What is known as "collateral" is the set of assets, in the form of securities or cash given as security by the debtor to the creditor in order to hedge the credit risk of the financial transactions negotiated between two parties. In case of default by the debtor, the creditor is entitled to retain the assets given as collateral in order to compensate the financial loss suffered.
The use of giving collateral, or "collateralising" operations, has undergone constant development in recent years and the financial crisis of 2007-2008 of course resulted in even greater development. The implementation of the Basel 2 agreements, which reduce the capital requirement for operations covered by collateral, also contributes to the interest in this practice. The management of available collateral, which can be used as security for a debt, thus becomes a strategic issue for the actors.
In contrast, the organized markets and the associated clearing houses, by concentrating the reciprocal exposures of the actors, allow to reduce these collateral requirements (even if some collateral is required to contribute to the compensation, it takes less than what what would be needed to cover the same volumes negotiated in a bilateral agreement!).
Contexts of use
The transfer of collateral is a common practice in OTC (Over The Counter) markets. The best known collateralised transactions are the repos or repurchase agreements, which are cash loans secured by securities. Securities lending and borrowing are loans of securities backed by cash or securities collateral. In the OTC derivatives market (swaps, credit derivatives), securing transactions by collateral has also become widespread.
The rules for the management of collateral are then usually defined in a bilateral agreement (legal agreement) signed by both parties prior to the start of negotiations. The agreement stipulates a number of elements that will be detailed below: the types of assets transferred as collateral, the rules for valuing these assets, the thresholds of margin calls, whether the collateral received may be reused ("rehypothecation"), etc.
Participation to clearing
The organized markets of securities or derivatives generally run in conjunction with a clearing house. The clearing house replaces the participants, becoming the buyer for all sellers, and the seller for all buyers (novation mechanism). Thus it assumes the counterparty risk in their stead. To hedge against this risk, it will ask for security deposits, therefore for collateral, whose value will be calculated according to the positions opened by the participant. The daily re-evaluation of these positions based on market prices leads to margin calls.
Refinancing operations of the central bank
Commercial banks can find funding from the central bank of their country of residence. Within the Eurosystem, as indeed in most countries, these loans are only granted by the central bank against collateral given as security. Such guarantees may be marketable securities - the list of securities eligible for refinancing by the Eurosystem is regularly updated and published on the ECB website. Credit institutions may also give as collateral credit claims on non-financial debtors (corporates), which roughly corresponds to the old abandoned practice of "discounting". Here too, specific rules define the eligibility of such mobilized claims.
Real time gross settlement systems (RTGS)
Payment systems and real time gross settlement systems (ESES, TARGET2) have the characteristic that all transactions are either settled immediately and charged to the accounts of participants or placed on hold. These systems have the advantage of safety: since imputation is immediate and irrevocable, the uncertainty of net settlement systems, which delay imputation until the end of the day, does not exist. On the other hand, in order to work properly, these systems require participants to have an important liquidity margin. This margin, or "purchasing power", will be given to them by the means of intra-day credit, once again secured by collateral.
In the ESES platform (Euroclear Settlement for Euronext Securities), the auto-collateralisation repo ("Pension Livrée Conservatoire", PLC) mechanism allows participants who temporarily do not have the required liquidity on their account to continue settling their purchase of securities. In TARGET2, the mechanism of the credit line fulfills that purpose. In France, intraday credit is granted in both cases by the Banque de France to the French credit institutions. In ESES, it is guaranteed by securities selected from the same list as securities eligible for refinancing. In TARGET2, it is guaranteed by the same pool of collateral (securities and credit claims) that covers refinancing operations (up to the total amount of the pool minus the value of outstanding refinancing operations).
Choice of the assets offered as collateral
The collateral can either be negotiable securities or cash (private claims used as part of the refinancing of credit institutions of the Eurosystem is a very specific case, although widely used in this context).
In the United States, "performance bonds" are also widely used. A performance bond is a document issued by a bank or insurance company for a third-party whereby the institution commits to cover the debts of the latter in case of failure, usually up to a maximum amount.
When it comes to negotiable securities, these are generally chosen among a pool of low-risk securities (government securities or coming from issuers rated triple-A by the credit rating agencies). They must also be liquid enough to enable the creditor, in case of default, to easily recover his debt by selling them on the market. In order to avoid unnecessary complications, it is preferred to avoid using securities coming to maturity or that pay a coupon during the lifetime of the hedged transaction. It is also good practive to avoid using collateral whose market value is closely related to the valuation of the contract covered (double default risk).
When it comes to cash, it is usually remunerated by the creditor at the market rate (EONIA in the case of the Euro).
The different ways to transfer collateral
The collateral may be transferred in full ownership from the debtor to the creditor against the commitment by the latter to return the same quantity of the same security or the same amount of cash at the maturity of the debt. In this case, the creditor can possibly (depending on the agreement previously negotiated) reuse this collateral as security in other transactions. If the collateral is received in the form of cash, the creditor will obviously invest it since he usually agrees to remunerate the debtor in this case.
The collateral may also be pledged. In this case, the delivered securities remain the property of the debtor, who may dispose of them at will, even if it means bringing another security ins its stead to keep covering his debt. When securities are dematerialised, they are registered in an account of financial instruments which is itself pledged for the benefit of the creditor.
The collateral can be transferred directly from the debtor to the creditor who is its custodian until the maturity of the debt covered. It can also be managed by a trusted third party. This is called "tri-party collateral". This practice is widespread in the repo market, it is called in this case "tri-party repo". Indeed, the tasks related to collateral management are a burden, which explains that some institutions prefer to reduce their back-office workload by outsourcing this activity.
Collateral management patterns
The collateral may be linked to the contract, that is to say that each transaction is guaranteed individually by one or several lines of securities. Conversely, each line of securities transferred as collateral is bound to a single transaction. The problem with this management method is its lack of flexibility whenever there exist several outstanding transactions between both parties. For example, if the debtor has given the same security twice, for two different operations, and wants his security back, then two substitutions of collateral will be needed (one per transaction).
The collateral can also be managed in a pool. In this case, the debtor provides the creditor with a pool of assets whose aggregate value shall cover all outstanding transactions. This way, substitution of collateral is easier.
Calculation of exposure
Of course, the commitments of both parties in bilateral negotiations are most frequently reciprocal, so that each party is exposed to a default of the other. In this case, the agreement should define whether the exposure calculations provide a netting of commitments or not.
- If netting is allowed, then only the party whose exposure is negative (its liabilities exceed its debts) must post collateral to the other one, to the extent of the difference. This practice is prevalent in the OTC derivatives market.
- If netting is not allowed, then each party shall deliver collateral to the other one up to its gross exposure. This second method obviously requires more collateral. This is the basic scheme of a repo, where the collateral remains associated with the cash loan transaction.
- An intermediate solution is to systematically deliver collateral during the introduction of each new contract, and to always return it at maturity, for an amount equal to the market value of the contract. Only daily variations of contracts and collateral via margin calls are then being made on a net basis.
Valuation of collateral and of transactions
At regular intervals, usually every day, the stock of collateral must be revalued, as well as the stock of contracts (on the OTC market) or open positions (in organized markets) that the collateral is supposed to cover.
The open contracts are valued at their market value or MTM (Mark to Market). Depending on the type of contract, the valuation takes into account the characteristics of the negotiated transaction (nominal value, rate...) as well as the observed market prices. The valuation may be affected by a margin, usually above 100%, that is to say the value of the contract will be overestimated in order to demand more collateral. This valuation determines the exposure, in other terms the loss the contract holder is exposed to in the event of the counterparty default.
Similarly, the collateral is valued at its market price. The collateral value may be affected by a discount or haircut, that is to say that it will be valued at a price less than its theoretical market value, again in order to demand more collateral. The haircut can depend on the nature of collateral. Cash will have a haircut of zero because such collateral is the safest and easiest to liquidate in case of default. Depending on the nature of the issuer, the size of the haircut for securities will vary.
The margin or the discount (haircut) are of course specified in the legal agreement which binds both parties. Both mechanisms are intended to offer a safety margin to the creditor, in order to take into account possible fluctuations in the value of collateral between two margin calls. They are rarely used simultaneously.
On the OTC market, each party revalues all outstanding transactions and the stock of collateral given or received, then both parties compare their results. Obviously there is often disagreement, which may come from differences in the selected price source, or from errors in the stock of contracts. A reconciliation of open positions of both sides may be necessary. This processing is highly demanding on technical and human resources, hence the need to resort to a third-party (tri-party repo).
In organized markets, open positions are valued by the clearing house for its direct members. A widely used method is the SPAN method (Standard Portfolio ANalysis) developed by the CME (Chicago Mercantile Exchange) and used by many clearing houses including LCH.Clearnet.
Regarding central banks, their refinancing operations and the associated collateral are obviously revalued by the central bank itself.
Security deposits and margin calls
The "initial margin" is a security deposit that designates the initial amount of collateral used to cover a new position. A threshold can be defined: open positions will be covered only once their value has exceeded this threshold.
Margin calls denote the flow of collateral exchanged with each revaluation of the stock. Again, to avoid unnecessary expenses, a threshold is set below which the exchange will not occur.
Substitution of collateral
The debtor may ask to recover all or part of a line of securities deposited as collateral. In this case, he will have to replace the returned collateral by another asset of equal value.
In general, it is preferred to avoid giving as collateral a security that may be subject to a corporate action (e.g. payment of a dividend) during the time of the deposit. Should this happen, however, the usage is to return the proceeds of the corporate action to the original owner of the security.