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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 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

Netherlands. The following types of collaterals are used by parties involved:  Cash  Government securities (often direct obligations of G10 countries: Belgium. Great Britain. According to ISDA. but the overwhelming driver for use of collateral is the desire to protect against credit risk. which is broadly consistent with last year’s results. 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. Italy. Government securities constitute fewer than 10% of collateral received and 14% of collateral delivered this year. Germany. France.[8] The other types of collateral are used less frequently. This is typically the case with hedge funds. Possibility of doing risky exotic trades These motivations are interlinked. Canada. Increased risks in the field of finance have inspired greater responsibility on the . the scope of collateral management has grown. Switzerland. Sweden. 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. as well as the introduction of newer forms of technology. Types of collateral[ There is a wide range of possible collaterals used to collateralise credit exposure with various degrees of risks. cash represents around 82% of collateral received and 83% of collateral delivered in 2009. again consistent with end-2008. Japan.[6] Many banks do not trade with counterparties without collateral agreements. With more institutions seeking credit.

Several sub-categories such as collateral arbitrage. and to liaise with other parties in the collateral chain. 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. The fundamental idea of collateral management is very simple. 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. and giving advice on collateral transactions in order to reduce credit risk in unsecured financial transactions. Collateral has to be returned or posted in the opposite direction when exposure decreases. deliver and to receive collateral. collateral outsourcing.  Middle Office  Legal Department  Valuation Department  Accounting & Finance  Third Party Service Providers . verifying. Aspects of portfolio risk. capital adequacy. and seek out further capital from lending excess assets. and credit risk assessment are just a few of the functions addressed in collateral management. In the case of a positive MtM. Party B then presents some form of collateral to party A to mitigate the credit exposure that arises due to positive MtM. handle margin calls. Collateral agreements are often bilateral.  Front Office: establishes trading relationships and on-boards new accounts. which is used to maximize bank's resources.[10] Collateral management has many different functions. and it is the aim of the collateral management to make sure the risks are as low as possible for the parties involved. an institution calls for collateral and in the case of a negative MtM they have to post collateral. maintain relevant data. in which a borrower is able to receive more affordable borrowing rates.  Credit Analysis Team: sets and approves collateral requirements for new and existing counterparties. triparty repurchase agreements.[9] Parties involved Collateral management involves multiple parties:[11]  Collateral Management Team: Calculate collateral valuations. risk management. Collateral management is the method of granting. The form of collateral is agreed before initiation of the contract. One of these functions is credit enhancement. ensure asset liability coverage rules are honoured. party A makes a mark-to-market (MtM) profit whilst party B makes a corresponding MtM loss.part of borrowers.

 Custody. Once the account is fully established the counterparties can trade freely. Important points in the collateral agreement to be covered are:  Base currency  Type of agreement  Quantification of parameters such as independent amount. Key details are communicated and entered into the two collateral systems. Daily actions include:  Managing Collateral Movements: to record details of the collateralised relationship in the collateral management system. Some initial collateral may be posted to enable the counterparties to trade immediately in small size. Only credit-worthy customers will be allowed to trade on a non-collateralised basis. to reconcile portfolio of transactions. to deal with disagreements and disputes over exposure calculations and collateral valuations. to check collateral to be received for the eligibility. a basic credit analysis of that customer is conducted by the Credit Analysis team.[11] In the next step parties negotiate and come to the appropriate agreement. to monitor customer exposure and collateral received or posted on the agreed mark-to-market. delivery periods)  Interest rates payable for cash collateral[12] Then the collateral teams on both sides establish the collateral relationship. to transfer collateral to its counterparty once a valid call has been made. to reuse collateral in accordance with policy guidelines. to call for margin as required. counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure clear and effective contracts exist before transactions begin. In the world's major trading centres.Establishment of collateral relationship Once a new customer is identified by the Sales department. notification time. 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. Clearing and Settlement .[2] Collateral management operations process The responsibility of the Collateral Management department is a large and complex task.

See credit risk. one party would like to substitute one form of collateral for another.  Substitutions: to deal with requests for collateral substitutions both ways. For example. balance sheet protection.  Processing: to pay over coupons on securities promptly after receipt to collateral providers. Valuations may be done on an end-of-day or intraday basis. Basel II.  Margin Calls: to notify.  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 . and resolve margin calls. Solvency II). Valuations: to evaluate all securities and cash positions held and posted as collateral. track. 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.

 Increased overhead  Reduced trading activity .