Should firms consider outsourcing collateral management in repo?

Key Takeaways

• Incoming US Treasury clearing rules are complex and potentially costly.
• Outsourcing collateral management can help repo market participants.
• Third-party providers should explore adding this service now.

Participants in the US Treasuries (UST) market, the largest and most liquid government securities market in the world, face one of the most significant changes in decades for which some may be sorely underprepared.

Finadium research finds that mandatory UST repo clearing rules announced by the Securities and Exchange Commission (SEC) in December, are set to put significant pressure on buy-side firms, particularly those with limited budgets or organizations – in geographies where hiring is difficult.

It predicts a difficult ride ahead, noting that “there is no way that enough capacity can be built between now and mid-2026 to enable each firm to manage margin calls for repo clearing”.

Consequently, firms already facing technological complexities and internal resource constraints are more likely than ever to consider outsourcing collateral management to a third party.

New clearing rules are necessary but costly

The new rules, which are currently planned to come into force in 2025 for cash and 2026 for repos, aim to bolster the market’s resilience through improved default management processes, smaller settlement flows, and reduced settlement fails.

These are laudable goals since, currently, only around 20% of the USD 4.5 trillion daily repo transactions are centrally cleared, presenting participants with what DTCC calls “leverage risks, particularly in bilateral trades where there is no margin collected”.

The SEC notes a lack of consistent and transparent margining practices in bilateral trades, which it believes places the Fixed Income Counterparty Clearing (FICC) at risk of contagion should there be a collapse in the peripheral markets.

The new mandate aims to increase the amount of central clearing in these markets thereby protecting FICC. The move seems sensible, particularly since the Congressional Budget Office forecasts the Treasury markets will almost double in size over the next 10 years.

As DTCC’s head of governance relations for Europe, Michalis Sotiropoulos, says: “Central counterparties make the system safer, more resilient, and allow trading for a longer time before official intervention is needed.”

However, Sotiropoulos concedes that the cost of this added resiliency is the margin premium paid even during normal circumstances.

“As the rule targets high volume, low margin transactions, these trades will be more expensive in interdealer markets. Additionally, there will be changes to legal documentations and to the GSD [Government Service Division] Rules,” he says.

Meanwhile BNY Mellon says implementation of the new rules “will be costly and difficult”, and calls on firms “to begin preparing now”.

Outsourcing collateral management can help

Outsourcing to third-party experts has its risks (from costs to potential service disruption at the service provider) but can help firms prepare, especially those smaller organizations that struggle to participate in central clearing.

Finadium says collateral obligation management outsourcing performs like an “extension of the client,” sitting between a firm’s internal trading and operations, and triparty services and central counterparties.

At its most basic, the service ensures margin movements, while a more complex iteration could be running collateral optimization models and using technology to conduct inventory management for regulatory and internal reporting.

Outsourcing, though it can be expensive, could prove a cost-effective solution for firms unable to hire a full-time resource, by bundling multiple client requirements and sharing the cost among one focused team. This, Finadium notes, is no different from any outsourced service, including cloud computing, across multiple industries.

Importantly, working with expert third parties can help funds and other buy-side firms on either side of the repo form relationships with FICC members that are willing to clear transactions. Establishing these relationships requires the negotiation and execution of additional agreements, which may be beyond the scope of some market participants.

Competing for clearing capacity

In addition to increasing margins, law firm Debevoise & Plimpton points out that clearing capacity may also become “a scarce resource” for which market participants may need to compete while new capacity providers and alternatives to clearing may emerge.

Consequently, market participants who are accustomed to bilaterally negotiating terms “will need to scope their current trading relationships against the Final Rules, assess the economic and operational impacts on their institutions and potentially restrategize their trading as the alternatives become clear,” the legal experts say.

Collateral management outsourcing providers can help market participants monitor developments and prepare as these events develop. They may be able to support in communicating with FICC, the SEC, and primary regulators like the CFTC on key business and regulatory matters as FICC prepares new rule filings to map out its path forward publicly.

Get ready!

Debevoise & Plimpton also advises market participants to assess readiness for mandatory clearing and potentially develop clearing or alternative relationships well before 31 March  2025, which marks the end of the first implementation phase.

Central clearing for UST is a legitimate move from regulators to secure market function, and while it brings challenges for some market participants, there are clear prospects for third-party providers to expand their propositions.

More broadly, firms dealing in repo must look at their internal infrastructure and processes to ensure they have the technology in place that helps them efficiently manage their collateral management needs with access to critical information in real time.