Collateral Management

What is Collateral Management?

Creditors often require collateral, which refers to securities, cash, or other assets that are offered by a borrower to hedge the credit risk of a transaction such as a commercial loan or mortgage. Should the borrower default, the creditor can take possession of the assets provided as collateral to cover the obligation. Collateral management is the process by which the two counterparties (creditor and debtor) exchange assets provided as collateral.

The underlying idea is simple: counterparties, which may be banks, insurance companies, broker-dealers, pension funds, hedge funds, large corporations, or asset managers, exchange assets as security for taking on credit exposure. Collateral mitigates credit risk, and cash or government bonds are the types of collateral most favored by creditors.

• The haircut, or the percentage of an asset’s market value that can be used as collateral, is influenced by various factors including interest rates, liquidity, and creditworthiness.

Collateral Management – Key Terms

Stated below are the key terms, which will enable you to better comprehend the concept of collateral management.

Credit Support Annex (CSA): a legal agreement that regulates the terms and conditions of the credit arrangements between the counterparties, including the terms for collateral to mitigate counterparty credit risk.

Over-the-Counter: an off-exchange system of trading, in which trades are made directly between two counterparties and executed outside of formal exchanges. In the OTC market, derivatives are traded through private negotiation between the two counterparties rather than through an established exchange or an intermediary.

Base Currency: the currency to be used in all collateral transactions between the counterparties. It is defined as part of the CSA.

Initial Margin: collateral posted to reduce future exposure to a counterparty’s credit risk. In brokerage, for example, the initial margin is the percentage of a margin transaction that must be paid in cash. FINRA’s Regulation T establishes this percentage. In the derivatives market, it’s a type of collateral paid to one counterparty in case of default by the other party.

Variation Margin: paid daily as securities are marked to market to compensate for any adverse change in market value.

Margin Call: a demand for additional cash or securities when a margin account falls below the required value. The additional margin compensates for increased credit exposure caused by a decline in collateral value.

Mark to Market: the process of valuing an asset at its most recent market price in order to provide an accurate appraisal of assets at the current market value.

Independent Amount: the amount of collateral required over and above the mark to market value of an asset.

Threshold Amount: the amount of exposure that the provider of collateral is not required to secure.

Minimum Transfer Amount: the minimum amount that can be transferred for any margin call.

Haircut: the percentage of an asset’s market value that can be used as collateral, and is influenced by various factors including interest rates, liquidity, and creditworthiness.

Collateral Management – Key Departments

From the initiation of collateral agreements to setting up CSAs in the collateral management system, departments including the front office and sales desk, negotiator, credit officer, and operations team are involved.

Front office and sales desk: liaises with the client’s sales team once the counterparty has decided to collateralize trades. The front office reviews trades that involve collateral and ensure that high risk options and swap deals are appropriately collateralized.

Negotiator: establishes the parameters relating to collateral and prepares the agreements that govern the exchange of collateral.

Credit officer: these officers are involved in the drafting and implementation of the CSA. They are also involved in the collateral management process. Clients must provide the collateral agreed upon in a timely fashion, and if there is any delay the operations team will inform the credit officer, who will ensure that the required collateral is provided.

Operations team: creates a new CSA or amends an existing agreement. The operations team receives the final draft of the CSA from the negotiator and is responsible for review and approval.  The ops team must validate all terms and conditions pertaining to the collateral. Once this team has signed off, the negotiator works with the counterparties to get the agreement signed.

Importance of Collateral Management

Following the global financial crisis of 2007-2009, the importance of collateral management has grown. The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions’ (IOSCO) Margin Requirements for non-centrally cleared derivatives cover collateral requirements and serve as regulatory mandates worldwide.

Collateral management has become increasingly important for corporates due to three main reasons:

Concerns over increasing counterparty risk have made collateralization a much more common requirement.

More and more borrowers are seeking to reduce the cost of funding by providing collateral, which lowers the risk exposure for the lender.

Collateralizing trades helps firms access markets or counterparties that otherwise would not be accessible. In some cases, the introduction of collateral allows counterparties to execute transactions in markets or instruments that are illiquid, which otherwise would have not been possible.

Haircuts

Below is an example in which an asset is worth US$ 2 million at the market price and is to be used as collateral for a loan. For the purpose of calculating the collateral level, margin or capital requirement, only a specified percentage of an asset’s value can be used as collateral.  By accepting only a portion of the asset’s value for use as collateral, the creditor is afforded a measure of risk protection against any drop in the market value of the asset.

When a 30% haircut is applied to the $2M market value, this implies that 70% of the asset value can be collateralized. A US$ 2 million asset is sufficient to collateralize a loan for US$ 1.4 million.

The percentage of haircut that is applied to the market value of the asset is influenced by various factors. Some of these include interest rates, liquidity, and the borrower’s creditworthiness.

Conclusion

Collateral management has become increasingly important as lenders seek to mitigate credit risk.  For sound collateral management, organizations need to adopt the right technology solutions (that address operational risk, while comprehensively managing and monitoring exposures to prudently manage collateral and liquidity), have a knowledgeable workforce, conclude legally robust agreements before collateral can be pledged or received, and have reliable management processes that are highly automated and reduce the need for manual intervention.

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