Collateral is a property or an asset that a borrower offers as a way for a lender to secure the loan. Collateral arrangement is a risk reduction tool that mitigates risk by reducing credit exposure. Collateral doesn’t turn a bad counterparty into a good one and doesn’t eliminate credit risk. Instead, it just reduces the loss at the time of default. Collateral arrangement is an essential element in the plumbing of the financial system.
The counterparty exposure is measured on a date when the counterparty is deemed to be in default. This is consistent with the terminology and concept of “Exposure at Default” in CCR. Standing at a reporting time bucket t, the collateral assets has been posted in the past, and the collateralized exposure depends on the “liquidation” value of the derivative portfolio and collateral assets at some future time.
The collateralized exposure is measured as the valuation difference between the derivative portfolio and collateral assets. In this collateral method, derivative trades and the collateral assets are handled similarly. They are deemed as two “sub-portfolios” with opposite trade direction.
The benefits of Collateral Posting inlude: reduce credit risk, free credit lines with existing counterparties, increase business with counterparties, expand the range of counterparties, and equalize the disparity in counterparty creditworthiness.
There are two types of collateral arrangement: pledge and title transfer. Under the Pledge type, the giver posts collateral to the taker and the giver still owns the collateral. If the giver defaults, the taker can take the cash or sell the securities. It is widely used in US.
Under the Title Transfer type, the taker owns the collateral and the giver is only entitled to the return of fungible securities and/or repayment of cash. It is widely used in the stock-lending and repo market.
CSA (or Margin Agreement or Collateral Agreement) is a legal document that regulates collateral posting. Trades under a CSA should be also under a netting agreement, but not vice verse. It defines a variety of terms related to collateral posting. Threshold (TH) defines the amount below which no collateral is posted. Minimum transfer amount (MTA) is the minimum amount that can be transferred for any margin call. Independent amount (or initial margin or haircut): it is the amount of collateral required to open a position.
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