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Margin (Collateral) and Settlement

After completing this reading you should be able to:

• Describe the rationale for collateral management.
• Describe the terms of a collateral and features of a credit support annex (CSA) within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount.
• Describe the role of a valuation agent.
• Describe the mechanics of collateral and the types of collateral that are typically used.
• Explain the process for the reconciliation of collateral disputes.
• Explain the features of a collateralization agreement.
• Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality.
• Explain aspects of collateral including funding, rehypothecation, and segregation.
• Explain how market risk, operational risk, and liquidity risk (including funding liquidity risk) can arise through collateralization.
• Describe the various regulatory capital requirements.

The Rationale for Collateral Management

In simple terms, collateral refers to an asset supporting a 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 deliver/make 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 to 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:

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/returning collateral and costs in the close-out process. The initial margin and the threshold work in opposite directions. How exactly, you might ask. Recall that by definition, the 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 undercollateralisation. 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 that can be used as collateral may not be infinitely divisible, e.g. cash. The rounding may always be up or always down, or 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 $$\left[=\frac {100m}{1-0.02} \right]$$ would have to be posted.

In essence, the haircut protects the buyer/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:

$$\textbf{Example of rating-linked collateral parameters}$$

$$\begin{array}{c|c|c|c} \textbf{Rating} & {\textbf{Initial Margin} \\ \textbf{(% of total notional)}} & \textbf{Threshold} & \textbf{Minimum Transfer Amount} \\ \hline \text{AAA/AAa} & {0} & {250\text{m}} & {5\text{m}} \\ \hline \text{AA+/Aa1} & {0} & {150\text{m}} & {2\text{m}} \\ \hline \text{AA/Aa2} & {0} & {100\text{m}} & {2\text{m}} \\ \hline \text{AA-/Aa3} & {0} & {50\text{m}} & {2\text{m}} \\ \hline \text{A+/A1} & {0} & {0} & {1\text{m}} \\ \hline \text{A/A2} & {1\%} & {0} & {1\text{m}} \\ \hline \text{A-/A3} & {1\%} & {0} & {1\text{m}} \\ \hline \text{BBB+/Baa1} & {2\%} & {0} & {1\text{m}} \\ \end{array}$$

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

The “credit support amount” as 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 the minimum transfer amount as discussed above.

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 to be 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/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; and
• 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.

There are certain key aspects that every collateral agreement must set out:

• Eligible currencies
• Type of agreement (one-way or two-way)
• Eligible securities
• Timing regarding posting/return of collateral
• Margin call frequency
• Interest rate for collateral posted in cash

There are many eligible securities that can be posted as collateral. The most common assets include the following:

• Cash
• Treasury securities
• Highly rated mortgage-backed securities
• Commercial paper
• Letters of credit
• Equity

Most parties prefer cash over any other eligible collateral in part because it is liquid and can be delivered on short notice without too much operational risk. The availability of cash, however, tends to be limited in times of market stress. Noncash collateral comes with several problems, particularly in terms of Rehypothecation and price volatility.

The Process for the Reconciliation of Collateral Disputes

For centrally cleared transactions, collateral disputes are rare and are quickly solved because the central counterparty is the valuation agent. Central counterparties are able to do this because their valuation methodologies are market standard, transparent, and robust. For OTC derivatives, however, disputes are fairly common.

In most cases, a dispute over a collateral call in OTC markets arises due to one or more of the following:

• Market data and market close time
• The value of previously posted collateral
• Application of credit support rules with regard to aspects like threshold and eligible collateral

Most disputes have much to do with the non-transparent and decentralized nature of the OTC market. Collateral agreements usually specify valuation differences that are considered tolerable. If a dispute is based on a valuation difference within the tolerable level, counterparties are allowed to “split the difference.” If not, the cause of the discrepancy has to be investigated further. Disputes lead to a situation where one party has a partially uncollateralized exposure which lasts until a solution is found.

Whenever there is a dispute, counterparties engage the following resolution steps:

The disputing party is required to notify the counterparty of its intention to dispute the exposure or collateral calculation. This should happen no later than the close of business on the day following the collateral call.

The disputing party transfers the undisputed amount and the two parties immediately launch a dispute resolution mechanism in an attempt to unearth the source of the dispute within a certain timeframe.

If no solution is found within the specified timeframe, the counterparties request MTM quotes from several market makers (usually four).

A good way to minimize the possibility (and frequency) of disputes and valuation differences is to perform reconciliation at regular intervals. Reconciliation can be done before the start of trading or during trading to pre-empt future disputes.

Two-way vs. One-way CSA Agreement

In the OTC market, three possible collateral agreements exist:

1. No CSA Some trading relationships do not use CSAs because both parties cannot commit to collateral posting. A party’s refusal to post collateral can arise due to:
• One party’s credit quality is far superior to the other party
• Unwillingness to absorb the operational and liquidity costs (risks) associated with CSAs
2. One-way CSA In a one-way CSA relationship, only one party can receive collateral either following a trade-related event such as a positive exposure event or a non-trade event such as a rating downgrade. A typical example would be a trade between a high-quality entity such as a triple-A sovereign and a bank. One-way CSA presents an additional risk to the collateral giver
3. Two-way CSA In a two-way CSA, both parties agree to post collateral. Parties with more or less the same credit quality often prefer this type of CSA. In fact, two-way CSAs are very common in the interbank market and create benefits for both parties.

Substitution

In some cases, a counterparty may want their collateral returned at some point after posting. Which begs the question, just why would a party want their securities returned? There are two main reasons:

• The collateral giver may wish to use the securities posted for some other purpose
• The collateral giver may withdraw the existing collateral if they feel some other collateral is more appropriate and optimal, perhaps due to a change in the state of the OTC market or the economy as a whole.

In these circumstances, the collateral giver makes a substitution request to replace the collateral in use with some other eligible collateral of equivalent value. In some trades, substitution can only happen with consent from the collateral receiver/holder. If no consent is required, then the holder cannot turn down the request.

Rehypothecation

Rehypothecation, also called re-use, is the process whereby one party receives collateral and then reuses it to honor their collateral obligations with another counterparty. While some assets such as cash and collateral posted under title transfer are intrinsically reusable, other types of collateral must have a right of Rehypothecation.

Although rehypothecation makes the OTC derivatives a bit more liquid, it comes with risks. Consider the case where party A pledges collateral to B, but B subsequently rehypothecates the collateral to another party C with whom it has a separate trade. If party C defaults, it means that party B will incur a loss since it won’t receive back the collateral, particularly under a title transfer agreement. The problem doesn’t end there; party B will still have a liability to party A for not returning the collateral.

In short, rehypothecation can create an intricate web of potentially crippling liabilities. It was a popular practice in the lead-up to the 2007/2008 financial crisis. Recent years, however, have seen a scaling back of rehypothecation as parties increasingly prefer cash and stricter collateral management rules.

Segregation

Even in the absence of rehypothecation, the risk that collateral posted by a party may not be retrieved remains. Segregation is a legally enforceable practice that requires counterparties to return any unused collateral at the end of a contract, in priority over any bankruptcy rules. Segregation can also be achieved by placing collateral in the hands of a third party custodian. Rehypothecation rules out segregation and vice versa.

Risks that Arise through Collateralization

Market Risk

Market risk arises in the sense that there is likely to be some market movement that will occur after the last posting of collateral. For example, the collateral may fall in value irreversibly, such that any haircuts in place do not offset all of the loss. Although the market risk may not result in an actual loss, it still exposes the collateral holder to a significant loss in the event of default.

Even though collateral significantly reduces counterparty risk, elements of the credit support annex such as thresholds and minimum transfer amounts, which tend to delay posting of collateral, mean that there’s still some residual risk

Margin Period of Risk

The margin period of risk (MRP) is a term that is specific to counterparty risk and refers to the effective time between a counterparty ceasing to post collateral and when the underlying transactions have been closed-out or replaced. The period between posting and close-out/replacement is crucial because any increase in an exposure remains uncollateralized.

Operational Risk

In the process of handling collateral, several specific operational risks emerge:

• missed collateral calls;
• failed deliveries;
• computer error;
• human error;
• fraud

Operational risk increases as an institution engages in a higher number of trades. A bank may have thousands of OTC collateral agreements with as many clients. Such a bank may post or receive collateral running into millions of shillings every day, a scenario that comes with large operational costs in terms of human and technological resources.

To reduce operational risks, the following are paramount:

• Legal agreements that are accurate and enforceable
• Robust and resilient IT systems that can handle many daily tasks and automate most of them
• Timely and accurate valuation of all transactions and securities used as collateral
• Maintaining a databank regarding initial margins, minimum transfer amounts, rounding, collateral types, and currencies for all counterparties
• Close monitoring of collateral deliveries where a delay or failure to post is considered a potentially dangerous signal

Legal Risk

Holding collateral gives rise to legal risk in that the non-defaulting party may be faced with legal challenges if they attempt to seize and use collateral held to compensate for their loss after a default event.

Liquidity Risk

As noted earlier, it is difficult to liquidate collateral at its market value, possibly in stressed market conditions. When a default event occurs, an institution (non-defaulting party) will usually seize assets designated as collateral, sell them for cash, and then attempt to initiate new hedges elsewhere. But selling such assets for their true worth in such circumstances is difficult. This is especially true for large volumes of collateral that cannot be sold without triggering some kind of a market shock that might push the price down. A party in such a situation may decide to sell the assets in smaller quantities, but that also means it exposes itself to market volatility for a longer period.

A case of wrong-way risk where there’s a link between the value of the collateral and the counterparty’s credit quality only serves to further drive up liquidity risk.

Funding Liquidity Risk

An institution engaged in collateralized transactions faces funding liquidity risk in the sense that it may not be able to meet frequent collateral demands in line with contractual agreements. Most institutions usually do not have substantial cash reserves or liquid securities that can be leveraged quickly and posted as collateral. Segregation, if present, further clips an institution’s funding capabilities because it cannot rehypothecate collateral already held.

Foreign Exchange Risk

Collateral posted in foreign currency is prone to exchange fluctuations. Although this risk can be hedged in spot and forward markets, care must be taken to ensure that it does not result in additional risks for the institution.

Practice Question

Apart from the derivatives market, collateral is also an important concept with regard to mortgages. Which of the following risks best represents market risk and is often called “negative equity”?

A. The risk of strong interdependence between the property value and the default of the mortgagor

B. The risk of the property value in consideration falling below the outstanding of the loan or mortgage

C. 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

D. The risk of funding needs that arise due to collateral terms, especially when collateral needs to be segregated and cannot be rehypothecated

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.

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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