Long box
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Brokerage Anatomy™
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In a triparty system, a participant’s “long box” is the house account into which the participant dumps all its securities available for financing each day. This is a vital, but dull, and therefore much overlooked, part of the plumbing of the modern financial system.
Because it is both dull and important, we should pay attention to it, because if we don’t understand it it can unexpectedly go wrong, and if it goes wrong we are all screwed.
Dull but important things that unexpectedly went wrong because no one was paying attention to them: LIBOR. Credit ratings for structured products. Delta-one ETFs.
Anyway.
Much of what a broker/dealer does is to manage positions for its customers. It might do this through its prime brokerage business — either by margin lending to its customers and holding the securities as collateral — or by giving synthetic exposure to those instruments and holding the instruments as a hedge.
In either case, this is capital-intensive: the customer does not put money down, so the broker must finance these hedges and collateral positions itself.
Can we call “hedges and collateral securities” just “collateral”, by the way? It will make life easier.
Now a broker/dealer can either raise the funds it needs to purchase its collateral the “traditional” way — with the banks borrowed funds, in the shape of capital reserves and customer deposits, which, for a prime broker, means borrowing from the bank’s central treasury department — or it can take the collateral it holds against its customer positions and raise funds somehow against them. That tends to be much more efficient: the treasury department is protective of its balance sheet and funding, and charges like a wounded bull — but financing a massive pool of fluctuating securities is operationally intense. You have lots of customers, and they are actively trading in and out of positions every day.
Even if the general shape of your net collateral position is somewhat predictable, it will change at the margins, and if a customer wants a stock back now, it must have it.
On the other hand, there are a lot of players in the market all wanting to optimise their positions. Some — brokers — have illiquid assets they want to finance, and others — asset managers and wealth managers have customer cash and assets they want to put to work.
These two constituencies match each other quite nicely: a prime broker has a grab-bag of assorted stocks and bonds which are relatively liquid and easily valued, and it wants high-quality liquid assets (cash, government bonds) that it can repatriate to its treasury team and reduce its internal borrowing costs. Asset managers have cash and high-quality assets they are sitting on, which they are prepared to lend out for an additional fee, as long as they are adequately collateralised.
It is fiddly at the edges, but if someone can be bothered building a system designed to manage that peripheral complexity, this is a valuable facility for all comers.
The triparty agents who have been bothered building such a system in Europe are: the Bank of New York Mellon (primarily stock loan) and Euroclear and Clearstream (primarily repo). JPMorgan Chase has a big operation in the US.
How it works is that participants dump all their available collateral securities into the system. Each sits in a proprietary “long box”: basically, a holding pen inside the triparty system held beneficially for the participant. Each party also has a separate collateral account, in which it can hold collateral assets for loans it has made.
The parties then trade repo and stock loan transactions bilaterally. Only the collateral legs are handled inside the triparty system: the principal leg is delivered directly between the parties.
So, for example, a prime broker will borrow cash or securities from an agent lender outside the system, but report this transaction to the triparty agent, who will debit collateral assets from the PB’s long box and credit them to the agent lender’s collateral account inside the system.
The PB’s operations team will be continually calling collateral back from and depositing fresh collateral into its long box; the triparty’s automated system will manage necessary substitutions and replacements of eligible collateral from that system.