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24. What is tri-party repo?
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Tri-party repo is a transaction for which post-trade processing --- collateral selection, payments and deliveries, custody of collateral securities, collateral management and other operations during the life of the transaction --- is outsourced by the parties to a third-party agent. A tri-party agent can be a custodian bank, an international central securities depository (ICSD) or a national central securities depository (CSD). In Europe, the principal tri-party agents are Clearstream Bank Luxembourg, Euroclear Bank, Bank of New York Mellon, JP Morgan and SIS. In the US, there is now only one: Bank of New York Mellon (JP Morgan largely gave up its tri-party role in 2018).

Because a tri-party agent is just an agent, use of a tri-party service does not change the risk relationship between the parties. If one of the parties defaults, the impact falls entirely on the other party. This means that parties to tri-party repo need to continue to sign bilateral legal agreements such as the ICMA’s Global Master Repurchase Agreement (GMRA).

Nor does the tri-party agent provide a trading venue where the parties can negotiate and execute transactions (although some tri-party agents are linked to trading platforms). Instead, once a transaction has been agreed directly between the parties --- usually by telephone or electronic messaging --- both parties independently notify the tri-party agent, who matches the instructions and, if successful, processes the transaction. The agent will typically automatically select, from the securities account of the seller, sufficient collateral that satisfies pre-agreed credit and liquidity criteria, concentration limits and any transaction preferences agreed between the buyer and the seller. The selected collateral will be delivered against simultaneous payment of cash from the account of the buyer (delivery-versus-payment or DVP), subject to the deduction from the collateral of pre-agreed initial margins. Subsequently, the tri-party agent manages the regular revaluation of the collateral, variation margining, income payments on the collateral, as well as (in the case of most European tri-party agents) substitution of any collateral which ceases to conform to the quality criteria of the buyer, substitution to prevent an income payment triggering a tax event, substitution to retrieve a security being used as collateral which is then sold by the seller to another party and substitution at the request of the seller. Tri-party agents also conduct optimisation of collateral, which means the ongoing reassessment of whether there is a better combination of securities that can be posted as collateral given changes in the seller’s holdings since the start of a tri-party repo and execution of the substitutions necessary to achieve the better combination (eg subsequent to the start of the tri-party repo, the seller may have bought new securities which have lower ratings than those posted as collateral but are still acceptable to the buyer, so these can be substituted for those initially posted).

Because collateral is typically selected automatically by the tri-party agent, tri-party repo cannot be used for borrowing and lending specific securities. It is a pure GC funding facility. This is reflected in the large average deal size of tri-party repo and collateralization by multiple securities.

Moreover, because tri-party collateral operations are automated and benefit from the agent's economies of scale, and because settlement is across the books of the agent, the post-trade costs of tri-party repo are less than those managed in-house and settled across a securities settlement system (which charges a settlement fee for each issue of securities transferred). This makes it economic to collateralise a tri-party repo with multiple securities. Tri-party agents also have the capability to efficiently manage baskets of collateral denominated in several currencies. The ability to collateralise with multiple securities facilitates larger deal sizes.

On the other hand, the lower post-trade overheads of tri-party repo also makes it economic to use non-government securities as collateral. These less liquid securities trade in smaller amounts than government securities, which can make bilateral transfers across securities settlement systems prohibitively expensive. Consequently, repos of equity, corporate bonds, MBS, ABS and other structured securities are concentrated in tri-party repo.

Tri-party is the preferred repo market segment for many customers (non-intermediaries) given that the delegation of collateral management to a tri-party agent allows these firms to avoid the cost of setting up and running their own collateral management operation. This includes central banks, some of whom allow the use of tri-party agents by the counterparties in their monetary policy operations and others who use tri-party services when conducting investment operations.

There are important differences between European and US tri-party markets.
  • Tri-party agents dominate the settlement of US repo, accounting for something in the order of two-thirds of the outstanding volume of the US market, compared to about 10% in the European market.
  • European tri-party repo is normally used to manage non-government bonds and equity (although the proportion of government bonds has more than doubled since the Great Financial Crisis), whereas US tri-party is focused on Treasury and Agency debt (over two-thirds of that market).
  • In most European tri-party systems, there has always been true term repo, whereas term repos in US tri-party systems were traditionally unwound each morning and re-arranged in the afternoon. This was intended to give sellers (who are usually broker-dealers) the daily opportunity to withdraw and replace collateral securities and adjust for price fluctuations (instead of operationally more intensive direct substitution and variation margining with the other party), but this procedure required the tri-party agents to finance the sellers for most of the day, creating a systemic intra-day credit exposure. In Europe, the need to unwind tri-party repos daily has been avoided by the use of direct substitution and variation margining. Concern about the systemic risk posed by the huge intra-day credit exposures taken by the US tri-party agents (Bank of New York Mellon and, until 2018, JP Morgan) have prompted reforms to the US tri-party market which are bringing it closer to the European tri-party model.
  • The US tri-party market is dominated by two types of investor, money market mutual funds and securities lending agents reinvesting cash collateral, who together account for almost two-thirds of that tri-party market. These investors are required or prefer to reinvest a substantial proportion of their cash in repo and they tend to use tri-party repo because of the operational convenience. The problem is that cash collateral taken in the securities lending market is an open-ended liability (as the securities loans can typically be recalled at any time) but most tri-party repos are collateralised by medium or long-term securities. If there were to be a default on a repo, investors would have to take the securities onto their balance sheets. Given that they cannot or may not wish to hold such longer-term collateral securities, they would be obliged or might feel impelled to immediately sell. If the default was by a large borrower, sufficient collateral might be sold to trigger a fire sale, that is, a self-reinforcing cycle of disposal and price collapse. The European tri-party repo market does not suffer from such a concentration of the investor base.

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