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Author: Financial-edu.com This 13-Part Collateral Management Guide is written as a source of useful free information on all aspects of collateral management. Each Part can be accessed by clicking the link at the bottom of the page. What 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, triparty / 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 Guide PART 2: Collateral Management Glossary
Author: Financial-edu.com 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
Netting: the process of aggregating all open trades with a counterparty together to reach a net mark-tomarket portfolio value and exposure estimate. Rehypothecation is the cornerstone of tri-party collateral management.Threshold Amount: the amount of unsecured credit risk that two counterparties are willing to accept before a collateral demand will be made.5% is being charged to offset period-to-period valuation risk and the collateral amount counted is only $98. the Valuation Percentage protects the collateral Taker from drops in the collateral's MTM value between margin call periods. . .com How Collateral Transfers Risk In OTC trading. so buy side participants often "haircut shop" for the best rate. corporate bond) with another form of collateral (e. These types of payments include derivative .Potential Future Exposure (PFE): The estimated likelihood of loss due to nonpayment or other risk. the MTA is usually in the USD 100.5% then 1. . .Valuation Percentage: a percentage applied to the mark-to-market value of collateral which reduces its value for collaterization purposes. .50. 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. For large banks.Substitution: replacing one form of collateral (e. The counterparty with positive mark-to-market (a gain) is usually the collateral Taker.Rehypothecation: the secondary trading of collateral. counterparties are exposed to the risk that the other counterparty will not make required payments when they are due. The counterparties typically agree to a Threshold Amount prior to dealing. Also known as a "haircut". Collateral Management Guide PART 3: How Collateral Transfers Risk Author: Financial-edu. Black Scholes). . but can be lower.Pledge: to give collateral to your counterparty. if the MTM value of the collateral is $100 and the Valuation Percentage = 98.g. in this case the likelihood of default on a counterparty's obligations. .Take: to receive collateral from a counterparty to meet a collateral or margin demand. . 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. but this is a source of ongoing friction between OTC counterparties and their brokers.g. . (SEE ALSO Give). The risk of non-payment is called credit risk. However.Minimum Transfer Amount (MTA): The smallest amount of currency value that is allowable for transfer as collateral.any price slippage or liquidity effect that might occur from exiting the deal in the open market. The Valuation Percentage offered by different counterparties and brokers may vary in the market. This is a lower threshold beneath which the transfer is more costly than the benefits provided by collaterization. For example.000 range.Top-up: To give additional collateral to your counterparty to meet a margin call. netting relies upon efficient and accurate pricing at a portfolio level to be effective. . . Treasury bond) during the life of a particular deal or trading relationship.
This is known as Potential Future Exposure or PFE. 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. or there is a disagreement on what the underlying deal value might be (this is common on illiquid OTC structured deals). In the event of a default.g. This provides some flexibility in the relationship and keeps things running smoothly in the event that a particular type of collateral (e.90 = CREDIT RISK 5) Collateral given = $15 6) Net exposure = $4.10) 4) Net Collateral delivery requirement = $19. 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. less the transaction costs associated with liquidating the collateral. and buy side institutions rely on a variety of . 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. lenders. etc. Since this form of insurance is not available to OTC counterparties. U. 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. dividend payments for stocks. Treasury Bonds) are not easily available at a reasonable price at the time of the margin call. they need another form of insurance. interest rate swap payments.90 = REMAINING CREDIT RISK There is an important difference between over the counter (OTC) deals and exchange-traded deals. this profit is "locked in" or insured up to the market value of the collateral posted. Collateral Requirements Credit departments of banks. weekly and monthly. adjust collateral amounts. Collateral acts as partial insurance to offset changes in market value.g. Credit Risk vs. mulitplied by the notional value of the expected payment(s). the creditor party then has the right to keep the asset to reduce his loss. CDS premiums or default payments). coupon payments for bonds. This is done by requiring the losing party to post or transfer an asset (cash. Margin agreements typically provide a grace period for the counterparties to negotiate differences in valuation.deal payments (e. Mark-to-market values on open positions change daily. 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. and net portfolio basis. This credit risk can continue to increase until the party has a large unsecured gain. substitute one collateral form for another. Credit risk can shift back and forth from one counterparty to the other on a constant basis. The counterparty with a net positive gain is exposed to unsecured credit risk in the amount of open uncollaterized gain.S. counterparty. etc. The currency value of the collateral represents the estimated probability of payment default. By demanding additional collateral. broker-dealers. marketable securities) to the winning party as a form of ongoing security. The amount of credit risk varies in real time and must be managed on a trade.
These include: . In bankruptcy.g.Payment histories .techniques to assess credit risk of their counterparties.Statistical default probabilities per counterparty.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 particular. Growth of Collateralized Transactions The following growth figures were obtained from ISDA. industry.Length of the deal: overnight repos have lower collateral requirements than 30 year swaps as there is far less time in which to default. Collateral Management Guide PART 4: The Collateral Landscape Author: Financial-edu. cut their staff significantly. . and other risks. Since OTC transactions need not be reported to regulatory authorities in most jurisdictions it is difficult to obtain accurate figures. However. While collateralization has always been important in OTC transactions. bankruptcy of a counterparty can pose extreme challenges in liquidating and collecting the cash value of the collateral posted. since many of the major reporting prime brokers have either gone under.External credit ratings .CDS spreads (if the counterparty is an issuer with CDS written on its bonds) . operational. 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. or market . the recent global credit crisis has put a spotlight on the need to fully understand and protect against credit risk in highly leveraged OTC derivative transactions. these numbers show 5x growth in collateral value since 2001.Internal credit ratings . there still remain legal. or are in the midst of legal actions to recover or defend against giving back collateral.Quality of collateral: more collateral is required if the securities posted are rated less than AAA.com The collateral management landscape has changed rapidly in recent years. This situation can be complicated further in cross-border deals (domestic or international) by differences in jurisdiction and legal systems. credit default swaps) Deal Risk Still Remains Even if a deal is properly collaterized. Post-2007 numbers may not be as accurate. 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. two additional factors can influence the amount of collateral required: . Year 2001 2002 2003 2004 2005 Collateral Value (USD billions) $250 $437 $719 $1017 $1209 . and will not be encumbered by prior pledges or debts. or have volatile prices (e. In addition. It is also critical that the jurisdiction in which the transaction was completed fully enforces the collateral agreements and does not invalidate them.
. and Canada have highly developed collateral markets focused on cash and Treasury Bonds.Exchange Traded securities . .000 trades. Commodities and government bonds (including U. Key Technical and Legal Developments in Collateral Operations . . and large banking relationships backed by government intervention tend to limit defaults.2005 ISDA Collateral Guidelines: ISDA embraces industry advances and lays out standard bi-lateral and tri-lateral operational processes.OTC derivatives .Asset Backed securities . Under Islamic banking law. the provision of adequate resources to the collateral .The Middle East has a rapidly developing collateral market in a form which is acceptable under Sharia or Islamic Law. . China's adoption of common collateral definitions in 2005 was a major milestone to development of efficient OTC and derivatives markets in Asia. .2003 ISDA Collateral Asset Definitions: standardized the definitions of eligible collateral. . which includes lending securities.Bank Loans .Fixed Income Repo . but is hindered by inefficient legal systems.Equity Finance . legal systems and variations in collateral treatment during bankruptcy. .Commodities Global Collateral Markets .2006 $1329 Markets that are Widely Collaterized . Europe still has fragmented tax systems.Asia is a mix of rapid development in China. Korea.Collateral Market Practices published .Securities lending .U. fragmented equity markets. and access to quality collateral. and a mature and sophisticated market in Japan.Latin America has a developing collateral market. In general. Treasuries) are the preferred form of collateral.July 31. . and enterprise-wide basis is embraced to increase efficiency. Indonesia. and include a wider range of risks.Mutual Funds .S.Corporate bonds . etc. customer. and historically fragmented settlement and clearing infrastructures (this is improving rapidly). underdeveloped custody and IT systems. .Cash payments .2003 Enterprise Wide Collateral Management: Netting on a portfolio.S. 2008 the major participating dealers agreed to a goal of weekly interdealer reconciliation of collaterized portfolios with more than 5. Lending is largely illegal in Muslim countries.FX margining . 2008 Major Dealers in the Operation Management Group letter to the U. most deals must be fully secured with collateral to ensure that no credit is extended between counterparties.Portfolio Reconciliation published to provide guidelines on managing complex collateral portfolios. . cut costs. credit (and hence the need for collateral) is used more conservatively. Federal Reserve: by Dec 31.2005 Chinese Market Collateral Glossary: The Chinese join with other trading powers in defining key terms to use in collateral and credit agreements.S.2003 Electronic Data Interchange (EDI) standards developed to automate collateral transactions and communications. Malaysia.Europe has highly efficient fixed income collaterization.Equities .
Front Office Sales and Traders: Sales people develop new eligible trading relationships and manage the onboarding process for new accounts. Once a new customer is identified by Sales. the Middle Office interacts with the Collateral Management team on a daily basis.com Managing financial collateral is a complex process involving multiple parties.management function to identify and resolve differences. maintains customer and securities data. Typically this entails a preliminary review as well as ongoing periodic reviews of the credit risk of each counterparty. including initiation of collections and lawsuits where appropriate. In the world's major . drafting and review of agreements. delivers and receives collateral. these types of collateral and deals are thinly traded rather than liquid exchange-traded instruments. and other parties in the collateral chain. Parties involved .Legal Department: Conducts negotiations. Consultants.Third Party Service Providers: Software providers. Legal. Creating a new collateral relationship For OTC transactions. runs the collateral operations. Only credit-worthy customers will be allowed to trade on a non-collaterized basis. collateral is the norm rather than the exception. collect and report metrics to supervisors (thus driving increased demand for systems to capture data and report disputes and risk metrics). and liaises with customers. and ongoing sales transactions.Collateral Management Team: Does collateral calculations on spreadsheets and dedicated software. under the assumption that other large banks would rarely default on their obligations. Traders may execute trades only with approved counterparties. the first step is to conduct a basic credit analysis of that customer. Auditors. issues and receives margin calls.Credit Analysis / Approval Team: Researches. This is done by the Credit Analysis team. Typically. . Middle Office. Tri-Party Collateral Managers. . including signing of legal collateral documents. . .Accounting & Finance Team: Works with the Middle Office to calculate and account for P&L on collateral posted and received. Also works with Tax and Auditors. Prior to the widespread use of derivatives. . The next step is to negotiate and enter into the appropriate legal agreements. . collateral was required by large banks only for smaller or riskier customers (such as hedge funds or niche brokers).Valuation Team: This group focuses on valuing illiquid or exotic collateral and underlying trade position that must be collaterized. Tax Specialists.Middle Office: Typically responsible for risk and valuation measures. Legal is required to sign off on all written agreements. account formation. . analyzes and sets collateral requirements for new and existing counterparties. collaterization is now mandatory between almost all counterparties. With the dramatically increased leverage built into the financial system through derivatives and securitized pools. Enforces collateral and margin agreements. service providers. Collateral Management Guide PART 5: Mechanics of Collateral Management Author: Financial-edu.
The above dynamics are reversed if the first party is the net debtor (i. If the two parties want to trade right away. valuation has been done on an end of day (EOD) basis. a margin call is issued. or a third party custodian may be hired. which will only require "topping up" the collateral to meet initial margin requirements. they will typically post some initial reciprocal collateral with the other party (either cash or default-free Treasury bonds) to "open the account. SWIFT codes. or SWIFT message. This is a large and complex task requiring sophisticated systems and dedicated personnel. and giving / taking collateral to offset credit risk on a deal and net portfolio basis. Then the collateral teams at each counterparty implement and automate the collateral relationship. margin requirements.trading centers. Margin calls are made via telephone. often extending weeks or months. This requires segregated accounts strictly for collateral by customer (and often sub-account level). counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure clear and effective contracts exist before transactions begin. are all communicated and entered into the collateral systems of both counterparties.Valuations: The Valuation team (often part of the Collateral or Middle Office team) is responsible for valuing all securities and cash positions held or posted as collateral. If the counterparty does not meet its margin call. The custodian manages collateral inflows and outflows. Bank codes. email." This lays the groundwork for new trades.Substitutions: Often one party would like to substitute one form of collateral for another. etc. custodian and transfer relationships. one or the other counterparty may act as a custodian for cash and securities. The custodian role is often outsourced. Once a trade is agreed upon. and the required Initial Margin is posted to enable the trade to occur. dividends. margin call processes. value. and the existing collateral may be seized. etc. Daily Collateral Operations Process The Collateral Management team's job is to continually track. etc. as well as accounting for and reporting all transactions accurately and timely. haircuts. independent amounts (haircuts) calculation and payment methods.e. key contacts and phone numbers. valuation models. and give or receive collateral during the life of every OTC trade in the institution's portfolio. This duty is affected by the valuation roles defined in the CSA -. the Collateral Team is notified of the deal. the Collateral team may issue a notice indicating the trading relationship is temporarily or permanently halted until the account is brought to net zero exposure.). Negotiation and finalizing these agreements can take up the bulk of the time in developing a new relationship. especially by hedge funds who typically outsource this function to a custodian subsidiary of their prime broker. the Front Office Sales and Traders can begin negotiating trades.for example. . Typically. . etc. Once these items are in place. fax. interest calculations. These agreements cover 90% plus of the information on eligible collateral. report formats. .Margin Calls: When the Collateral Team determines that the mark-to-market change of a particular deal or net portfolio position has moved against the counterparty by at least the Minimum Amount. but is now moving toward intraday and real time valuation where possible. receives one or more margin calls). If the counterparty does not respond the custodian is notified. making and fielding margin calls. The counterparty is then required to top-up its collateral account by delivering cash or securities. typically by overnight wire transfer. if defined in the relevant CSA.Custody. and the account turned over to the Legal department for enforcement of any outstanding obligations. For example. The general tasks on a day-to-day basis include: . and the amount is large enough. coupon payments. Traditionally. . and large teams of qualified staff. Clearing and Settlement: Depending on how the legal relationship is structured. the Front Office will offer the counterparty the opportunity to "break" the deal and pay a penalty before full legal action is taken. . stating the amount of collateral demand and often the type of collateral required.Managing Collateral Movements: tracking the net MTM valuation. This process may be done in a matter of days or take up to several weeks. many smaller hedge funds delegate valuation to their prime brokers who may have greater access to comparative valuation data. counterparty payments (top-ups.
). eligible collateral must be easily converted into economic value when needed (i. Types of Collateral According to ISDA. This function includes: . Basic Requirements for Collateral Eligibility . easy to transfer.Approved by the Credit Department: The Credit Team must approve all securities offered as collateral prior to acceptance.Easy to settle: Treasury bonds. sovereign bonds. when a counterparty defaults). AAA Corporate bonds. this must be properly tracked in the Collateral Management system as well as communicated to all relevant parties (custodians. .Corporate actions (splits.Coupon payments .Taxes (accounting for and issuing the necessary tax documents for each tax jurisdiction so customers can properly account for and pay their taxes) Collateral Management Guide PART 6: Collateral Eligibility and Valuation Author: Financial-edu. etc. Major industrialized country government bonds are unlikely to default. The Collateral Team will then look to the CSA for guidance on acceptable substitute collateral (if covered) or make a decision based on the perceived value of the substitute collateral. .High quality (default free): Collateral itself should not have significant embedded credit risk itself.USD and EUR are liquid. and the ability to deliver good collateral at a lower net price. . accounting and charging interest or lost capital gains/losses) . .Payment delays (accruing. typically taking no more than one day.Bank Guarantees . and many mortgage-backed bonds are easy to settle. Collateral substitution allows for flexibility in the relationship. but Turkish Lira may not be.). valuation team.Dividend payments . and followed up to ensure the substitution actually occurs.e.Cash (73% of USD and EUR trades according to ISDA 2005).com Collateral eligibility is one of the key steps in a stable trading relationship. Since the purpose of collaterization is to secure or insure all or a portion of the counterparty credit risk in a trading relationship. requires little or no valuation. Agency Bonds. but the Credit Team should have final say since their credit analysis is often more up to date than the legal documents.Redemptions . ABS. Cash is easy to hold.Processing: Payment and event processing is often outsourced to a dedicated third party. . etc. share buybacks. large-cap equities. etc. This may also apply to certain currencies as well -.) . or Corporate Bonds rather than Treasuries. Guidance is taken from the Credit Support Annex (CSA). reverse splits. the following types of collateral are most predominant: . corporate bonds. whereas junk bonds and emerging market bonds have significant and widely varying credit risk and are unlikely to be accepted as collateral.Liquid: Securities used as collateral must be highly liquid (marketable) so they can be sold for cash in the open market on short notice. but also includes other types such as MBS.cash rather than Treasury Bonds. Once a substitution is accepted. .Fixed Income Securities: Predominantly Government Securities (Treasury Bonds. etc.
or at least subject to approval by the Collateral or Valuation teams before a deal is completed.Who values the collateral? This is usually governed by either the CSA or trade documents (deal term sheet). Two banks will typically push for either 2) me or 3) both. 3) both. or 4) third party. mark to market is selected. without which the collateral has little use. the issue becomes cost. Margin Call mechanics . Where the trade is fairly vanilla and there are plenty of comparative market prices. Illiquid trades are still valued on a daily basis and sometimes weekly or monthly for highly structured deals. electronic order networks. the number of independent valuators used. Collateral Management Guide PART 7: Margin Calls and Collateral Disputes Author: Financial-edu. ownership concentrations. 2) me. trading limitations. and the determination of a) the model used. and b) who does the valuation.com The Margin Call is the primary mechanism which ensures adequate collateral is posted during the life of a deal. This collateral is more relevant to structured project financing transactions. When deciding whether collateral is eligible. 30 or 60 minute intervals) or real time valuation. mark to model may be necessary. etc.Independent valuation required? In some instances a deal is so unique or illiquid that a third party valuator or appraiser is required to theoretically price a deal for collateral and PnL purposes.How is it valued? Depending on the type of trade. Collateral provides no security if it cannot be valued or traded for a known value.Real Estate: Commercial buildings. Smaller hedge funds without dedicated valuation teams usually choose 1) you or 4) third party. or the amount of collateral requested. and must convert into marketable common stock or premium stock at a significant discount.Equities (stocks): Usually large-cap and highly liquid shares listed on major exchanges. However.e. if deemed sufficiently liquid. becomes extremely important. the valuation may be done on a mark to market (MTM) or mark to model (theoretical valuation) basis. For more exotic or complex transactions.. . . . and redemption rights.How often is it valued? Traditional valuation is done on an end of day basis (EOD) after the market closes. . . . Considerations in Valuing Eligible Collateral The ability to quickly and accurately value collateral is a critical element of its eligibility. taxes. and how to decide on a final value from multiple different estimates without proceeding to litigation. These factors should be decided up front before doing a deal.Mutual Fund Shares: This can be very complicated due to interactions between custody.Convertible Bonds: These must be issued by a credible company with low default risk. The choices are: 1) you. land. Where this is necessary.Exchange Traded Funds (ETFs) . so that each has a hand in the final determination and can bring their valuation expertise to bear. with the advancement of collateral systems. Occasionally counterparties may disagree on whether a margin call is appropriate. and other technology. there is a movement toward periodic intraday (i. This gives valuation control to the prime broker which typically has dedicated valuation personnel and a wider view of market prices. the following factors are important: .
or the quality of the collateral has dropped below the required threshold (e. 7) The counterparties come to an agreement on how much needs to be posted.Portfolio mismatches: Missing trades are not included in the portfolio which creates net exposure calculation differences. weekly. valuation consultants. . This is quite common. using different price samples. 5) A margin call is made to counterparty if exposure limit exceeded. 6) Perform price change analysis walk-through with counterparty. 3) Check the net collateral requirement vs. Collateral Disputes There are several types of collateral disputes which occur most frequently. 2) All collateral is marked to market.Ineligible collateral / collateral recharacterization: The losing counterparty attempts to post securities having less quality than required. This may take longer for non-standard collateral or international transactions. the party receiving a margin call either accepts the call on its face or analyzes it and determines how much needs to be posted by looking at market prices. . 4) Check rounding amounts (rounding up or down at a specified level of granularity). interest rates. collateral agreements. then implement formal dispute resolution procedures.) b) get one or more appraisals done.1) All trades are marked to market (daily. etc. 2) Make sure the Credit Support Annex (CSA) covers the specific securities or locations/branches in question.Payment delays . banks. Dispute Procedure Resolving collateral disputes generally takes the following path: 1) Check the collateral value using market data such as FX rates. 6) Counterparties net their collateral calculations (if both have posted / received collateral from the other). monthly). thresholds (specific and general). 3) Net collateral requirement is calculated internally by each party 4) Credit risk exposure is compared to a pre-defined acceptable exposure level. 9) Collateral posting settles T+1 (next normal business day). etc. an investment grade bond has dropped to B-rated and is no longer eligible). bond prices.Valuation disagreements: Curves or prices may be captured at different times. . 7) If the counterparties still cannot agree on the correct amounts. Otherwise. from different data sources. The disputed portion (if any) may be negotiated. These should be governed by the appropriate CSA: a) get additional external quotes (3rd party dealers. These include: . etc. This helps determine the source of the valuation issue over time. especially where the Front Office has failed to properly enter trades at one of the counterparties.g. or the theoretical valuation done using different valuation models or settings. 8) The undisputed portion of collateral required (imbalance) is posted by the losing counterparty to the winning counterparty.
These factors have led to the rapid growth of the tri-party collateral business. Without the proper systems and procedures. Usually this is in the form of a haircut differential between the haircut paid to the collateral giver (lower). the creditor may then turn around and pledge that collateral for another transaction with a second counterparty. Collateral rehypothecation is the foundation of tri-party collateral management services. there is a risk of double-committing collateral or not being able to obtain the collateral back when needed.Mark-to-market and mark-to-model valuation .Holding securities (security.com Collateral Trading: Rehypothecation of Collateral When a net creditor in a deal receives marketable collateral from the debtor counterparty. eliminating inefficiencies caused by differences in contractual interpretations. and the haircut received from the collateral taker (higher). Facilitation of tri-party repos and total return swaps provides access to a common pool of collateral posted by a wide variety of market participants from different locations around the world. For this valuable service. across a broad array of products. . The basic function of rehypothecation is to provide counterparties with a broader array of collateral availability and the ability to enter into a wider breadth of trade types. Tri-Party Collateral Management Tri-Party or multi-party collateral managers provide a central service to manage.Reporting and recordkeeping . Collateral agreements are standardized in ISDA format across the entire pool of trading counterparties. accounting) .Securities Lending Escrow (SLE): Manages securities received from borrowers for the benefit of lenders. and to obtain and post additional collateral as needed by leveraging other profitable deals.Substitution of collateral . However. an odd word meaning the secondary re-use of collateral. In exchange for providing access to different markets and collateral types to the service membership. the tri-party manager takes a small cut of each collateral movement. safekeeping. Additional services provided by tri-party collateral managers include: . and legal support unavailable to many smaller institutions such as hedge funds. taking a small portion of each collateral transaction as a fee or trading spread. the tri-party manager acts as a central broker. This is known as "rehypothecation". A trader who is able to access different types of collateral from other transaction has a greater ability to get into trades where collateral security is required. The trader may also earn an interest rate spread between the haircut charged and the haircut paid to two different counterparties. clear. and rehypothecate collateral among many different OTC counterparties in the market.Collateral Management Guide PART 8: Rehypothecation and Tri-Party Collateral Management Author: Financial-edu. inventory and accounting systems. Rehypothecation has been traditionally used in bi-lateral trading relationships. collateralization can be done at a net portfolio level and rolled up into a single statement in near real time. to rehypothecate collateral efficiently and on a larger scale is very complex and requires dedicated staff. With tri-party management. In certain transactions with credit risk such as credit default swaps. the quality and marketability of collateral is essential to be able to enter into and maintain a deal over its life.
interest accruals. stock voting. at negotiated interest rates The benefits of using a tri-party collateral manager include: .7 Secured Amount Bank Account: Futures Commission Merchants (FCMs) must invest customer cash in a way to protect client assets.Reduced overhead: There is no need to maintain a large back office team and IT investments required to process.Access new forms of collateral at competitive rates .Technology: Tri-party collateral managers utilize the latest sophisticated real-time processing and communication systems.Collateral eligibility testing . Accounts can accomodate multiple . financing or lending. dividends. Cash deposits may be invested in "qualified securities" or held as cash deposits. .Asset servicing: Processing bond coupons.Rehypothecation tracking: Accounting for and managing the movement of collateral through the chain of trading counterparty accounts.Arbitrage rates of borrowing and lending across different collateral types (e. etc. interest payments and receipts. . . rehypothecate.Delivery and receipt of collateral postings . and there are no limits on the number of withdrawals. Accounts must accept and maintain only cash.Commodity Futures segregated accounts: CFTC Rule 1. Corporate Bonds): Trading institutions can use the collateral function as a source of arbitrage or directional trading.Segregated reserve bank accounts under SEC Rule 15c3-3: The SEC Act of 1934 requires broker dealers to maintain "special reserve bank accounts" strictly for customers which are separated from the broker dealer's own accounts.Margin calls: issuing and managing responses versus margin agreements . and account for collateral on OTC positions. . . This compares to 50% of excess net capital for money market deposit accounts. .. a common bottleneck is removed. Tri-party member institutions can have access to 50 or more different transaction types to choose from. Segregation is required to prevent cash assets from begin mixed with securities payments and failures to pay.Trust services: Calculation and payment of interest on cash collateral in the form of trust assets. as if they purchased and sold deals directly with an OTC counterparty. instead of managing collateral. . Cash deposited is held in a segregated trust acccount which is FDIC-insured and accounted for on the trust ledger of the bank.Enables higher trading volume: By outsourcing the back office functions of collateral to a highly efficient and automated service provider. . Treasury Bonds vs. Similar segregation is provided pursuant to rules of the Investment Industry Regulatory Organization of Canada (IIROC).20 Commodity Customer Segregated Account and CFTC Rule 30. There is no limitation to a broker dealer placing client cash in such accounts. and the trading instution can trade at much higher volumes without overwhelming the back office function. with no securities allowed.Concentrating on core business: The counterparties can concentrate on their core businesses of trading. .No cost to the Lender: Lenders do not pay for the tri-party collateral management service .g.Enables diversification into more instruments: The typical bi-lateral trading relationship is limited to 2-5 unique instruments.
. . repeatable manner.Reduced credit risk: mitigation of current and potential future exposure to losses due to nonpayment by a counterparty.) .More efficient trading between counterparties: collaterization formalizes an ongoing relationship and makes transactions and payments smoother. etc.SWIFT Collateral Management Guide PART 9: Advantages and Disadvantages of Collateral Author: Financial-edu.Bank of New York Mellon .Northern Trust . Basel 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.currencies.Improved market liquidity: increased opportunity to do more transactions in the markets.Deutsche Bank .Depository Trust and Clearing Corporation (DTCC) . and less time required for credit review and settlement.Clearstream . . .Euroclear . with less capital.State Street Bank and Trust .com There are both advantages and disadvantages to collaterizing OTC transactions: Advantages of Collateral . corporate treasury. Tri-Party Service Providers include: .Access to higher risk trades: collaterization reduces the risk of illiquid or new trade types which have higher risk but higher profit margins. Solvency II). .Capital savings: collaterizing and netting counterparty exposures reduces the amount of economic capital required to cover credit risk and balance sheet protection (e.JPMorgan .g. .Benefits to Buy Side (asset managers. with more opportunity to check valuations and balance the gains and losses in a standard.Minimize collateral amounts by cross-collaterization .
Can Increase 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. third-party relationships. etc.Long CSA negotiation period while traders want to trade . etc. Treasury Bonds) . or other reasons. .Benefits to Sell Side (broker dealers.Legal Risks: How to structure.Collaterize exposures by client .) .Delays in posting / receiving collateral . political pressures. . Disadvantages of Collateral . . the firm must include collateral securities and cash in portfolio-wide market risk and pricing calculations. storage.Pricing risk and model risk: Even though a transaction may be collaterized..Minimize collateral movements and give/take collateral on a net basis . and operate collateral processes accurately and efficiently creates additional operational risk and a false sense of security. staff. confidentiality. making the collateral ineligible. Failure to invest in the correct technologies.Enforcement risk: risk that the counterparty won't give back your collateral. and manage the collateral agreements requires specialized legal skills.Recharacterization risk: the possibility that the collateral might be recharacterized as non-eligible under the jurisdiction's laws and "clawed back" in bankruptcy proceedings. document. (however this risk also exists in non-collaterized transactions).Legal procedures: proper documentation.Inactive CSA's: Maintaining inactive agreements that may be outdated. This increases default correlation and leads to underestimation of single large risks such as a the counterparty going bankrupt suddenly.Overly high thresholds . .Perfection risk: the possible risk of inability to "perfect a claim" to collateral (assert proper legal ownership) when default is imminent or default occurs. High correlations lead to increased market risk through the belief that you are adequately collaterized. . technologies. but everything goes down in value at once. deals that are complex or securities which are thinly traded rely heavily on pricing models for their valuation and resulting collateral required. .g. . . custody.Increases Operational Risk (aka Murphy's Law): Collaterization is complicated.reduces capital charge to allocate for asset liability management.Concentration Risk: the overreliance on a single counterparty once a collateral relationship is established. etc. banks.Settlement Risk: The possible failure of securities settlement procedures. . etc. This occurs when there are: .Collateral Operations are highly manual and slower than the traders .Priority risk: the risk that some other counterparty has a prior claim on the collateral you hold. . .Trade eligibility is lowered based on low availability of a narrow and expensive range of acceptable collateral (e. and the jurisdiction does not honor the collateral agreements due to lax enforcement of contract laws. Any errors or rapid market shocks during the valuation process can lead to under-collaterization (or over-collaterization) and subsequent losses or inefficient use of capital. etc. including the cost of review.Expensive: The solution is often to outsource to tri-party collateral service .Can reduce trading activity: Collaterizing transactions can actually reduce trading activity by eliminating more risky counterparties. storage. including payments. and trained staff. resulting in rapid under-collaterization. . To account for this.
Length of the trading relationship and history of payments . For a Clearing House to operate properly requires clear regulation. etc. In return.g. International Aid Bank then hedges its interest rate and currency risk in the open markets and. For example. Emerging Government uses the Euros to purchase necessary inputs (steel. For example. engineering services. transparency. The deal is essentially all cash up front with no collateral required between the original counterparties.g.com Collaterizing every OTC transaction is not always necessary.) for its infrastructure project.Current and projected market conditions . EUR) to Emerging Government up-front. backed by Industrialized Countries Syndicate) transfers a specified amount of developed market currency Y (e. concrete.Loss-Leader transactions: If the trading relationship is designed to be a loss-leader. AAA credit rating. then requiring collateral may be counter-productive to the end goal by driving customers away. locks in a profit on the deal. .) . trading with a government or quasi-government entity which has an explicit government guarantee on its transactions is normally considered risk-free. the lending party (International Aid Bank. Other factors that may lead to choosing an uncollaterized relationship include: . hopefully. SWIFT messaging setup with reliable third-party custodians. and concentrates risk management and processing into one efficient location. but may not offer rehypothecation. etc. standardization of contract terms for both counterparties.Collateral Management Guide PART 10: Alternatives to Using Collateral Author: Financial-edu. including all expected notional and interest payments over the life of the deal. a history of payment. Clearing House If two counterparties do not want to enter into a collateral relationship. The role of a Clearing House (compared to using in-house collateral management with a credit team) is to act as a middle man and a single point of netting for trade payments.How profitable the deal is without collaterization: If the deal has a large built-in risk free arbitrage profit and is fully hedged already. . control. Prepaid Exchange of Notional Plus Profits Some deals are structured to essentially pay the estimated profits and notional amount up-front in an all-cash deal. The Clearing House is responsible for processing payments between counterparties. However.How automated the relationship is (e. it can add costs. for example to generate highly lucrative investment banking deals. The Clearing House is one function offered by TriParty Collateral service providers.Length of deal (less than 1 month) . especially if the counterparties do not trade frequently. just as if the deal was done on a exchange. provides a net collateral position across counterparties and instruments. a common emerging market cross-border structured deal involves the transfer by the borrowing party (Emerging Government) of a specified amount of that country's currency X. they can hire a Clearing House to risk-manage the transactions for them. Using a Clearing House reduces the burden on internal credit departments. this may make any effort to collaterize the deal more costly than the potential gain. Collateral must be posted with the Clearing House on an ongoing basis as a guarantee of cash payment. A multinational corporation in a low risk industry with high cash balances. operating in a reliable legal jurisdiction would also be considered nearly default-free. There are several alternatives to collaterization which are widely used: Uncollaterized Transactions Trading without the use of collateral is still effective where the credit risk between the counterparties is low or non-existent.
Data feeds .Credit Manager: Credit analysis skills . Accounting.Collateral Agreements (SEE ISDA.com The following checklist is helpful for building a basic collateral management function. Risk. Risk . research. regulatory / legal skills .Break Clauses A break clause permits one or other of the counterparties to terminate a trade on specified dates. Collateral Management Guide PART 11: Checklist for Building a Collateral Management Function Author: Financial-edu. mathematics or financial engineering skills .Management Support and Enforcement Technology: .Outsourcing? People and Skills: . simulation tools.Cash Manager . SWIFT messaging. When a break occurs.New York Law (pledge) = used by 54% .Credit Support Annex (CSA) .Collateral Software . the parties settle the difference in MTM value and go their separate ways.Accounting Software . Europe. Business Plan: . A break clause can provide for complete freedom to terminate the deal.Accounting Manager .Budgets . comprehensive.IT Support: Database. data feed skills Legal Agreements: . enforceable .Goals .Risk Management Software . which can be difficult and expensive for customized OTC trades. Sales.Valuation Specialist: Valuation. Treasury. By breaking the trade. or only allow for termination under specific conditions. Asia authorities) . UK. accurate.Data and document storage .Costs vs. Collateral provides further insurance against non-payment beyond the ability to back out of a losing trade and take losses before they get bigger.Authority and Buy In from Key Constituents (Trading. the counterparty holding a losing position is able to prevent further losses without having to go out in the market and find another counterparty to offset the trade. like a non-breakable trade. Break clauses reduce counterparty risk by allowing termination when the deal valuation has moved significantly in one direction to the benefit of one party and detriment of the other. relationship management.Collateral Manager: Operations. Savings vs. one counterparty may not make the required payment even if the break process is followed. However. Senior Management) .Key Factors: Correct form.
.Use of third party providers: custodians. and alerts) . . customer. through a common interface. .Margin Agreement . and record collateral eligibility under varying conditions and inventory levels. approval processes .Sophisticated trade matching algorithms (especially for tri-party systems) . These should be fully integrated in a single package. exposure over time) . Know Your Customer. such as Trading.Simulations (exposures with/without different collateral. etc. resolution.Intraday optimization and rebalancing .Process oversight / control: fully documented. etc. due to the high complexity. regulatory. calculate.Dispute process: identification.Monitoring (via blotters. based on various market data inputs. standard valuation models. and criticality of the function to the financial and operational health of the organization. deal number.English Law (deed) = used by < 1% . and integrated into all existing upstream and downstream software platforms.com The correct software and systems are crucial for operating an effective collateral management function. accountants. negotiation.. trader.English Law (transfer) = used by 22% . valuation. messages. . reports.Other Country Definitions: China.Valuation (real time or EOD. Key Features of Modern Collateral Management Systems The following features are considered mandatory for an effective collateral management system. use of 3rd parties . Dubai. large amounts of data.Speed (real time or near real time) . . software.Systems and technologies in place . Payment Processing. escalation. Accounting.Connectivity to multiple dealers and venues: The ability to connect to multiple external systems. and trade type.2003 ISDA Collateral Asset Definitions .Collateral selection tools: The ability to select collateral from an eligible and available pool. both bi-lateral and tri-lateral. Japan.Collateral eligibility: Tools to analyze.Document management processes and systems Processes: . .Daily process / workflow design . industry groups Collateral Management Guide PART 12: Collateral Software and Systems Author: Financial-edu.Collateral allocation engine: A controlled and accurate matching engine between collateral posted / taken. custom models) . Valuation.Tri-party agreements . Risk.
collateral inventory. Bilateral Collateral SWIFT messages MT503 . non-repudiation.. book. reconciliations. Collateral Management Software and Systems Providers The following companies offer dedicated collateral management software.SWIFT = Messaging using ISO 15022 securites standards on FIN.Scalable . . guarantee of sender. Has connectivity to more than 8. trade data. etc. .Connectivity with other systems: confirmation. histories.Inventory management . STP.SunGard = Adaptiv Collateral .omgeo. .Rehypothecation .AcadiaSoft = Collateral messaging and workflow . market and static data. Listing here is not a recommendation to purchase.Allustra = Kyros solution. trade/securities definition components. SWIFT). etc.com) in Sept 2008. settlement engines. settlements .Access to underlying data: collateral statements. Collateral Management Guide PART 13: SWIFT Messages for Collateral Management Author: Financial-edu.Straight through processing: price. MT503 . .com The following SWIFT messages are standard for all collateral transactions.Lombard Risk = Colline Collateral Management . audit logs .Reconciliations: Reconciliation between Ours and Theirs view of the portfolio and collateral is automatically done and messaged/emailed/saved to shared messaging queues. margin calls. trade files.300 institutions globally.Standardized: Cmmunication protocols (e.Algorithmics = Algo Collateral . Swift is a major provider of standardized messaging systems. Acquired by Omgeo (http://www.Management tools: dashboards.Collateral Claim return .g. market data. confirm. message validation. ISDA terms and definitions. trade management systems .Collateral Claim From: Collateral Taker To: Collateral Giver Purpose: Initiation: Taker initiates a new or additional collateral request from the Giver.
MT569 . Taker notifies Agent of collateral demand.Tri-Party Collateral Instruction From: Collateral Taker/Giver To: Tri-Party Agent Purpose: Initiation: Giver notifies Agent of available collateral. MT506 .Tri-Party Collateral Status & Processing Advice From: Tri-Party Agent To: Collateral Taker/Giver Purpose: Initiation: Agent responds to MT558 from either Giver or Taker.Collateral & Exposure Statement From: Both To: Both Purpose: Administration: Shows net exposure and details by collateral position MT507 .Collateral Proposal From: Collateral Giver To: Collateral Taker Purpose: Initiation: Giver proposes new collateral MT505 . .From: Collateral Giver To: Collateral Taker Purpose: Initiation: Giver responds to Taker's new/additional collateral request MT504 . Tri-Party Collateral / Tri-Party Repo SWIFT messages MT527 .Tri-Party Collateral & Exposure Statement From: Tri-Party Agent To: Collateral Taker/Giver Purpose: Settlement: Shows net mark-to-market for collateral and underlying exposure and details by collateral position. MT558 .Collateral Substitution From: Both To: Both Purpose: Settlement: Either party substitutes new collateral for existing collateral.Collateral status & processing advice From: Both To: Both Purpose: Shows collateral transactions and status.
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