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 1520 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 is now a
very complex process with interrelated functions involving multiple parties.[2] Since
2014, large pensions and sovereign wealth funds, which typically hold high levels of
high-quality securities, have been looking into opportunities such as collateral
transformation to earn fees.[3]

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[4] 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[5]

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.[6] 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[7]

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 years results. Government
securities constitute fewer than 10% of collateral received and 14% of collateral
delivered this year, again consistent with end-2008.[8] The other types of collateral are
used less frequently.

What Is Collateral Management?

The idea of collateral management[edit]
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.[9] 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.[10]
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, triparty repurchase agreements, and credit risk assessment are just a few of the functions
addressed in collateral management.[9]

Parties involved
Collateral management involves multiple parties:[11]

Collateral Management Team: Calculate collateral valuations, deliver and to

receive collateral, maintain relevant data, handle margin calls, and to liaise with
other parties in the collateral chain.

Credit Analysis Team: sets and approves collateral requirements for new and
existing counterparties.

Front Office: establishes trading relationships and on-boards new accounts.

Middle Office

Legal Department

Valuation Department

Accounting & Finance

Third Party Service Providers

Establishment of collateral relationship

Once a new customer is identified by the 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.[11] 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 on both sides establish the collateral relationship. Key details
are communicated and entered into the two collateral systems. Some initial collateral
may be posted to enable the counterparties to trade immediately in small size. Once the
account is fully established the counterparties can trade freely.[2]

Collateral management operations process

The responsibility of the Collateral Management department is a large and complex
task. Daily actions 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 mark-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

Valuations: to evaluate all securities and cash positions held and posted as
collateral. Valuations may be done on an end-of-day or intraday basis.

Margin Calls: to notify, track, and resolve margin calls.

Substitutions: to deal with requests for collateral substitutions both ways. For
example, one party would like to substitute one form of collateral for another.

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[5][13]

Advantages and disadvantages

The advantages and disadvantages of collateral include:[14]

Advantages of collateral:

Reduced credit risk

Economic capital savings: netting counterparty exposures reduces economic

capital required to trade. See credit risk, balance sheet protection, Basel II,
Solvency II).

Diversification

Improved liquidity

Higher profits

Higher trading efficiency

Disadvantages of collateral:

Increases operational risk

Legal risk

Concentration risk

Settlement risk

Valuation risk

Increasing market risk

Increased overhead

Reduced trading activity