RATIONALE FOR COLLATERAL MANAGEMENT

EXCHANGE TRADED OTC

Terminology Margin, Initial Margin Settlement Collateral, Independent Amount Security
Purpose (Realised Immediately) (legal challenges ownership)
Type Cash (Same CCY as trade) Multiple ccys/securities

A B
CASH
+ SECURITIES
-

Bank A becomes economic owner of collateral if B defaults.

Reduces counterparty risk but gives rise to new risks.
Posting: B has optionality.
Returning: B may ask for specific securities

1
 COLLATERAL TERMS

‘RISK MITIGATION BENEFIT VS. OPERATIONAL WORKLOAD’

1. THRESHOLD
C = max (MtM – Threshold, 0)
 Lowers Operational Burden & Liquidity Cost.
 Determination: Credit Limit
 Zero Threshold: More common (Central Clearing)

2
2. INITIAL MARGIN/INDEPENDENT AMOUNT
Threshold UNDER – Collateralization, Initial Margin OVER - Collateralization

 Posted upfront
 Irrespective of
 Uncommon in bilateral markets MtM
 Intuitively, a negative threshold.  Tackle GAP risk
IM & Threshold don’t occur
together.

3. MINIMUM TRANSFER AMOUNT & ROUNDING

 Min. amount of collateral that  Collateral amount called/returned

can be Transferred (BALANCE!) rounded to multiple of a certain size
 Additive with Threshold. (securities)
 Round up/round down/advantage of
one party
Apply mainly to securities
collateral
4. HAIRCUT
PRE – SPECIFIED
HAIRCUT (x%)
(When CSA agreed)
MARGIN 4
Valuation Percentage Set to cover a severe potential worst case
POSTED (100%)
drop during chosen horizon
(100 – x)%

FACTORS impacting Haircut

 Time taken to liquidate

 Vol. of underlying market variables.
 Default risk of security
 Maturity & liquidity of security
 WWR e.g. Sovereign Bonds from Bank; Euros (Cash) from Euro bank.

4
 CSA

MASTER Cover same

AGREEMENT transactions

Based on Net MtM of covered

transactions

CREDIT Terms:
SUPPORT  Method/timing of valuations.
ANNEX  Calculation of Collateral.
(CSA)  Method/timing of transfers.
 Eligible collateral.
 Dispute resolution.
 CSA

NO CSA TWO WAY CSA ONE WAY CSA

One/both parties cannot Both parties agree to post. One party can receive but
commit. Corp. treasury & will not post.
bank Bank & Bank
Supranational & Bank

(*) can be riskier than no CSA

6
 Mechanics of Collateral

2. Call Frequency:
1. Valuation Agent:
Trade off: Lower Freq. helps reduce opr.
Calculates MTMt (netted), Exposure, Ct
Burden
(Haircuts),
OTC: Daily; (less frequent practical for
Ct
low volatility)
Larger of two (Responsibility) | Both CCP: Intraday
(Disputes) 3rd Party

7
 Disputes Resolution

Amount Y
SPLIT THE
< Tolerance DIFFERENCE

Notify counterparty/VA
before CoB (T+1)

Transfer Undisputed amount.

Identify reason within “resolution
time”

Call for MtM quotes

(traders/collateral)
Types of Collateral

Collateral Back Office

Collateral = Optimization tool (Deliver/Substitute Collateral to
optimize on funding costs/remuneration rates)

Types:

Cash, Govt. Securities, Govt. agency securities, US municipal

bonds, covered bonds, equities.

Non - Cash Vs Cash:

Problems:
- more costly
-Reuse & rehypothecation
limited supply
-Price uncertain
-Correlation with exposure
11
 Types of Collateral Transfer

Collateral Transfer: Economic Ownership

 Security Interest  Collateral give stays economic owner (till default).
Receives economic benefits. (unless netted against
A B a collateral call).
 Remuneration: Interest @ OIS rate paid on cash
collateral (higher to incentivize posting of cash)
“Interest” Transferred. Collateral can be used
in certain events.

 Title Transfer

A B

Legal Possession transferred

10
 Types of Collateral Treatment

Collateral Substitution
 Giver may request a return co-operational reasons, optimism
 Post alternative amount of eligible collateral (haircut applied)

Collateral Rehypothecation
 Cash collateral& collateral under title transfer: reusable (used in a repo/another
agreement).
 Reduces funding costs & demand for HQ collateral.
 Obvious in OTC markets: (flow of collateral in system).
 Risk : Hypothecation collateral not returned in default (Less prevalent after GFC)
Collateral Segregation
 ↓ Contemporary risk & ensure return of collateral.
 Held with collateral receiver, 3rd party acting on behalf of one party, triparty custody.
 Legal vs Operational.
 Cash: only by triparty.
 Segregation relevant in security interest.
 Causes funding issues.
 Variation on margin: never segregated (avoid added counterparty risks)
Note – Variation margin is rehypothecated while Initial Margin is Segregated
 REGULATORY CAPITAL REQUIREMENTS

CENTRALLY CLEARED
Threshold Zero
IM Required for all parties
Type of VM Cash (Transaction ccy)
Type of IM Cash & liquid secs.
Frequency Daily/intraday
Negotiation CCP defined

16
 Bilateral Clearing – New Guidelines

1. AIMS – 4. REQUIREMENTS IN –
In full (no netting), α = 99% T = 10d, internal
Reduce Systemic risk & Promote Central
models/regulatory tables stressed historical
Clearing
data
(conservative + procyclicality) segregated,
2. APPLICABLE TO – phase
‘Covered’ entities (Sovereigns, Central – in, secured interest, securities allowed
Banks, BIS exempt.) (risk sensitive haircuts)
IM – allow netting across positions
3. REQUIREMENTS VM –
standard approach – ISDA SIMM
Daily, zero threshold, MTA < €500,000,
Hypothecated & netted, posted in full (no
phase – in), cash 5. IMPLEMENTATION & IMPACT IM – Impact
new transactions only.
CSA –
 New CSA
 Amend CSA (new & old)
 Replicate & amend (existing CSA:
legacy amended: new trades)
17
 Risks arising because of Collateralization

1. MARKET RISK

Qualifying market risk: MPOR (Effective time b/w a counterparty ceasing to post collateral
time when call transactions have been successfully closed out/replaced).

2. LIQUIDITY, FX AND WRONG WAY RISKS

Transaction Liquidity Risk Adverse link b/w default &

(Volatility over Liquidn period, Bid offer spreads, value of margin securities.
exogenous + endogenous) Solution: Impose Currency mismatch
concentration limits b/w margin portfolio
FUNDING LIQUIDITY RISK in question
High Funding cost during stressed times
Asymmetricity
3. LEGAL AND OPERATIONAL RISKS

Ability to net margin against value Missed margin calls, failed deliveries,
portfolio, portfolio valuation, human error. with scale and non-
segregation and rehypothecation. 13
standard margin agreements.