Once a piece of collateral is posted, it has also to be serviced (in terms of income collection, for example) and occasionally substituted (when client retrieve securities to sell them).

All of this functionality is now in place. “Our collateral management platform is built and it is live,” says Hélène Virello. “We are now discussing with clients whether and how we can on-board them.” To attract managers, BNP Paribas is emphasising something much more old-fashioned: a custodial service capable of transferring securities, wherever they are held, from cash takers to cash providers, by digital book-entry. The ability to do this rests on what the bank sees as its principal competitive advantage over the four incumbents: its own local custody and clearing operations.

“We can make available pools of assets previously trapped in local markets, and so not eligible for use on a global scale,” says Patrick Colle.

“Those assets can only be released if you are not only a global custodian but also a local sub-custodian. This is the first time a multi-local sub-custodian has got into the tri-party space. Collateral management is all about making more collateral available, and what enables us to do that is our ability to build a global platform on local franchises. In this case the tri-party platform, up-to-date as it is, is only the most visible and high-profile part of an in-house infrastructural iceberg that dates back to the foundation of the business.”

Emmanuel Denis elaborates. “BNP Paribas is not just a global custodian but has a local custody franchise in 27 markets,” he explains. “We can access domestic assets directly, and manage them at the local and the global level between the giver and the taker. What the clients of the incumbent tri-party providers do every day is thousands of movements of assets from local accounts to global accounts. That costs money, and it takes time. We can do it all in-house, so it is quicker and cheaper than via the existing providers. Moving assets between a local sub-custodian and a centralised tri-party agent, as they must do, is simply not as efficient.”

BNP Paribas knows this because it is already working with both Clearstream and Euroclear in exactly that fashion. In 2013 the bank joined forces with Clearstream to offer clients of both organisations the ability to move fixed income and equity assets from any local market in Europe in which BNP Paribas Securities Services has a proprietary sub-custody and clearing operation into a Clearstream account on the books of BNP Paribas Securities Services. From that account, the assets can be posted as collateral using the Clearstream collateral management engine. A similar arrangement with Euroclear was introduced in 2014.

Patrick Colle says these arrangements are not threatened by the entry of BNP Paribas into the collateral management markets in its own right. “The buy-side will only want to appoint one tri-party agent,” he says. “The sell-side has to work with all five tri-party agents, so we will continue to connect sell-side clients to buy-side clients at either the local level or the central level. Our arrangements with Clearstream and Euroclear will continue.”

What will be different in future is that BNP Paribas Securities Services is planning to offer its tri-party collateral management service on a global scale. The bank is now running a domestic custody and clearing operation in the United States, with accounts at the Depository Trust and Clearing Corporation (DTCC), so adding tri-party to the product set is not difficult, and discussions are in hand with both investment banks and fund managers active in the American markets.

“Do we want to offer this service in the United States?” asks Colle.

“We decided to be present there a few years ago. We are already a custodian, and want to become a full-fledged domestic fund administrator. On tri-party, the idea is not to go into domestic tri-party and compete with BNY Mellon and J.P. Morgan to service the leading domestic investment banks and brokers. Our goal is to service our global clients globally, wherever they operate. The collateral they want to use will be multi-currency and in multiple locations. We want to be able to manage their collateral in the United States as well as elsewhere. We are aiming at the global tri-party market, servicing the global needs of our clients, but we also want to be realistic. We are realistic and focused.”

Ultimately, the success of the service will depend on the ability of BNP Paribas to deliver on its promise to use its custody and clearing network to create a community of buy-side and sell-side collateral takers and givers on a global scale. Different currencies, and legal and regulatory regimes, and variations in the quality and inter-operability of domestic payments and securities market infrastructures, make that harder to deliver in practice today than in prospect tomorrow. Patrick Colle is confident the network can deliver.

“Seven years ago we embarked on a new strategy for BNP Paribas Securities Services to grow from being European to being truly global,” he says. “Today, we are truly global. Whether in custody or fund administration, we perform across all the major financial markets of Asia Pacific, Europe, North America and Latin America. But we are always anchored by our local presence as a sub-custodian and clearing agent. Our global, multi-local presence and franchise is the key to our ability to launch a competitive tri-party collateral management platform. This service is a milestone for the industry, but it is also a milestone for us.”

Dominic Hobson