Collateral management

Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation^[1].

In the modern banking industry collateral is mostly used in over the counter (OTC) trades. 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 is very complex process with interrelated functions involving multiple parties.^[2]

The basics of collateral

What is collateral and why is it used?

Borrowing funds often requires the designation of collateral on the part of the recipient of the loan.

Collateral is legally watertight, valuable liquid property^[3] that is pledged by the recipient as security on the value of the loan.

The main reason of taking collateral is credit risk reduction, especially during the time of the debt defaults, the currency crisis and the failure of major hedge funds. But there are many other motivations why parties take collateral from each other:

• Reduction of exposure in order to do more business with each other when credit limits are under pressure
• Possibility to achieve regulatory capital savings by transferring or pledging eligible assets
• Offer of keener pricing of credit risk
• Improved access to market liquidity by collateralisation of interbank derivatives exposures^[4]
• Access to more exotic businesses
• Possibility of doing risky exotic trades

These motivations are interlinked, but the overwhelming driver for use of collateral is the desire to protect against credit risk.^[5] Many banks do not trade with counterparties without collateral agreements. This is typically the case with hedge funds.

Types of collateral

There is a wide range of possible collaterals used to collateralise credit exposure with various degrees of risks. The following types of collaterals are used by parties involved:

• Cash
• Government securities (often direct obligations of G10 countries: Belgium, Canada, France, Germany, Great Britain, Italy, Japan, Netherlands, Sweden, Switzerland, the US)
• Mortgage-backed securities (MBSs)
• Corporate bonds/commercial papers
• Letters of credit/guarantees
• Equities^[6]
• Government agency securities
• Covered bonds
• Real estate
• Metals and commodities

The most predominant form of collateral is cash and government securities. According to ISDA, cash represents around 82% of collateral received and 83% of collateral delivered in 2009, which is broadly consistent with last year’s results. Government securities constitute fewer than 10% of collateral received and 14% of collateral delivered this year, again consistent with end-2008.^[7] The other types of collateral are used less frequently.

What Is Collateral Management?

The idea of collateral management

The practice of putting up collateral in exchange for a loan has long been a part of the lending process between businesses. With more institutions seeking credit, as well as the introduction of newer forms of technology, the scope of collateral management has grown. Increased risks in the field of finance have inspired greater responsibility on the part of borrowers, and it is the aim of the collateral management to make sure the risks are as low as possible for the parties involved.

Collateral management is the method of granting, verifying, and giving advice on collateral transactions in order to reduce credit risk in unsecured financial transactions. The fundamental idea of collateral management is very simple, that is cash or securities are passed from one counterparty to another as security for a credit exposure.^[8] In a swap transaction between parties A and B, party A makes a mark-to-market (MtM) profit whilst party B makes a corresponding MtM loss. Party B then presents some form of collateral to party A to mitigate the credit exposure that arises due to positive MtM. The form of collateral is agreed before initiation of the contract. Collateral agreements are often bilateral. Collateral has to be returned or posted in the opposite direction when exposure decreases. In the case of a positive MtM, an institution calls for collateral and in the case of a negative MtM they have to post collateral.^[9]

Collateral management has many different functions. One of these functions is credit enhancement, in which a borrower is able to receive more affordable borrowing rates. Aspects of portfolio risk, risk management, capital adequacy, regulatory compliance and operational risk and asset-liability management are also included in many collateral management situations. A balance sheet technique is another commonly utilized facet of collateral management, which is used to maximize bank's resources, ensure asset liability coverage rules are honoured, and seek out further capital from lending excess assets. Several sub-categories such as collateral arbitrage, collateral outsourcing, tri-party repurchase agreements, and credit risk assessment are just a few of the functions addressed in collateral management.^[10]

Parties involved

Collateral management is a complex process involving multiple parties:

• Collateral Management Team: their responsibilities are to calculate collateral on spreadsheets and dedicated software, to deliver and to receive collateral, to run the collateral operations, to maintain customer and securities data, to issue and to receive margin calls, and to liaise with customers, service providers, Legal, Middle Office, and other parties in the collateral chain.
• Credit Analysis / Approval Team: does researches, analyzes and sets collateral requirements for new and existing counterparties. Typically this entails a preliminary review as well as ongoing periodic reviews of the credit risk of each counterparty.
• Front Office Sales and Traders: develops new eligible trading relationships and manage the on-boarding process for new accounts, including signing of legal collateral documents, account formation, and ongoing sales transactions. Traders may execute trades only with approved counterparties.
• Middle Office: typically responsible for risk and valuation measures, the Middle Office interacts with the Collateral Management team on a daily basis.
• Legal Department: conducts negotiations, drafting and review of agreements; enforces collateral and margin agreements, including initiation of collections and lawsuits where appropriate. The department has to sign off on all written agreements.
• Valuation Team: this group focuses on valuing illiquid or exotic collateral and underlying trade position that must be collateralised.
• Accounting & Finance Team: works with the Middle Office to calculate and account for profit and loss on collateral posted and received.
• Third Party Service Providers: there are software providers, consultants, auditors, tax specialists, and Tri-Party collateral managers.^[11]

Establishment of collateral relationship

Once new customer is identified by Sales department, a basic credit analysis of that customer is conducted by the Credit Analysis team. Only credit-worthy customers will be allowed to trade on a non-collateralised basis. In the next step parties negotiate and come to the appropriate agreement. In the world's major trading centres, counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure clear and effective contracts exist before transactions begin. Important points in the collateral agreement to be covered are:

• Base currency
• Type of agreement
• Quantification of parameters such as independent amount, minimum transfer amount and rounding
• Appropriate collateral that may be posted by each counterparty
• Quantification of haircuts that act to discount the value of various forms of collateral with price volatility
• Timings regarding the delivery of collateral (margin call frequency, notification time, delivery periods)
• Interest rates payable for cash collateral^[12]

Then the collateral teams of each counterparty implement and automate the collateral relationship. Bank codes, SWIFT codes, custodian and transfer relationships, key contacts and phone numbers, report formats, margin call processes, etc. are all communicated and entered into the collateral systems of parties involved. If the two parties want to trade right away, they will typically post some initial reciprocal collateral with the other party (either cash or default-free Treasury bonds) to "open the account." This lays the groundwork for new trades, which will only require "topping up" the collateral to meet initial margin requirements. Once these items are in place, the Front Office Sales and Traders can begin negotiating trades. As a trade is agreed upon, the Collateral Team is notified of the deal, and the required Initial Margin is posted to enable the trade to occur.^[13]

Collateral management operations process

The responsibility of the Collateral Management department is to continually track, value, and give or receive collateral during the life of every trade in the institution's portfolio. This is a large and complex task requiring sophisticated systems and dedicated personnel. The general tasks on a day-to-day basis include:

• Managing Collateral Movements: to record details of the collateralised relationship in the collateral management system, to monitor customer exposure and collateral received or posted on the agreed market-to-market, to call for margin as required, to transfer collateral to its counterparty once a valid call has been made, to check collateral to be received for the eligibility, to reuse collateral in accordance with policy guidelines, to deal with disagreements and disputes over exposure calculations and collateral valuations, to reconcile portfolio of transactions.
• Custody, Clearing and Settlement (depending on how the legal relationship is structured): to segregate accounts strictly for collateral by customer, to manage collateral inflows and outflows, counterparty payments (top-ups, etc.), interest calculations, haircuts, dividends, coupon payments, etc.
• Valuations: to valuate all securities and cash positions held or posted as collateral. Traditionally, valuation has been done on an end of day (EOD) basis, but is now moving toward intraday and real time valuation where possible.
• Margin Calls: a margin call is issued if the mark-to-market change of a particular deal or net portfolio position has moved against the counterparty by at least the Minimum Amount. Margin calls are made via telephone, fax, email, or SWIFT message, stating the amount of collateral demand and often the type of collateral required. The counterparty is then required to top-up its collateral account by delivering cash or securities.
• Substitutions: to deal with requests for collateral substitutions both way. For example, one party would like to substitute one form of collateral for another. Collateral substitution allows for flexibility in the relationship, and the ability to deliver good collateral at a lower net price.
• Processing: to pay over coupons on securities promptly after receipt to collateral providers, to pay over interest on cash collateral and to monitor its receipt^[14][15]

Advantages and Disadvantages of Collateral

There are both advantages and disadvantages to collateralising business transactions:

Advantages of Collateral:

• Reduced credit risk: mitigation of current and potential future exposure to losses due to non-payment by counterparty.
• Capital savings: collateralising and netting counterparty exposures reduces the amount of economic capital required to cover credit risk and balance sheet protection (e.g. Basel II, Solvency II). This allows increased leverage and profit potential of a bank's assets.
• Increased competitiveness: the ability to trade in a wider variety of markets where the margins may be higher or profits more predictable.
• Improved market liquidity: increased opportunity to do more transactions in the markets, with less capital, and less time required for credit review and settlement.
• Access to higher risk trades: collateralisation reduces the risk of illiquid or new trade types that have higher risk but higher profit margins.
• More efficient trading between counterparties: collateralisation formalises an ongoing relationship and makes transactions and payments smoother, with more opportunity to check valuations and balance the gains and losses in a standard, repeatable manner.
• Benefits to Buy Side (asset managers, corporate treasury, etc.): minimize collateral amounts by cross-collateralisation, minimize collateral movements and give/take collateral on a net basis, collateralise exposures by client
• Benefits to Sell Side (broker dealers, banks, etc.): reduces capital charge to allocate for asset liability management, etc.

Disadvantages of Collateral:

• Increases Operational Risk: Collateralisation is complicated. Failure to invest in the correct technologies, staff, third-party relationships, and operate collateral processes accurately and efficiently creates additional operational risk and a false sense of security.
• Legal Risks: Structuring, documenting, and managing the collateral agreements require specialised legal skills, technologies, legal procedures (proper documentation, storage, confidentiality) and trained staff. The following risks can also occur:

- Perfection risk: the possible risk of inability to "perfect a claim" to collateral (assert proper legal ownership) when default is imminent or default occurs.

- Re-characterisation risk: the possibility that the collateral might be re-characterised as non-eligible under the jurisdiction's laws and "clawed back" in bankruptcy proceedings.

- Priority risk: the risk that some other counterparty has a prior claim on the collateral you hold, making the collateral ineligible.

- Enforcement risk: risk that the counterparty won't give back your collateral, and the jurisdiction does not honour the collateral agreements due to lax enforcement of contract laws, political pressures, or other reasons.

• Concentration Risk: the overreliance on a single counterparty once a collateral relationship is established. This increases default correlation and leads to underestimation of single large risks such as the counterparty going suddenly bankrupt.
• Settlement Risk: The possible failure of securities settlement procedures, including payments, custody, etc.
• Pricing risk and model risk: Even though a transaction may be collateralised, deals that are complex or securities which are thinly traded rely heavily on pricing models for their valuation and resulting collateral required. Any errors or rapid market shocks during the valuation process can lead to under-collateralisation (or over-collateralisation) and subsequent losses or inefficient use of capital.
• Increasing Market Risk: Market risk on securities held as collateral can contribute to the firm's Value-at-Risk by increasing correlations in the firm-wide portfolio under market stress. High correlations lead to increased market risk through the belief that you are adequately collateralised, but everything goes down in value at once, resulting in rapid under-collateralisation. To account for this, the firm has to include collateral securities and cash in portfolio-wide market risk and pricing calculations.
• Expensive: The solution is often to outsource to tri-party collateral service.
• Reduction of trading activity: Collateralising transactions can actually reduce trading activity by eliminating more risky counterparties. This occurs when there are:

- Overly high thresholds

- Delays in posting / receiving collateral

- Collateral Operations are highly manual and slower than the traders

- Trade eligibility is lowered based on low availability of a narrow and expensive range of acceptable collateral^[16]

References

1. ^ Jon Gregory. Counterparty credit risk. ISBN 978-0-470-68576-1.p.59.
2. ^ Collateral Management article on Financial-edu.com
3. ^ Paul C. Harding, Christian A. Johnson (2002). Mastering collateral management and documentation. ISBN-13: 978-0-273-65924-2. p. 3.
4. ^ Paul C. Harding, Christian A. Johnson (2002). Mastering collateral management and documentation. ISBN-13: 978-0-273-65924-2. p. 4.
5. ^ ISDA-Margin-Survey-2001
6. ^ Paul C. Harding, Christian A. Johnson (2002). Mastering collateral management and documentation. ISBN-13: 978-0-273-65924-2. p. 5.
7. ^ ISDA-Margin-Survey-2010
8. ^ www.wisegeek.com
9. ^ Jon Gregory. Counterparty credit risk. ISBN 978-0-470-68576-1. p. 61.
10. ^ www.wisegeek.com
11. ^ Collateral Management article on Financial-edu.com
12. ^ Jon Gregory. Counterparty credit risk. ISBN 978-0-470-68576-1. p. 62.
13. ^ Collateral Management article on Financial-edu.com
14. ^ Paul C. Harding, Christian A. Johnson (2002). Mastering collateral management and documentation. ISBN-13: 978-0-273-65924-2. p. 4.
15. ^ Collateral Management article on Financial-edu.com
16. ^ Collateral Management article on Financial-edu.com

See also

• Margin (finance)
• Repurchase agreement
• OTC derivatives
• Collateral Management