Tripartite Agreements (TPAs)
Financing the initial margin for hedges, and coming up with cash to pay margin calls can cause difficulties for commodity companies. Even when credit lines for IM and VM are offered by brokers to commodity companies, they are usually limited in order to keep the broker’s risk low in the event of default. However, there is a solution that is available to commodity firms that helps eliminate the worry over funding initial and variation margins, I am talking about tripartite agreements, also known as TPAs. A tripartite agreement when it comes to hedging is an agreement between a bank, a broker, and the commodity company that allows for seamless execution and management of hedge positions.
The agreement works as follows:
The broker will set up a separate hedging account where the bank has a control agreement over the cash flow of that trading account.
The commodity company transacts as normal with their suppliers. When they purchase metal that the bank is financing, they will hedge with the broker.
After approval from the bank, that hedge will be placed into the separate hedging account under the control of the financing bank.
The bank will finance the payment of the physical metal.
Any margin payments related to the futures trades in the segregated account are paid directly by the financing bank. Because of this, the broker is now taking credit risk on the bank, not on the commodity company and they will be willing to extend much higher position limits to the bank than they otherwise would have to the commodity company.
Should the commodity company face default, the financing bank will have the collateral of the metal they financed, but they will also own the corresponding futures hedge.
The advantages of TPAs are clear: The broker’s risk is drastically reduced as banks are (typically) far more secure than commodity companies. The commodity company has access to a much higher credit facility with the broker and also no longer needs to worry about cash financing margin on their futures trades. And the bank now has the additional protection of a futures short position in the event of a default of the commodity company.
I have honestly been surprised that banks are willing to finance metal without having a TPA in place. Banks will typically only finance a certain percentage of the value of a transaction, usually in the range of 85-95%, known as an advance rate. The 5-15% difference between the advance rate and 100% is known as a haircut. Despite not financing 100% of the value of the commodity, banks can still face serious exposure to prices in the case of default.
Let’s say a bank finances a refined copper parcel that was priced at $10,000/mt, and the haircut on the borrowing facility is 10%. This means that the bank will finance $9,000/mt of that purchase and the commodity company is left to finance the remaining $1,000/mt of the purchase in cash. If the commodity company faced bankruptcy, the bank would have rights to the physical copper they had financed. However, if the copper price decreases below the price at which the bank financed (in this case $9,000/mt), the bank would face an outright loss on this position. When they sold it to other market participants, they would simply have to take the current price for copper at the time of the sale. Given the volatility that we see in base metals, it is perfectly conceivable that in the time between a bank financing material, and being forced to sell it themselves in the event of a default, prices could drop far below the level of the protection a haircut offers.
Under a TPA however, in the event of a default the bank would have rights to not only the physical metal but also the futures hedge in the broker’s segregated account. In the above example, the bank would own metal that they had financed at $9,000/mt and they would also hold a futures short position at $10,000/mt. If this copper was exchange deliverable, they could simply use the short position at $10,000/mt as a physical sale and deliver in warrants to the exchange. Or they could find a willing market participant to sell the physical copper to and buy futures to hedge the physical sale, squaring out their futures short. Either way, the bank is fully protected against a drop in price of the commodity when operating under a TPA.
