Collateral 101

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Strate logo 2014

Collateral management is increasingly becoming a topic of interest. Not only has the volume of collateral exchanged rapidly grown over the past decade, but regulatory reforms and international recommendations are also expected to place additional pressure on the need for collateral in global financial markets.

Many financial institutions have only just begun to fully appreciate the high cost of inefficient collateral management and the importance of using systems to more effectively manage their collateral.

Here, Strate features collateral management 101. If you have any further questions, email collateral@strate.co.za.

Some questions answered

1. What is collateral?

Collateral is typically an asset (such as cash or securities, the latter of which is made of equities, bonds and money market instruments) that is used by borrowers to offer lenders as security over a loan.  The collateral serves as protection for the lender against the borrower in the event that the borrower defaults. Should the borrower not be able to pay back the loan, then the lender has the right to sell the collateral (asset) to recoup potential losses that are owed to them.

2. So is collateral a type of financial insurance?

In some ways it is. Collateral acts as partial insurance to cover the credit exposure or credit risk i.e. which is the loss to the lender, in the case of the borrower defaulting on his payment.

a. What is a bilateral transaction?

This is a transaction that takes place between two parties, which are called counterparties. The agreement between these two counterparties comes with its own criteria specific to the deal and have been negotiated beforehand, where both parties promise to carry out the terms of their agreement.

Counterparties can include banks, broker-dealers, hedge funds and corporates.

3. Placed collateral versus received collateral

When you are the counterparty that is lending cash/an asset to a counterparty, then you receive collateral from that party as your insurance against the credit risk of that transaction. However, if you are the borrower that lends from another counterparty, then you have to give/place/pledge collateral with that party to provide them with security over that transaction in the case that you default on the payment.

4. Collateral management

Collateral management is the continuous process of providing, taking and evaluating collateral to cover against the credit risk you may be faced with relating to your counterparty credit exposures.

The allocation of collateral is a complex process that involves defining which collateral is eligible to be received or placed and valuation mechanisms, both pre-agreed by counterparties. Efficient collateral management assists counterparties to mitigate credit risk, by identifying and allocating a similar valued asset in return for the loan/assets/cash that were lent.

Based on the changes in the market value, the collateral value to be allocated is continually adjusted, and margin calls will be made. Margin calls are calls from the lender of funds to invoke the borrower to provide additional funds, when there is a decrease in market value of the collateral. These calls are made to minimize the credit risk, so that in case of a default by the borrower, there are sufficient assets as collateral. Efficient collateral management should be able to rebalance the exposures by either requesting for more collateral from, or returning collateral to counterparties when market prices of the collateral change.

For example, if you need shares as collateral to cover an exposure of R1000, and those share prices move on a daily basis, there may be times that the share price drops and you are exposed to counterparty credit risk. Depending on certain criteria in your agreement as well as various calculations that determine the credit risk, you can call on more collateral to cover this risk.

5. Re-use/rehypothecation of collateral

When hedge funds, pension funds and insurers place collateral with large financial institutions, these banks can potentially re-use the collateral that has been placed with them in the bank’s name, to generate a return for themselves. This means that a single source of collateral can be recycled by a number of parties in the financial market, helping to lubricate the financial system. Therefore, collateral has multiple uses.

6. Collateral optimisation

Collateral optimisation is the process that determines the most efficient manner to identify and allocate collateral, keeping all parameters set out by the lender and borrower in mind.

a. The benefits of collateral optimisation for both the lender and the borrower show that an investment in technology can generate a greater return on investment through optimisation related cost-savings.

The benefits include:

  • the efficient management and allocation of collateral;
  • avoiding over-collateralisation;
  • easily identify idle surplus collateral;
  • compliance with regulatory requirements; and
  • freeing up liquidity, to name a few.

7. What is placing more pressure on collateral?

Since the financial crisis, investors want more protection – safer assets and less credit risk. So they want high quality collateral and they want counterparties that can be trusted.

Part of that crisis internationally was that banks in the US lent out money recklessly. As credit was given easily, foreign counterparties borrowed from US banks. A lending or credit bubble formed across the world, particularly across the US, Europe and some parts of Asia. When a large number of these counterparties defaulted and went insolvent, they couldn’t pay their debt and needed to get bailouts from the government, as they were not sufficiently collateralised.

In an attempt to stop the 2008 financial crisis from happening again, more stringent regulatory requirements are being implemented by government. Regulators are calling on banks and other financial institutions to have more liquid assets, such as cash, on their balance sheets (with Basel III and Solvency Assessment and Management), which will have an impact on the availability of high-quality liquid assets in the market.

Also, the Group of 20 (G-20) Finance Ministers have recommended that all standardised OTC derivatives should be centrally cleared with central counterparties (CCPs), which will require counterparties to place collateral with CCPs, while non-cleared OTC derivatives have to also be collateralised. As a member of the G-20, South Africa also adopts their recommendations, which include the processing of collateral management transactions.

8. The curious case of collateral fragmentation and operational silos:

Collateral agreements are more often than not bilateral in nature. This therefore leads to fragmentation of collateral through silos, not only within an institution, but also within the greater market as agreements that exist between counterparts and are not visible to the market.

The nature of the current bilateral arrangements within the market bring with it limitations, such as:

  • inefficient use of and ability to optimise collateral within an organisation operating in silos, as there is often an incomplete overview of available collateral as well as collateral placed and received across an organisation;
  • inability to optimise market wide collateral due to the fact that counterparties are unaware of common bilateral relationships that exist with their counterparts, as they can only ‘see’ their collateral as far as their direct counterparts;
  • the uncertainty relating to the location and size of the collateral that has been placed;
  • lack of an audit trail of reused collateral movements; and
  • movements of collateral on a T+1 basis or later, which exposes the collateral receiver to credit risk until the collateral is received.

9. What is the solution for South Africa?

Strate has launched its centralised, market-wide integrated tri-party collateral management service to complement current collateral management functions within financial institutions. This service aims to improve the tracking and efficient use of collateral management in South Africa.

Strate’s Collateral Management Services can manage bonds, equities, money markets and other eligible asset classes in multi-currencies

a. This service brings the following benefits to the South African financial markets:

  • standardisation of collateral operations, message types and timelines across counterparts;
  • near-time collateral movements of cash (through central bank payments) and securities (by leveraging Strate’s existing position as South Africa’s CSD);
  • the ability to automatically manage bilateral eligibility criteria of collateral regularly on an intra-day basis;
  • automatically allocate the cheapest way to deliver securities against open exposures;
  • automatic management of collateral top-ups, returns and cash margin calls;
  • automatic substitutions within the bilaterally defined eligibility criteria;
  • internal and market-wide optimisation of collateral;
  • improved market liquidity;
  • improved asset safety:
    • mandatory use of Segregated Depository Accounts (SDAs);
    • perfecting pledges; and
    • tracking of all collateral movements – prevention of unauthorised reuse and controlled reuse.
  • Reduction in operational and settlement risk and the concomitant administrative burden associated with using securities as collateral.

10. A global approach to collateral management: The Liquidity Alliance

Strate is one of the initial five members of the Liquidity Alliance, a group of CSDs that have joined forces to collaborate on a global solution for collateral management. The Alliance gives members an opportunity to exchange information, identify common needs and extend global collateral solutions while encouraging the development of informed research. All members of the Alliance operate off the Clearstream platform, which will also pave the way for cross-border collateralisation in the future.

The initial members of the Alliance are as follows:

  • ASX, Australian Stock Exchange;
  • Cetip, one of the Brazilian CSDs;
  • Clearstream, the German and Luxembourg-based international CSD;
  • Iberclear, the CSD in Spain; and
  • Strate, the CSD in South Africa.