Collateral ManagementWhat is Collateral Management?
At a high level, collateral management is the function responsible for reducing credit risk in unsecured financial transactions. Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party (or parties) in a trade. In our modern banking industry collateral is used most prevalently as bilateral insurance in over the counter (OTC) financial transactions. However, collateral management has evolved rapidly in the last 15-20 years with increasing use of new technologies, competitive pressures in the institutional finance industry, and heightened counterparty risk from the wide use of derivatives, securitization of asset pools, and leverage. As a result, collateral management now encompasses multiple complex and interrelated functions, including repos, tri-party / multilateral collateral, collateral outsourcing, collateral arbitrage, collateral tax treatment, cross-border collateralization, credit risk, counterparty credit limits, and enhanced legal protections using ISDA collateral agreements.
Credit risk exists in any transaction which is not executed on a strictly cash basis. An example of credit-risk free transaction would be the outright purchase of a stock or bond on an exchange with a clearing house. Examples of transactions involving credit risk include over the counter (OTC) derivative deals (swaps, swaptions, credit default swaps, CDOs) and business-to-business loans (repos, total return swaps, money market transactions, term loans, notes, etc.). Collateral of some sort is usually required by the counterparties in these transactions because it mitigates the risk of payment default. Collateral can be in the form of cash, securities (typically high grade government bonds or notes, stocks, and increasingly other forms such as MBS or ABS pools, leases, real estate, art, etc.)
Collateral is typically required to wholly or partially secure derivative transactions between institutional counterparties such as banks, broker-dealers, hedge funds, and lenders. Although collateral is also used in consumer and small business lending (for example home loans, car loans, etc.), the focus of this article is on collaterization of OTC derivative transactions.
Collaterization is the act of securing a transaction with collateral. It has multiple uses which fall under the umbrella of collateral management: - A credit enhancement technique allowing a net borrower to receive better borrowing rates or haircuts.
- A credit risk mitigation tool for private/OTC transactions -- offsets risk that counterparty will default on deal obligations (in whole or part).
- Applied to secure individual deals or entire portfolios on a net basis.
- A trade facilitation tool which enable parties to trade with one another when they would otherwise be prohibited from doing so due to credit risk limits or regulations (for example European pension fund regulations or Islamic banking law).
- A component of firm wide portfolio risk and risk management including market risk (VaR, stress testing), capital adequacy, regulatory compliance and operational risk (Basel II, MiFid, Solvency II, FAS 133, FAS 157, IAS 39, etc.), and asset-liability management (ALM).
- A money market investment (lending for short periods to earn interest on available cash or securities).
- A balance sheet management technique used to optimize bank capital, meet asset-liability coverage rules, or earn extra income from lending excess assets to other institutions in need of additional assets.
- An arbitrage opportunity through the use of tri-party collateral transactions.
- An outsourced tri-party collateral / tri-party repo service for major broker-dealers to offer to their clients.
Collateral Management Glossary of Key Terms
The following key terms will be useful as you read through this Guide.
- Add-On: An additional currency amount added on to the mark to market value of an underlying trade or security to offset the risk of non-payment. This represents the credit spread above the default-free rate which one counterparty charges the other based on its internal calculations (often negotiated beforehand and memorialized in a CSA).
- Call amount: the currency amount of collateral being requested by the Taker.
- Credit Support Annex (CSA): a legal agreement which sets forth the terms and conditions of the credit arrangements between the counterparties. The trades are normally executed under an ISDA Master Agreement then the credit terms are formalized separately in a CSA (SEE ALSO Collateral Support Document).
- Collateral Support Document (CSD): a legal agreement which sets forth the terms and conditions that collaterization will occur under in a bi-lateral or tri-lateral / multilateral relationship.
- Give: to transfer collateral to a counterparty to meet a collateral or margin demand. The counterparty with negative mark-to-market (a loss) is usually the collateral Giver. (SEE ALSO Pledge).
- Haircut (SEE Valuation Percentage).
- Independent Amount: An additional amount which is paid above the mark-to-market value of the trade or portfolio. The Independent Amount is required to offset the potential future exposure or credit risk between margin call calculation periods. If daily calculations are used, the Independent Amount offsets the overnight credit risk. If weekly calculations are done, the Independent Amount will usually be higher to offset a large amount of potential mark-to-market movement that can occur in a week versus a day. Many counterparties set the Independent Amount at zero then substitute the Minimum Transfer Amount (MTA) as the Independent Amount on a counterparty-by-counterparty basis.
- Margin: Initial margin is the amount of collateral (in currency value) that must be posted up front to enter into a deal on day 1. Variation margin (a.k.a. maintenance margin) is the amount of collateral that must be posted by either party to offset changes in the value of the underlying deal. Initial margin is generally, but not always, higher than variation margin.
- Margin Call: A request typically made by the party with a net positive gain to the party with a net negative gain to post additional collateral to offset credit risk due to changes in deal value.
- Mark to Market (MTM): Currency valuation of a trade, security, or portfolio based on available comparative trade prices in the open market within a stated time frame. MTM does not take into account any price slippage or liquidity effect that might occur from exiting the deal in the open market, but uses the same or similar transaction prices as indicators of value.
- Mark to Model: Currency valuation of a trade or security based on the output of a theoretical pricing model (e.g. Black Scholes).
- Minimum Transfer Amount (MTA): The smallest amount of currency value that is allowable for transfer as collateral. This is a lower threshold beneath which the transfer is more costly
than the benefits provided by collaterization. For large banks, the MTA is usually in the USD 100,000 range, but can be lower.
- Netting: the process of aggregating all open trades with a counterparty together to reach a net mark-to-market portfolio value and exposure estimate. Netting facilitates operational efficiency and
reduced capital requirements by taking advantage of reduced risk exposures due to correlation effects of portfolio diversification versus valuing all trades independently. However, netting relies upon efficient and accurate pricing at a portfolio level to be effective.
- Pledge: to give collateral to your counterparty. (SEE ALSO Give).
- Potential Future Exposure (PFE): The estimated likelihood of loss due to nonpayment or other risk, in this case the likelihood of default on a counterparty's obligations.
- Rehypothecation: the secondary trading of collateral. Rehypothecation is the cornerstone of tri-party collateral management.
- Substitution: replacing one form of collateral (e.g. corporate bond) with another form of collateral (e.g. Treasury bond) during the life of a particular deal or trading relationship.
- Take: to receive collateral from a counterparty to meet a collateral or margin demand. The counterparty with positive mark-to-market (a gain) is usually the collateral Taker.
- Threshold Amount: the amount of unsecured credit risk that two counterparties are willing to accept before a collateral demand will be made. The counterparties typically agree to a Threshold Amount prior to dealing, but this is a source of ongoing friction between OTC counterparties and their brokers.
- Top-up: To give additional collateral to your counterparty to meet a margin call.
- Valuation Percentage: a percentage applied to the mark-to-market value of collateral which reduces its value for collaterization purposes. Also known as a "haircut", the Valuation Percentage protects the collateral Taker from drops in the collateral's MTM value between margin call periods. For example, if the MTM value of the collateral is $100 and the Valuation Percentage = 98.5% then 1.5% is being charged to offset period-to-period valuation risk and
the collateral amount counted is only $98.50. The Valuation Percentage offered by different counterparties and brokers may vary in the market, so buy side participants often "haircut shop" for the best rate.
How Collateral Transfers RiskIn OTC trading, counterparties are exposed to the risk that the other counterparty will not make required payments when
they are due. The risk of non-payment is called credit risk. These types of payments include derivative deal payments (e.g. interest rate swap payments, CDS premiums or default payments), dividend payments for stocks, coupon payments for bonds, etc. The amount of credit risk varies in real time and must be managed on a trade, counterparty, and net portfolio basis.
The primary purpose for collateralization is to transfer risk from the party in the net positive (gain) position to the party in the net negative (loss) position during the life of a deal. This is done by requiring the losing party to post or transfer an asset (cash, marketable securities) to the winning party as a form of ongoing security. In the event of a default, the creditor party then has the right to keep the asset to reduce his loss. The currency value of the collateral represents the estimated probability of payment default, mulitplied by the notional value of the expected payment(s). This is known as Potential Future Exposure or PFE.
Two simple examples demonstrate this dynamic:
Securities Collateral Example:
1) Net Exposure (single or multiple deals) = $100
2) Collateral posted previously = ($80)
3) Net collateral delivery requirement = $20 = CREDIT RISK
4) Collateral given = $20
5) Net exposure = $0 = NO CREDIT RISK REMAINS
Cash Collateral Example:
1) Net Exposure (single or multiple deals) = $100
2) Cash Collateral Posted = ($80)
3) Overnight interest earned on Cash ($0.10)
4) Net Collateral delivery requirement = $19.90 = CREDIT RISK
5) Collateral given = $15
6) Net exposure = $4.90 = REMAINING CREDIT RISK
There is an important difference between over the counter (OTC) deals and exchange-traded deals. OTC transactions do not normally have a clearing house acting in a credit risk mitigation role between the counterparties which guarantees and processes deal payments. An exchange clearing house insures that buyers and sellers on the exchange will make and receive their payments by requiring traders to post daily margin in the form of cash or marketable securities. Since this form of insurance is not available to OTC counterparties, they need another form of insurance. Collateral acts as partial insurance to offset changes in market value.
Credit risk can shift back and forth from one counterparty to the other on a constant basis. Mark-to-market values on open positions change daily, weekly and monthly. The counterparty with a net positive gain is exposed to unsecured credit risk in the amount of open uncollaterized gain. This credit risk can continue to increase until the party has a large unsecured gain. By demanding additional collateral, this profit is "locked in" or insured up to the market value of the collateral posted, less the transaction costs associated with liquidating the collateral. In the event of a missed or delayed payment the Taker of collateral can keep the collateral posted and sell it in the open market to offset the lost income.
Margin agreements typically provide a grace period for the counterparties to negotiate differences in valuation, adjust collateral amounts, substitute one collateral form for another, etc. This provides some flexibility in the relationship and keeps things running smoothly in the event that a particular type of collateral (e.g. U.S. Treasury Bonds) are not easily available at a reasonable price at the time of the margin call, or there is a disagreement on what the underlying deal value might be (this is common on illiquid OTC structured deals).
Credit Risk vs. Collateral Requirements
Credit departments of banks, broker-dealers, lenders, and buy side institutions rely on a variety of techniques to assess credit risk of their counterparties. These include:
- External credit ratings
- Internal credit ratings
- Payment histories
- Statistical default probabilities per counterparty, industry, or market
- CDS spreads (if the counterparty is an issuer with CDS written on its bonds)
- Equity prices (the counterparty's equity price is considered an accurate forward-looking gauge of financial health)
Collateral requirements can increase or decrease depending on the factors above. In addition, two additional factors can influence the amount of collateral required:
- Length of the deal: overnight repos have lower collateral requirements than 30 year swaps as there is far less time in which to default.
- Quality of collateral: more collateral is required if the securities posted are rated less than AAA, or have volatile prices (e.g. credit default swaps)
Deal Risk Still Remains
Even if a deal is properly collaterized, there still remain legal, operational, and other risks. In particular, bankruptcy of a counterparty can pose extreme challenges in liquidating and collecting the cash value of the collateral posted. In bankruptcy, it is possible that the collateral can be "clawed back" by the bankruptcy court if it is found that another counterparty had a prior claim to the collateral posted by the defaulting party. This situation can be complicated further in cross-border deals (domestic or international) by differences in jurisdiction and legal systems.
It is critical that the Collateral Support Document between the counterparties address these issues and provide for adequate assurance that the collateral posted will be capable of transfer and liquidation on failure to pay, and will not be encumbered by prior pledges or debts. It is also critical that the jurisdiction in which the transaction was completed fully enforces the collateral agreements and does not invalidate them.