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]

Contents

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:

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:

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:

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:

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:

Advantages and Disadvantages of Collateral

There are both advantages and disadvantages to collateralising business transactions:

Advantages of Collateral:

Disadvantages of Collateral:

- 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.
- 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 978-0-273-65924-2. p. 3.
  4. ^ Paul C. Harding, Christian A. Johnson (2002). Mastering collateral management and documentation. ISBN 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 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 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