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Collateral Management Guide PART 5: Mechanics of Collateral Management


Managing financial collateral is a complex process involving multiple parties.

Parties involved

 - Collateral Management Team:  Does collateral calculations on spreadsheets and dedicated software, delivers and receives collateral, runs the collateral operations, maintains customer and securities data, issues and receives margin calls, and liaises with customers, service providers, Legal, Middle Office, and other parties in the collateral chain.

 - Credit Analysis / Approval Team:  Researches, analyzes and sets collateral requirements for new and existing counterparties.  Typically this entails a preliminary review as well as ongoing periodic reviews of the credit risk of each counterparty.

 - Front Office Sales and Traders:  Sales people develop new eligible trading relationships and manage the onboarding process for new accounts, including signing of legal collateral documents, account formation, and ongoing sales transactions.  Traders may execute trades only with approved counterparties. 

- Middle Office:  Typically responsible for risk and valuation measures, the Middle Office interacts with the Collateral Management team on a daily basis.

 - Legal Department:  Conducts negotiations, drafting and review of agreements.  Enforces collateral and margin agreements, including initiation of collections and lawsuits where appropriate.  Legal is required to sign off on all written agreements.

 - Valuation Team:  This group focuses on valuing illiquid or exotic collateral and underlying trade position that must be collaterized.  Typically, these types of collateral and deals are thinly traded rather than liquid exchange-traded instruments.

- Accounting & Finance Team:  Works with the Middle Office to calculate and account for P&L on collateral posted and received. Also works with Tax and Auditors.

- Third Party Service Providers: Software providers, Consultants, Auditors, Tax Specialists, Tri-Party Collateral Managers.

Creating a new collateral relationship

For OTC transactions, collateral is the norm rather than the exception.  Prior to the widespread use of derivatives, collateral was required by large banks only for smaller or riskier customers (such as hedge funds or niche brokers), under the assumption that other large banks would rarely default on their obligations.  With the dramatically increased leverage built into the financial system through derivatives and securitized pools, collaterization is now mandatory between almost all counterparties. 

Once a new customer is identified by Sales, the first step is to conduct a basic credit analysis of that customer. This is done by the Credit Analysis team.  Only credit-worthy customers will be allowed to trade on a non-collaterized basis.

The next step is to negotiate and enter into the appropriate legal agreements.  In the world's major trading centers, counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure clear and effective contracts exist before transactions begin. These agreements cover 90% plus of the information on eligible collateral, margin requirements, independent amounts (haircuts) calculation and payment methods, etc.  Negotiation and finalizing these agreements can take up the bulk of the time in developing a new relationship, often extending weeks or months.

Then the collateral teams at each counterparty implement and  automate the collateral relationship.  Bank codes, SWIFT codes, custodian and transfer relationships, key contacts and phone numbers, report formats, margin call processes, etc. are all communicated and entered into the collateral systems of both counterparties.  This process may be done in a matter of days or take up to several weeks.

If the two parties want to trade right away, they will typically post some initial reciprocal collateral with the other party (either cash or default-free Treasury bonds) to "open the account."  This lays the groundwork for new trades, which will only require "topping up" the collateral to meet initial margin requirements.

Once these items are in place, the Front Office Sales and Traders can begin negotiating trades.  Once a trade is agreed upon, the Collateral Team is notified of the deal, and the required Initial Margin is posted to enable the trade to occur.  

Daily Collateral Operations Process

The Collateral Management team's job is to continually track, value, and give or receive collateral during the life of every OTC trade in the institution's portfolio.  This is a large and complex task requiring sophisticated systems and dedicated personnel.  The general tasks on a day-to-day basis include:

- Managing Collateral Movements:  tracking the net MTM valuation, making and fielding margin calls, and giving / taking collateral to offset credit risk on a deal and net portfolio basis.

- Custody, Clearing and Settlement:  Depending on how the legal relationship is structured, one or the other counterparty may act as a custodian for cash and securities, or a third party custodian may be hired.  This requires segregated accounts strictly for collateral by customer (and often sub-account level).  The custodian manages collateral inflows and outflows, counterparty payments (top-ups, etc.), interest calculations, haircuts, dividends, coupon payments, etc. as well as accounting for and reporting all transactions accurately and timely.  The custodian role is often outsourced, especially by hedge funds who typically outsource this function to a custodian subsidiary of their prime broker.

 - Valuations:  The Valuation team (often part of the Collateral or Middle Office team) is responsible for valuing all securities and cash positions held or posted as collateral.  This duty is affected by the valuation roles defined in the CSA -- for example, many smaller hedge funds delegate valuation to their prime brokers who may have greater access to comparative valuation data, valuation models, and large teams of qualified staff.  Traditionally, valuation has been done on an end of day (EOD) basis, but is now moving toward intraday and real time valuation where possible.

 - Margin Calls:  When the Collateral Team determines that the mark-to-market change of a particular deal or net portfolio position has moved against the counterparty by at least the Minimum Amount, a margin call is issued.  Margin calls are made via telephone, fax, email, or SWIFT message, stating the amount of collateral demand and often the type of collateral required, if defined in the relevant CSA.  The counterparty is then required to top-up its collateral account by delivering cash or securities, typically by overnight wire transfer.  If the counterparty does not meet its margin call, and the amount is large enough, the Collateral team may issue a notice indicating the trading relationship is temporarily or permanently halted until the account is brought to net zero exposure.  If the counterparty does not respond the custodian is notified, and the existing collateral may be seized, and the account turned over to the Legal department for enforcement of any outstanding obligations.  Typically, the Front Office will offer the counterparty the opportunity to "break" the deal and pay a penalty before full legal action is taken.  The above dynamics are reversed if the first party is the net debtor (i.e. receives one or more margin calls).

- Substitutions:  Often one party would like to substitute one form of collateral for another.  For example, cash rather than Treasury Bonds, or Corporate Bonds rather than Treasuries.  The Collateral Team will then look to the CSA for guidance on acceptable substitute collateral (if covered) or make a decision based on the perceived value of the substitute collateral.  Collateral substitution allows for flexibility in the relationship, and the ability to deliver good collateral at a lower net price.  Once a substitution is accepted, this must be properly tracked in the Collateral Management system as well as communicated to all relevant parties (custodians, valuation team, etc.), and followed up to ensure the substitution actually occurs.

Processing:  Payment and event processing is often outsourced to a dedicated third party.  This function includes:
  - Coupon payments
  - Dividend payments
  - Corporate actions (splits, reverse splits, share buybacks, etc.)
  - Payment delays (accruing, accounting and charging interest or lost capital gains/losses)
 - Redemptions
 - Taxes (accounting for and issuing the necessary tax documents for each tax jurisdiction so customers can properly account for and pay their taxes)



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