Collateral

To reduce counterparty risk beyond the accomplishments of other risk-mitigating procedures, the role of collateral and the crucial relation between collateralization and funding is expounded in this chapter.

Rationale for Collateral

Any asset that supports a risk in a legally enforceable way can be termed as collateral. The risk is reduced by a collateral agreement when specifications are made that the posting of collateral should be done by one counterparty to the other for the exposure to be supported.

They are similar to a netting agreement as it is essential for a collateral to be posted by both counterparties against a negative mark-to-market value, therefore making it two way. In case of a decline in exposure, the collateral must be returned or posted in the opposite direction, due to the bilateral nature of collateral agreements.

In the event of a default, often, collaterals posted against positions of OTC derivatives may be immediately liquidated as they are under the counterparty’s control. The implication, therefore, is that new risks, like liquidity risk, arise even though the purpose of collateral is reducing counterparty risk. Additionally, collateral has funding implications.

Analogy with Mortgages

Because a mortgagor may fail to pay for the mortgage in future, the mortgage lender incurs credit risk. To mitigate the risk, the house takes the role of collateral and gets pledged against the borrowed value. This arrangement gives rise to the following residual risk:

  1. Negative liquidity corresponding to market risk: This entails the property’s value falling below the mortgage outstanding;
  2. Operational or legal risks: The mortgage lender may be forced to incur costs in order to evict the defaulters in the event;
  3. Liquidity risk: The challenges of immediate selling of the property in the open market and an eventual fall in the property’s price; and
  4. Liquidity risk: A strong dependence between the property’s value and the mortgagor’s default poses the another risk.

Collateral Terms

The Credit Support Annex (CSA)

Parties are permitted by CSA to further mitigate their counterparty risk by agreeing to contractual collateral posting, as it has become, in bilateral markets, the market standard collateral agreement. As included in the master agreement CSA will cover the same range of transactions and the basis of collateral requirements will be made by the net MTM of these transactions.

The collateral posting agreement will be defined in details by the number of key terms and parameters chosen by the parties within the CSA, and it cover a number of aspects, namely: the underlying valuations’ method and timings, the posted collateral amount’s computation, the collateral transfers’ mechanics and timing, the eligible collateral, the collateral substitutions, the dispute resolutions, the posted collateral’s remuneration, haircuts applied to collateral securities, the likelihood of re-hypothecation of collateral securities, and triggers changing the conditions of the collateral.

If two counterparties agree to collateralize their exposure, then they can apply the following process:

  1. The CSA containing the terms and conditions under which they will operate will be signed and negotiates by the parties;
  2. Transactions subject to collateral are regularly marked-to-market, and the overall valuation is agreed;
  3. The collateral is delivered by parties with negative MTM and if relevant, posting of the initial margins is also affected;
  4. To reflect the cash and securities transfer, the collateral position is updated; and
  5. Risk of disputes will be reduced when periodic reconciliations are performed.

Types of CSA

The existence of the many different collateral arrangements can be attributed to OTC derivatives counterparties’ different nature. Collateral agreements that exist are:

  1. No CSA: Due to the lack of commitment, by one or both parties, to collateral posting, CSAs are not used in trading relationships of some OTC derivatives.
  2. Two-way CSA: As the agreement to post collateral is by two parties, the CSA becomes two-way and is more typical for two financial counterparties.
  3. One-way CSA: In case the receipt of collateral can be by a single party only, which sometimes is the case, then the used CSA will be one way.

All collateralization parameters must be explicitly defined by a collateral agreement and all likely scenarios taken to account. Balancing between calling and returning collateral versus the benefit of doing so to risk mitigation determines the choice of parameters.

Threshold

Under-collateralization comes about when the collateral falls below the threshold. Un-collateralization of the underlying portfolio occurs when no collateral can be called due to MTM falling below the threshold. Only the collateral’s incremental amount can be called for in case of the MTM being above the threshold.

Zero thresholds is re-becoming increasingly common for both parties as collateral agreements are as much pure counterparty risk issues. CSAs with nonzero thresholds receive a rather conservative treatment from the regulatory capital.

Initial Margin

Irrespective of the underlying portfolio’s MTM, the extra collateral amount that must be posted is defined by the initial margin which in general, is independent of MTM and is usually required upfront at the inception of trade.

In bilateral markets, the initial margin has been uncommon except for hedge funds posting to banks and banks posting to supranationals or sovereigns. Even though initial margins are being increasingly driven by more dynamic methodologies, they have been historically relative static amounts.

Typically, an initial amount can be taken as a negative threshold since thresholds and initial margins function in opposite directions. Hence, they are never seen together. Furthermore, gap risk is also cushioned by the initial amount; in case the portfolio’s value, in a short time-span, gaps substantially.

The common methods for computing initial margin are based on \(VaR\) models, but there is no market standard set for this computation.

Minimum Transfer Amount and Rounding

This is the least transferrable collateral amount and is used to avoid the workload of transferring insignificant collateral amounts frequently. Since the sum of the minimum transfer amount and threshold must be exceeded by the exposure for any collateral to be called, the minimum transfer amount and threshold are additive.

For noncash collateral, minimum transfer amounts and rounding quantities are relevant as it becomes challenging for small amounts to be transferred. The terms are generally zero in cases where cash-only collaterals are used.

Haircuts

The most common type of posted collateral has always been cash. In the event of default by a counterparty, the price of the asset may fall between the last collateral call and liquidation. This will be accounted for with the reduction in the asset’s value.

An \(n\%\) haircut implies that for every security posted as collateral, only \((1 – n)\%\) of credit will be given, with an account of the haircut being given by the collateral giver. The potential correlation between the valuation of collateral and the exposure is a crucial consideration.

In the determination of eligible collateral, the points to consider that when assigning haircuts are: the security’s default risk, the security’s maturity, the security’s liquidity, the period of collateral liquidation, and the volatility of the underlying market variables defining the collateral’s value.

Linkage to Credit Quality

As the credit quality of a counterparty deteriorates, the collateral becomes more crucial and it becomes worthwhile to be frequently able to take more collateral. For increased mitigation of counterparty risk, an increased operational cost in the management of the collateral is worthwhile when a lower-rated counterparty is faced.

The deterioration of a counterparty’s credit quality leads to limited benefits of rating triggers. Furthermore, the need for more collateral to be posted and the consequent funding challenges can introduce great suffering to institutions afflicted by a downgrade.

Credit Support Amount

The credit support amount is the collateral amount requested at a given point in time. The collateral subject can possibly be called for the minimum transfer amount should the MTM of the portfolio less the threshold take a positive value from either party’s view. For either party to call the collateral amount at any point in time, the following steps must be applicable:

    1. The hypothetical collateral amount is computed by accounting for the thresholds using:

$$ max\left( MTM-{ threshold }_{ c },0 \right) -max\left( -MTM-threshold,0 \right) $$

Where; \(threshold\) and \({ threshold }_{ c }\) represent the institution’s threshold and their counterparty’s threshold, respectively, with \(C\) being the already held collateral amount.

  1. Ascertain if the absolute value of that calculated amount above exceeds the minimum transfer amount.
  2. The amount is rounded to the relevant figure if it exceeds the minimum transfer amount.
  3. The value of any initial margins is separately calculated since they do not depend on the above variation margin amount.

Mechanics of Collateral

Collateral Call Frequency

The periodic timescale with which the collateral may be called and returned is called collateral call frequency. For operational workload to be reduced and relevant valuations carried out, a longer collateral call frequency may be called upon. In most OTC derivatives markets, daily calls have grown more standard despite collateral call frequency longer than daily being practical for asset classes and not-so-volatile markets.

Valuation Agents, Disputes and Reconciliations

The parties making the computations on the amount of credit support are referred to as valuation agents. Their role in collateral computation is to calculate:

  1. The current MTM under the netting impact;
  2. The previously posted collateral’s market value and adjusted by the relevant haircuts;
  3. The total exposure that is uncollateralized; and
  4. The amount of credit support.

The OTC market has been known to be decentralized and non-transparent leading to significant disagreements. In case of disputes, the following are steps to apply:

  1. Before the close of the day following the collateral call, the disputing party has to notify its counterparty of the intended exposure or collateral computation dispute.
  2. The undisputed amount should be transferred by the disputing party upon agreement and the resolution of the dispute will be attempted within a specified timeframe.
  3. In case of failure to solve the dispute within the resolution time, mark-to-market quotations will be obtained by the parties for the disputed exposure’s components.

The factors that normally lead to a dispute are: trade population, methodology of trade valuation, the market’s close time and data, previously posted collateral’s valuation, and CSA rules application.

Title Transfer and Security Interest

The two practical collateral transfer methods are:

  1. Security interest: An interest in the collateral assets is acquired by the receiving party and used under certain events that are contractually defined, but the collateral does not change hands.
  2. Title transfer: With potential restrictions on their usage, the underlying collateral assets and legal possession of collateral changes hands are outrightly transferred.

Collateral and Funding

The eligibility and re-use of collateral have recently gained interest significantly due to the significance of funding costs. Traditionally, for OTC derivatives, the role of the collateral has been to mitigate counterparty risk. Funding provision has been a role incorporated with the passage of time.

Substitution

For operational or optimization reasons, a party may request the return of its collateral securities. It, therefore, becomes necessary for a substitution request to be made for an alternative amount of eligible collateral to be exchanged. The collateral holder must give consent for the substitution to be affected. A gentleman’s agreement, in some situations, based on the consent for the substitution request, seems to be the best way forward.

Rehypothecation

The right of rehypothecation must be possessed by other collaterals, despite cash collateral and collateral posted under title transfer being intrinsically reusable, implying that it can be used by the collateral holder.

The use of hypothecation, where allowed, reduces funding costs and demands for collateral of high quality. In OTC derivatives markets, many parties possess multiple hedges and offsetting transactions. Hence, rehypothecation would seem to be obvious. Therefore, a flow of collateral through the system is allowed by rehypothecation without the creation of additional liquidity challenges.

Segregation

Counterparty risk can be reduced by the segregation of collateral which calls for the legal protection of the posted collateral should the receiving party be insolvent. This can be achieved by either legal rules that ensure any unrequired collateral is returned, or by third-party custodians holding the initial margin.

The segregation collateral can be potentially held in the following three ways: by the collateral receiver directly, by a third party representing either party or in a tri-party custody. Despite segregation being the clear optimal method to reduce counterparty risk, it still causes potential funding challenges for replacing a collateral that can be simply rehypothecated.

Collateral Usage

In the markers of OTC derivatives, practices have in the recent years been changing significantly. Those market practices will be a review in this chapter.

Extent of Collateralization

Across the market, collateral posting is quite mixed, depending on the type of the institution. Liquidity needs and operational workload linked to posting cash under tight collateral agreements are main causes of these differences. However, the usage of collateral has witnessed significant increase in the recent past.

Type of Collateral

Challenges, of reuse or Rehypothecation and additional volatility due to posted collateral’s price uncertainty and its likely adverse correlation to the original exposure, are created by non-cash collateral.

The major collateral form taken against exposures of OTC derivatives is cash. It may be limited in supply and generally expensive to post in extreme market conditions.

Immediate replacement an underlying security held as collateral becomes necessary when its credit rating declines below the specified one in the collateral agreement.

The Risks of Collateral

Just like netting, the overall effect of collateral is barely to reduce risks but instead redistributing it. Counterparty risk is essentially transformed into other forms of financial risks. This, therefore, gives rise to other potential risks like legal risks, should the envisaged terms fail to be upheld within the relevant jurisdiction.

Impacts of Collateral outside the Markets of OTC Derivatives

In a default scenario, OTC derivatives creditors are paid more at the expense of other creditors. Consider the following case scenarios:

  1. No Collateral: Other creditors, in this case, claim two-thirds of the defaulting firm’s assets while the other senior party receives the remaining third.
  2. Variation Margin: If a defaulting party posts encumber of variation margin to another party against their full derivative liability, the value received by other creditors in default will be reduced.
  3. Initial Margin: Should the defaulting party pay a number of variation margin, say 60, and a lower number of initial margin, say 30, the initial margin is used entirely by the other party in the close-out and replacement expenses of its transaction with the initial party.

Market Risk and Margin Period of Risk (MPR)

The residual risk that remains under the collateral agreement can exist due to contractual parameters effectively delaying the collateral process. The inherent delay in receiving collateral is a crucial aspect despite the freedom of thresholds and minimum transfer amounts to be set at zero/small values.

The effective period between the stop by the counterparty to post collateral and when all the underlying transactions have been closed-out and successfully replaced is called the margin period at risk (MPR).

It is generally useful for the MPR to be defined as a combination of two periods namely pre-default and post-default:

  • Pre-default represents the time before the counterparty defaults and includes the following components: valuation or collateral call, receiving collateral, settlement, and grace period.
  • Post-default represents the process after the counterparty is in default contractually hence the start of the close-out process to: close-out the transactions, re-hedge and replace the collateral, and finally liquidate the collateral.

The need for the initial margin is primarily driven by the MPR which is a rather simple catch-all parameter that should never be literally compared with the actual time taken to perform the closeout and replace the transactions.

Operational Risk

The operational risk is a very crucial aspect as the nature of collateralization is time-consuming and intensely dynamic. The examples of operational risk are: missed collateral calls, failed deliveries, computer and human error, and fraud plus many others.

The following should be considered based on operation risk:

  1. Accurate and enforceable legal contracts;
  2. The many distinct tasks and checks should be automated by capable systems;
  3. The complexity and extreme time-consuming aspects of the regular calls and returns processes of collateral increase the workload in volatile markets;
  4. It is crucial to value accurately all transactions and collateral securities in a timely manner;
  5. Accurate maintenance of data concerning initial margins, minimum transfer amounts, rounding, collateral types and currencies, for each counterparty; and
  6. Swift follow-up of failure to deliver the collateral, which is a dangerous signal.

Funding Liquidity Risk

Funding needs arising due to collateral terms is an important aspect of liquidity risk. This is called funding liquidity risk. Liquid assets may be possessed by some end users who hold limited amounts of cash but most do not have substantial liquid assets or cash that can serve as collateral.

Some non-financial clients trade with banks under CSA to increase the range of counterparties for lower transaction costs. This may raise funding liquidity challenges as collateral requirements may be significant.

When posting collaterals, end users face funding liquidity risks due to the likelihood of default as they may be solvent but unable to meet collateral requirements within the period specified. Banks also face funding liquidity issues as their aim is to run flat OTC derivatives books hence raising the cost of funding from the nature of their hedging.

Regulatory Collateral Requirements

General Requirements

The intention of variation and initial margin is to reflect the current and potential future exposures in that order. The following should be exchanged by covered entities for non-centrally cleared derivatives:

  1. Variation margin: must be bilaterally exchanged on a regular basis with a maximum transferable amount clearly stipulated.
  2. Initial margin: should be exchanged with no netting amount by both parties, bankruptcy protected. The underlying value portfolio should have a 99% confidence level and be based on an extremely plausible move. In addition to the daily variation margin exchanged, the assumption of a ten-day period is consistent with the Basel capital requirements. Its computation can be based on internal models and regulatory tables.

The following aspects should be considered by new or modified CSAs:

  1. Minimum amounts transferred and thresholds
  2. Eligibility of collaterals
  3. Haircuts
  4. Computations, timings, and deliveries
  5. Dispute resolutions
  6. Initial margin computations and mechanisms of segregation.

Computation of Initial Margin

For different asset classes, the initial margin should be separately computed and their sum should be the total requirement. The following are the relevant asset classes: currency/rates, equity, commodities, and credit.

When using standardized margin schedule, the net gross ratio (NGR) formula, defined as the net replacement divided by the gross replacement of transactions, should be applied to account for initial portfolio effects.

The following formula is used by the NGR to compute the net standardized initial margin requirement:

$$ Net \quad initial \quad margin=\left( 0.4+0.6+NGR \right) \times Gross\quad initial\quad margin $$

A simple representation of the future offset between positions is given by the NGR, applying the reasoning that 60% of the current offsets can be assumed for future exposures.

Standardized Initial Margin Method (SIMM)

A general model for initial margin possesses the following features:

  1. The effects of diversification recognition and risk-sensitivity
  2. The ease of implementation
  3. The transparency for the purposes of dispute resolution and predictions
  4. The possession of general regulatory approval

The driving factors of initial margin needs are as follows:

  1. Sensitivity to various risk factors;
  2. Risk weights; and
  3. Correlations and aggregation.

Converting Counterparty Risk into Funding Liquidity Risk

When the initial margin is required, the collateral is further increased by bilateral collateral rules. This is taken further by adding default funds and potentially more conservative initial margin requirements through central clearing.

Practice Questions

1) Which of the following risks best represents market risk and is often called “negative equity”?

  1. The risk of strong interdependence between the property value and the default of the mortgagor
  2. The risk of the property value in consideration falling below the outstanding of the loan or mortgage
  3. The risk of the mortgage lender facing legal obstacles and is, therefore, unable to claim ownership of the property in case of default by the borrower
  4. The risk of funding needs that arise due to collateral terms, especially when collateral needs to be segregated and cannot be rehypothecated

The correct answer is B.

Option \(B\) corresponds to market risk and is often called negative equity. Negative equity occurs when the value of a real estate property falls below the outstanding balance on the mortgage used to purchase that property.

In mathematical terms:

$$ Negative\quad equity=Current\quad market\quad value\quad of\quad the\quad property-Balance\quad on\quad the\quad outstanding\quad mortgage $$

Option \(A\) represents correlation or wrong way risk. Option \(C\) corresponds to operational risk or legal risk and affects mortgage in that, the lender faces expenses \(I\) order to evict the defaulter. Option \(D\) represents funding liquidity risk.


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