November 30, 2011

TriParty Battle Explained

I saw this piece by Reuters last week “Insight:Funds battle banks over $300 trillion derivatives market“, and despite trying to research it, didn’t understand what the problem was. With help from Deus Ex Macchiato I can now explain.

US & EU clearing models (agency versus principal)

Before going on, it is worth setting out the two clearing models, as the US and EU models differ in some substantial ways:

  • US model: The Fund has a trade direct with the CCP, the FCM acts as an outsourced operational function, passing cash / coupons / margin backwards and forwards between the fund and the CCP.
  • European model: The Clearing Broker is a party to a trade between the Fund and itself, and then a back-to-back trade to the CCP. The CB – Fund leg will be covered by an ISDA CSA, which is linked to the CCP rules on margin calls.

Bilateral trading

In the current trading environment, fund manager FM can trade with bank B (executing broker) provided they have an ISDA Master in place, and a suitable credit line from B for each of the Funds FM is trading on behalf of. Once the trade is executed via broker or direct, FM & B book the trade in their systems and life goes on.

Note: For clarity I am not differentiating between the Fund Manager and the underlying fund here, just using the FM to illustrate the point.

Cleared business in Europe

FM now trades with B again, but in a cleared world, FM needs an intermediary, a Clearing Broker, CB. The steps in the process look like this:

  1. FM & B execute a trade
  2. FM asks the CB (electronically) to step into the trade, meaning legally you then have FM <-> CB <-> EB
  3. CB & EB then send their trade to the CCP for clearing
  4. In a nice world, the CCP registers the trade, end result is FM <-> CB <-> CCP <-> EB
  5. In a bad world, the trade is rejected due to lack of margin (from either party), and you remain at step 2

Cleared business in the US

FM now trades with B again, but in a cleared world, F needs an intermediary, a Futures Commission Merchant (FCM). The steps in the process look like this:

  1. FM & B execute a trade
  2. In a post DFA world, the SEF sends the trade to the CCP
  3. The CCP requests the FCM (nominated by the FM) to accept the trade for submission into clearing
  4. Assuming the FCM says Yes, the CCP then runs their risk checks and margin runs
  5. In a nice world, the CCP registers the trade, end result is FM <-> CCP <-> EB
  6. In a bad world, the trade is rejected due to lack of margin, and you remain at step 3

It’s making Gary madder

The issue dealers and the buy-side are aggravated about, is EU step 5 or US step 6, where the CB/FCM now has a trade with the FM which they can’t clear, and potentially have to tear up the trade and get involved in a compensation payment to terminate. In the European model the CB also has a trade with the EB which they really don’t want and might not have the credit line to cover. The reasons the FM might end up in this state can be two fold: 1) the CCP called the FM for margin, which they didn’t pay, or 2) the CCP called the EB for margin, which they didn’t pay. [Assuming of course this trade is eligible in the first place].

[Another thought, if either one of the parties doesn’t pay their margin call, are they potentially in default?, this scenario is going to be rare]

Some dealers would like to pre-agree with the FM, who their EBs can be. The FMs don’t want this, and according to the Reuters article Gary Gensler proposed to ban the TriParty agreements (FM – CB/FCM – EB) which would express these choices. The dealers keep pushing this approach forward which according to Reuters “made him madder”.

From Reuters: “Angered by the triparty addendum, Gensler brought a ban of triparty up for commissioners’ approval at their July 19 meeting. It passed with Democratic support, and Republican opposition, making it an official proposal and open for comment before a final vote.”

Whether the CFTC / SEC need to intervene at all is subject to debate amongst the commissioners, split down party lines with three being Democrats and likely to support intervention.

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