Collateral Management
Encyclopedia
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.
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.
.
Collateral is legally watertight, valuable liquid property 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 default
s, 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. Many banks do not trade with counterparties without collateral agreements. This is typically the case with hedge funds.
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. The other types of collateral are used less frequently.
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. 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.
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.
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.
Advantages of Collateral:
Disadvantages of Collateral:
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
documentation.
In the modern banking industry collateral is mostly used in over the counter (OTC)
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
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
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, securitization of asset pools, and leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. As a result, collateral management now is very complex process with interrelated functions involving multiple parties.
What is collateral and why is it used?
Borrowing funds often requires the designation of collateral on the part of the recipient of the loanLoan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
.
Collateral is legally watertight, valuable liquid property that is pledged by the recipient as security on the value of the loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
.
The main reason of taking collateral is credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
reduction, especially during the time of the debt default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
s, 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 riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
- Improved access to market liquidity by collateralisation of interbank derivativesDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
exposures - 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. 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:- CashCashIn common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
- 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
- EquitiesEquity (finance)In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
- Government agency securities
- Covered bonds
- Real estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
- Metals and commodities
The most predominant form of collateral is cash and government securities. According to ISDA
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
, 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. The other types of collateral are used less frequently.
The idea of collateral management
The practice of putting up collateral in exchange for a loanLoan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
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
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty 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. In a swap
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
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.
Collateral management has many different functions. One of these functions is credit enhancement
Credit enhancement
Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization. The credit crisis of 2007-2008 has discredited the process of credit enhancement of structured securities as a financial practice as...
, in which a borrower is able to receive more affordable borrowing rates. Aspects of portfolio risk, risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
, capital adequacy, regulatory compliance and operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
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
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
, and credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
assessment are just a few of the functions addressed in collateral management.
Parties involved
Collateral management is a complex process involving multiple parties:- Collateral Management Team: their responsibilities are to calculate collateral on spreadsheetSpreadsheetA spreadsheet is a computer application that simulates a paper accounting worksheet. It displays multiple cells usually in a two-dimensional matrix or grid consisting of rows and columns. Each cell contains alphanumeric text, numeric values or formulas...
s 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 AnalysisCredit analysisCredit analysis is the method by which one calculates the creditworthiness of a business or organization. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or...
/ 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 OfficeFront officeFront office is a business term that refers to a company's departments that come in contact with clients, including the marketing, sales, and service departments...
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 OfficeMiddle officeThe middle office comprises departments of a financial services company that manage position-keeping . These divisions make sure these transaction representations properly capture profit flows given the technological resources...
: typically responsible for risk and valuation measures, the Middle Office interacts with the Collateral Management team on a daily basis. - Legal DepartmentLegal DepartmentThe Legal Department , headed by the Attorney General, was the department responsible for the laws of Hong Kong until 1997, when Hong Kong ceased to be a British crown colony....
: 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.
Establishment of collateral relationship
Once new customer is identified by Sales department, a basic credit analysis of that customer is conducted by the Credit AnalysisCredit analysis
Credit analysis is the method by which one calculates the creditworthiness of a business or organization. The audited financial statements of a large company might be analyzed when it issues or has issued bonds. Or, a bank may analyze the financial statements of a small business before making or...
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
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
Credit Support Annex (CSA)
Credit Support Annex
A Credit Support Annex, or CSA, is a legal document which regulates credit support for derivative transactions. It is one of the four parts that make up an ISDA Master Agreement but is not mandatory...
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 volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
- Timings regarding the delivery of collateral (margin call frequency, notification time, delivery periods)
- Interest rates payable for cash collateral
Then the collateral teams of each counterparty implement and automate the collateral relationship. Bank codes, SWIFT
Swift
The swifts are a family, Apodidae, of highly aerial birds. They are superficially similar to swallows, but are actually not closely related to passerine species at all; swifts are in the separate order Apodiformes, which they share with hummingbirds...
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.
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.
- CustodyCustodian bankA Custodian bank, or simply custodian, is a specialized financial institution responsible for safeguarding a firm's or individual's financial assets and is not likely to engage in "traditional" commercial or consumer/retail banking such as mortgage or personal lending, branch banking, personal...
, ClearingClearing house (finance)A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
and SettlementSettlement (finance)Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against payment of money, to fulfill contractual obligations, such as those arising under securities trades....
(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. - ValuationValuation (finance)In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
s: to valuate all securities and cash positions held or posted as collateral. Traditionally, valuationValuation (finance)In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
has been done on an end of day (EOD) basis, but is now moving toward intraday and real time valuationValuation (finance)In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
where possible. - Margin CallMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
s: 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 callMargin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
s are made via telephone, fax, email, or SWIFTSwiftThe swifts are a family, Apodidae, of highly aerial birds. They are superficially similar to swallows, but are actually not closely related to passerine species at all; swifts are in the separate order Apodiformes, which they share with hummingbirds...
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
Advantages and Disadvantages of Collateral
There are both advantages and disadvantages to collateralising business transactions:Advantages of Collateral:
- Reduced credit risk:Credit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
mitigation of current and potential future exposure to losses due to non-payment by counterparty. - Capital savings: collateralising and nettingNettingIn general, netting means to allow a positive value and a negative value to set-off and partially or entirely cancel each other out.In the context of credit risk, there are at least three specific types of netting:...
counterparty exposures reduces the amount of economic capital required to cover credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
and balance sheetBalance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
protection (e.g. Basel IIBasel IIBasel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
, Solvency IISolvency IIThe Solvency II Directive is an EU Directive that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency....
). 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 settlementSettlement (finance)Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against payment of money, to fulfill contractual obligations, such as those arising under securities trades....
. - 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 managementAsset liability managementIn banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
, etc.
Disadvantages of Collateral:
- Increases Operational RiskOperational riskAn operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
: Collateralisation is complicated. Failure to invest in the correct technologies, staff, third-party relationships, and operate collateral processes accurately and efficiently creates additional operational riskOperational riskAn operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
and a false sense of security. - Legal RiskLegal riskLegal risk is risks that counterparty are not legally able to enter into a contract. Another legal risk relates to regulatory risk, i.e., that a transaction could conflict with a regulator's policy or, more generally, that legislation might change during the life of a financial contract.-The Risk...
s: 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 RiskMarket riskMarket risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
: 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
See also
- Margin (finance)Margin (finance)In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
- Repurchase agreementRepurchase agreementA repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
- OTC derivativesOver-the-counter (finance)Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
- Collateral Management