How Collateral Transfers Risk

In OTC trading, counterparties are exposed to the risk that the other counterparty will not make required payments when
they are due.  The risk of non-payment is called credit risk.  These types of payments include derivative deal payments (e.g. interest rate swap payments, CDS premiums or default payments), dividend payments for stocks, coupon payments for bonds, etc. The amount of credit risk varies in real time and must be managed on a trade, counterparty, and net portfolio basis.

The primary purpose for collateralization is to transfer risk from the party in the net positive (gain) position to the party in the net negative (loss) position during the life of a deal.  This is done by requiring the losing party to post or transfer an asset (cash, marketable securities) to the winning party as a form of ongoing security.  In the event of a default, the creditor party then has the right to keep the asset to reduce his loss. The currency value of the collateral represents the estimated probability of payment default, mulitplied by the notional value of the expected payment(s).  This is known as Potential Future Exposure or PFE.

Two simple examples demonstrate this dynamic:

Securities Collateral Example:

1) Net Exposure (single or multiple deals) =  $100
2) Collateral posted previously =     ($80)
3) Net collateral delivery requirement =  $20 = CREDIT RISK
4) Collateral given = $20
5) Net exposure = $0 = NO CREDIT RISK REMAINS

Cash Collateral Example:

1) Net Exposure (single or multiple deals) =  $100
2) Cash Collateral Posted =   ($80)
3) Overnight interest earned on Cash  ($0.10)
4) Net Collateral delivery requirement =   $19.90 = CREDIT RISK
5) Collateral given = $15
6) Net exposure = $4.90 = REMAINING CREDIT RISK

There is an important difference between over the counter (OTC) deals and exchange-traded deals.  OTC transactions do not normally have a clearing house acting in a credit risk mitigation role between the counterparties which guarantees and processes deal payments.  An exchange clearing house insures that buyers and sellers on the exchange will make and receive their payments by requiring traders to post daily margin in the form of cash or marketable securities.  Since this form of insurance is not available to OTC counterparties, they need another form of insurance.  Collateral acts as partial insurance to offset changes in market value. 

Credit risk can shift back and forth from one counterparty to the other on a constant basis.  Mark-to-market values on open positions change daily, weekly and monthly.  The counterparty with a net positive gain is exposed to unsecured credit risk in the amount of open uncollaterized gain. This credit risk can continue to increase until the party has a large unsecured gain.  By demanding additional collateral, this profit is "locked in" or insured up to the market value of the collateral posted, less the transaction costs associated with liquidating the collateral.  In the event of a missed or delayed payment the Taker of collateral can keep the collateral posted and sell it in the open market to offset the lost income.  

Margin agreements typically provide a grace period for the counterparties to negotiate differences in valuation, adjust collateral amounts, substitute one collateral form for another, etc.  This provides some flexibility in the relationship and keeps things running smoothly in the event that a particular type of collateral (e.g. U.S. Treasury Bonds) are not easily available at a reasonable price at the time of the margin call, or there is a disagreement on what the underlying deal value might be (this is common on illiquid OTC structured deals).

Credit Risk vs. Collateral Requirements

Credit departments of banks, broker-dealers, lenders, and buy side institutions rely on a variety of techniques to assess credit risk of their counterparties.  These include:

 - External credit ratings
 - Internal credit ratings
 - Payment histories
 - Statistical default probabilities per counterparty, industry, or market
 - CDS spreads (if the counterparty is an issuer with CDS written on its bonds)
 - Equity prices (the counterparty's equity price is considered an accurate forward-looking gauge of financial health)

Collateral requirements can increase or decrease depending on the factors above.  In addition, two additional factors can influence the amount of collateral required:

 - Length of the deal:  overnight repos have lower collateral requirements than 30 year swaps as there is far less time in which to default.
 - Quality of collateral: more collateral is required if the securities posted are rated less than AAA, or have volatile prices (e.g. credit default swaps)

Deal Risk Still Remains

Even if a deal is properly collaterized, there still remain legal, operational, and other risks.  In particular, bankruptcy of a counterparty can pose extreme challenges in liquidating and collecting the cash value of the collateral posted.  In bankruptcy, it is possible that the collateral can be "clawed back" by the bankruptcy court if it is found that another counterparty had a prior claim to the collateral posted by the defaulting party.  This situation can be complicated further in cross-border deals (domestic or international) by differences in jurisdiction and legal systems. 

It is critical that the Collateral Support Document between the counterparties address these issues and provide for adequate assurance that the collateral posted will be capable of transfer and liquidation on failure to pay, and will not be encumbered by prior pledges or debts.  It is also critical that the jurisdiction in which the transaction was completed fully enforces the collateral agreements and does not invalidate them.

<< BACK TO PART 2

CONTINUED IN PART 4 >>