Collateral is an asset (normally cash or Bonds) transferred or pledged by a borrower to a lender. In the event of a default, the collateral may be taken by the lender to repay the loan.
Collateral is typically required to fully or partially secure derivative transactions between institutional counterparties such as banks, broker-dealers, hedge funds, and lenders.
In the case of a privately negotiated derivatives transaction, the essential mechanism by which collateralization works is to provide an asset of value that is to the side of the primary transaction.
In the event of default on the primary transaction, the collateral receiver has recourse to the collateral asset and can thus indirectly make good any loss suffered.
Importance of Collateral Management:
- Covers counterparty risk (default risk).
- Increases liquidity.
Regulation
The International Swaps and Derivatives Association, Inc. (“ISDA”) has outlined guidelines for all OTC transactions.
Two parties have to sign ISDA agreement while entering into OTC trade.
This ISDA agreement has Credit Support Annex (CSA) which outlines standard guidelines for collateral management.
Types of Collateral Assets
- Cash Collateral.
- Physical assets and Commodities Collateral.
- As mentioned under CSA (Credit Support Annex)
Terms in Margin Call Calculation
Mark to Market (MTM / Exposure): The act of recording the price or value of a security, portfolio or account to reflect its current market value. If the exposure is in favor of our client, he is in the money and vice versa.
Initial Margin (IM): Initial Margin or Independent Amount (IA) are additional amounts of collateral for specific trades or types of trades, the amount of which generally is determined based risk of the underlying. Because they are trade-specific, IM typically are documented in a trade confirmation rather than in the ISDA master agreement.
Collateral Balance: This is collateral pledged or held by the client or counterparty as off today. Collateral can be settled in cash as well as securities (bonds) and depends upon client’s preferences.
Threshold: The parties may agree to collateralize their exposure to one another only to the extent that such exposure exceeds a certain amount – namely, the Threshold. Hedge funds generally have agreed to post collateral based on a zero Threshold amount, so that dealer is fully collateralized, while dealers generally have agreed to post only above a specified amount.
Minimum Transfer Amount (MTA): MTAs are designed to prevent the calling of nuisance amounts. This avoids unnecessary costs involved in small transfers. Collateral calls for amounts smaller than the MTA are not permitted.
Rounding: This amount is agreed between the two parties to avoid uneven amounts being transferred.
Notification Time: The standard ISDA Credit Support Annex requires collateral to be posted by the next business day or the second following business day, depending upon whether a demand for collateral was made prior to or after the Notification Time.
OTC Collateral Calculations
Example of Margin Call Calculation:
| Margin Call Calculation | CSA Factors | |||
| MTM (Exposure) | 1,235,698 | Threshold | – | |
| Independent Amount | 500,000 | MTA | 250,000 | |
| Collateral Balance | – | Rounding | 10,000 | |
| Margin Requirement | 1,735,698 | |||
| Margin Call Amount | 1,740,000 | |||
Note: CSA factors are applied to the “Margin Requirement” figure based on which “Margin Call Amount” figure is derived.
Interest Settlement Process
The Interest Settlement process is basically settlement of interest on the cash collateral pledged or held by clients and counterparties on monthly basis. The interest rates are decided as per the currency in which collateral is settled.
Example: If counterparty A is holding USD 1,000,000 as collateral from client then they have to pay interest on monthly basis as per the interest rate agreed in CSA.
If the collateral is settled in securities, there will be NO collateral interest settled. Collateral team will confirm securities balance as off the last day of the month.
Repo & Reverse Repos
Repurchase agreement or a Repo is an agreement of sale of securities for cash by one party (the cash borrower) to another party (the cash lender), with the promise made to repurchase those securities later.
Reverse Repo is the repo as seen from the point of view of the cash lender, since the cash lender does not repurchase, but rather has securities repurchased from.
Purpose – For the repo seller, the purpose of a repo is to acquire short-term capital and obtain access to cheaper funding costs of other speculative investments.
For the repo buyer, repo is an opportunity to invest cash for a customized period of time. It is short-term and safer as a secured investment since the investor receives collateral.
Process – Daily & month end process remains similar to OTC Collateral process.
OTCWIRE 