The Rationale for Collateral Management

In simple terms, collateral refers to an asset supporting risk in a legally enforceable way. Why is collateral necessary? At any point during the life of a derivative contract, one party will have a positive exposure (the party will be “winning”) while the other will have a negative exposure (the party will be “losing”). The winning party needs a sign that the counterparty is committed to delivering/making available the winnings in accordance with contractual stipulations. The party with the negative exposure will, therefore, post collateral in the form of cash or marketable securities to the party with positive exposure.

In most cases, collateral is bilateral, i.e., either side of a transaction is required to provide collateral to the other side with positive exposure. The collateral receiver becomes the permanent economic owner of the collateral only upon default by the collateral giver. If the collateral giver defaults, the non-defaulting party has a legally enforced right to seize the collateral and use it to offset any losses relating to the MTM of their portfolio.

However, collateral may also be one-way, particularly when trading with institutions that have an impeccable credit history.

Counterparties regularly mark their positions to market and calculate the net value. After that, the party that has a negative exposure may be required to post collateral against their position in line with the dictates of the contract. In most cases, collateral posting takes place in blocks at specified points during the life of the contract.

There are several motivations for managing collateral:

1. By reducing credit exposure, a counterparty is able to get into a relatively higher number of transactions. In other words, collateral provision increases either party’s confidence to initiate more trades.
2. Collateral provision sometimes gives an institution the ability to trade. This often happens in situations where an institution’s financial condition or credit rating precludes it from participating in the uncollateralized derivatives market.
3. Collateral provision paves the way for competitive pricing of counterparty risk.
4. Collateral provision provides institutions with a way of reducing their regulatory capital requirements by transferring or pledging eligible assets.

Since collateral agreements are often bilateral, collateral must be returned or posted to the other party as soon as exposure decreases. Posting and returning collateral are not materially different. However, the party returning collateral may be asked to deliver specific instruments.

Collateral Terms

Credit Support Annex

The Credit support annex, CSA, is a document that sets out the terms for the provision of collateral in a derivatives contract. It forms part of the ISDA Master Agreement which is the umbrella document that sets out the overarching terms between parties in a contract. The CSA need not be part of the Master Agreement but in recent years, it has become an important part of bilateral OTC agreements.

As with netting, ISDA has a major input in the wording and enforceability of the CSA throughout a large number of jurisdictions. The CSA covers the same range of transactions at the Master Agreement but collateral requirements are still based on the net MTM of all the transactions. However, the CSA will often give parties room for negotiations with regard to a number of parameters and terms that dictate posting/return of collateral. Precisely, parties are allowed to deliberate over the following issues:

• Method and timings of the underlying valuations.
• The calculation of the amount of collateral that will be posted.
• The timing of collateral transfers.
• Eligible collateral securities.
• Collateral substitutions.
• Dispute resolution.
• Haircuts applied to collateral.
• Rehypothecation (reuse) of collateral securities.
• Triggers that may initiate a tightening or loosening of collateral requirements.
• Remuneration of collateral posted.

The CSA defines the following parameters:

Threshold

The threshold is the amount below which collateral is not required. If the MTM is below the threshold then no collateral can be called and the underlying portfolio is, therefore, uncollateralized. But as soon as the MTM rises above the threshold, the incremental amount of collateral has to be called for. For example, let’s assume that a contract specifies a threshold of $10,000 but the MTM, following today’s market movement, stands at $12,000. In this case, $2,000 worth of collateral would be required.

A non-zero threshold indicates that counterparties are willing to tolerate counterparty risk up to a certain level. In some cases, the threshold is set at zero, indicating that collateral needs to be posted under any circumstance.

Initial Margin

Also known as independent margin in bilateral markets, the initial margin refers to the extra collateral required independent of the level of exposure. Every party must post the initial margin irrespective of the MTM of the underlying portfolio, and this usually happens upfront. In effect, the initial margin serves as an extra layer of protection against potential risks such as delays in receiving or returning collateral and costs in the close-out process.

The initial margin and the threshold work in opposite directions. “How exactly?” you might ask. Remember that, by definition, a threshold is the amount below which collateral is not required, and in essence, therefore, it limits or rather puts a cap on the amount of collateral. The initial margin, on the other hand, specifies an amount of extra collateral that must be posted irrespective of the MTM of the underlying portfolio. In essence, therefore, the initial margin actually increases collateral and leads to overcollateralization, while the threshold leads to undercollateralization.

Minimum Transfer Amount

This is the minimum amount of collateral that can be called at a given time. Counterparties often set a minimum in a bid to avoid the workload associated with the frequent transfer of insignificant amounts of collateral. The minimum transfer amount and threshold are additive in that the MTM must exceed the sum of the two before any collateral can be called.

Rounding

When posting or returning collateral, the quoted amount is usually rounded to a multiple of a certain size to avoid dealing with awkward quantities that may not be deliverable. Some securities, e.g. cash, that can be used as collateral may not be infinitely divisible. The rounding may always be up or down, or, it might always be in favor of one counterparty. For example, collateral may be rounded up for all calls and rounded down for all returns.

Haircut

In most cases, it is difficult to liquidate collateral at its market value, possibly in stressed market conditions. Therefore, a repo margin (called haircut in the US) is imposed. It is the difference between the market value of the security used as collateral and the value of the exposure.

A haircut of 2%, for example, means that for every unit of that security posted as collateral, only 98% of the credit (“valuation percentage”) will be given. To see how this works, assume that a 2% hair cut applies, and the collateral call amounts to $100 million. In this case, collateral with a market value of $102.041 million [=$100m1−0.02] would have to be posted.

In essence, the haircut protects the buyer or lender against:

• Liquidity risk when liquidating the collateral.
• Credit risk of the seller.
• Operational risk (e.g. margining lag and efficiency and speed of default procedure).
• Legal risk, i.e. legal challenges that may come up during the liquidation process.

Most of the assets used as collateral are subject to haircuts except cash posted in a major currency.

Credit Quality

Credit quality refers to the creditworthiness of a counterparty as indicated by their credit rating (issued by a reputable, widely recognized rating agency). As the credit quality decreases (increases), the need for collateral increases (decreases). In fact, thresholds, initial margin, and minimum transfer amounts may all be linked to credit quality. A party rated AAA, for example, may not be requested to post an initial margin, and it may as well enjoy higher threshold and minimum transfer values. The table below illustrates this:

Although collateral parameters are mostly linked to credit ratings, they can also be linked to a counterparty’s market value of equity, traded credit spread, or even their net asset value.

Credit Support Amount (Margin)

The “credit support amount” is the amount of collateral that one counterparty must have transferred to the other party at a given point in time. As mentioned previously, collateral requirements are set in a way that minimizes operational costs. The collateral that may be requested at a given point in time is subject to the threshold and minimum transfer amount as discussed above.

Example 1: Credit Support Amount

Suppose two counterparties enter into a derivative contract which includes an initial margin requirement of $10,000 and a threshold of $5,000. On a particular valuation day, the mark-to-market value of the derivative in favor of Counterparty A is $18,000. What is the credit support amount that Counterparty B needs to post?

Solution:

The credit support amount refers to the variation margin that must be posted when the mark-to-market exposure exceeds the threshold. Initial margin is posted separately as an independent amount and does not reduce or replace the variation margin requirement.

Given:

• MtM in favor of A = $18,000
• Threshold = $5,000
• Initial Margin = $10,000 (independent amount, handled separately)

First, calculate the exposure above the threshold:

Exposure above threshold = $18,000 – $5,000 = $13,000

Since variation margin is calculated independently of initial margin, Counterparty B must post the full amount above the threshold:

Credit Support Amount = $13,000

Hence, Counterparty B must post $13,000 in variation margin.

Example 2: Credit Support Amount

Consider two counterparties with an existing collateral agreement and the following measures in place: a threshold of $4,000, a minimum transfer amount (MTA) of $1,000, and no initial margin. The current collateral balance stands at $3,000 in favor of Counterparty A. On the following valuation day, the mark-to-market value moves to $6,500 in favor of Counterparty A. How much collateral must Counterparty B post or receive after this market movement?

Solution:

1. Calculate the new exposure for Counterparty A after market movement: $6,500.
2. Deduct the threshold to find the collateral required above the threshold: $6,500 – $4,000 = $2,500.
3. Since the new exposure above the threshold ($2,500) is less than the existing collateral balance ($3,000), we must check against the MTA. The decrease in required collateral is $500 ($3,000 – $2,500), which is less than the MTA of $1,000.
4. Counterparty B does not have to post or receive any additional collateral, because the change is less than the established MTA.

Therefore, the collateral balance remains unchanged due to the MTA provision, and no additional collateral is required to be posted by either counterparty.

The Role of a Valuation Agent

The valuation agent is the party charged with calculating the credit support amount in line with the dictates of the credit support annex.

In trades where there’s a big gap in the credit quality between the counterparties, the party with better credit quality (which we may call the senior party) often insists on being the valuation agent for all purposes. The party will evaluate the trade status at the end of each day of trading to determine whether collateral needs to be called or returned. The smaller (less creditworthy) party is not obligated to post or return collateral unless it receives a notification from the valuation agent, but the latter may be under obligation to make collateral returns where possible. In trades where both counterparties have largely the same credit quality, they may both act as valuation agents.

In general, the valuation agent calculates:

• The current MTM under the impact of netting.
• The market value of collateral previously posted, taking into account the relevant haircuts.
• The total uncollateralized exposure.
• The credit support amount.
• Mechanics of collateral and the types of collateral typically used.

Since the 2007/2008 financial crisis, collateral requirements have been tightened in OTC markets around the world. As the figure below shows, credit derivatives are the most collateralized due to the high volatility of credit spreads, while the commodities market is the least collateralized.