Collateral eligibility is one of the key steps in a stable trading relationship.  Since the purpose of collaterization is to secure or insure all or a portion of the counterparty credit risk in a trading relationship, eligible collateral must be easily converted into economic value when needed (i.e. when a counterparty defaults).

Basic Requirements for Collateral Eligibility

- Liquid:  Securities used as collateral must be highly liquid (marketable) so they can be sold for cash in the open market on short notice.  This may also apply to certain currencies as well -- USD and EUR are liquid, but Turkish Lira may not be.

- Easy to settle:  Treasury bonds, AAA Corporate bonds, large-cap equities, and many mortgage-backed bonds are easy to settle, typically taking no more than one day.

- High quality (default free):  Collateral itself should not have significant embedded credit risk itself.  Major industrialized country government bonds are unlikely to default, whereas junk bonds and emerging market bonds have significant and widely varying credit risk and are unlikely to be accepted as collateral.

- Approved by the Credit Department:  The Credit Team must approve all securities offered as collateral prior to acceptance.  Guidance is taken from the Credit Support Annex (CSA), but the Credit Team should have final say since their credit analysis is often more up to date than the legal documents.

Types of Collateral

According to ISDA, the following types of collateral are most predominant:

- Cash (73% of USD and EUR trades according to ISDA 2005).  Cash is easy to hold, easy to transfer, requires little or no valuation.

- Fixed Income Securities:  Predominantly Government Securities (Treasury Bonds, Agency Bonds, etc.), but also includes other types such as MBS, ABS, corporate bonds, sovereign bonds, etc.

- Bank Guarantees

- Equities (stocks):  Usually large-cap and highly liquid shares listed on major exchanges.

- Real Estate:  Commercial buildings, land, etc. if deemed sufficiently liquid.  This collateral is more relevant to structured project financing transactions.

- Convertible Bonds:  These must be issued by a credible company with low default risk, and must convert into marketable common stock or premium stock at a significant discount.

- Exchange Traded Funds (ETFs)

- Mutual Fund Shares:  This can be very complicated due to interactions between custody, taxes, trading limitations, ownership concentrations, and redemption rights.

Considerations in Valuing Eligible Collateral

The ability to quickly and accurately value collateral is a critical element of its eligibility, without which the collateral has little use.  Collateral provides no security if it cannot be valued or traded for a known value.  When deciding whether collateral is eligible, the following factors are important:

- Who values the collateral? This is usually governed by either the CSA or trade documents (deal term sheet).  The choices are: 1) you, 2) me, 3) both, or 4) third party.  Two banks will typically push for either 2) me or 3) both, so that each has a hand in the final determination and can bring their valuation expertise to bear.  Smaller hedge funds without dedicated valuation teams usually choose 1) you or 4) third party.  This gives valuation control to the prime broker which typically has dedicated valuation personnel and a wider view of market prices. 

- How is it valued?  Depending on the type of trade, the valuation may be done on a mark to market (MTM) or mark to model (theoretical valuation) basis.  Where the trade is fairly vanilla and there are plenty of comparative market prices, mark to market is selected.  For more exotic or complex transactions, mark to model may be necessary, and the determination of a) the model used, and b) who does the valuation, becomes extremely important.  These factors should be decided up front before doing a deal, or at least subject to approval by the Collateral or Valuation teams before a deal is completed.

- How often is it valued?  Traditional valuation is done on an end of day basis (EOD) after the market closes.  However, with the advancement of collateral systems, electronic order networks, and other technology, there is a movement toward periodic intraday (i.e. 30 or 60 minute intervals) or real time valuation.  Illiquid trades are still valued on a daily basis and sometimes weekly or monthly for highly structured deals.

- Independent valuation required?  In some instances a deal is so unique or illiquid that a third party valuator or appraiser is required to theoretically price a deal for collateral and PnL purposes.  Where this is necessary, the issue becomes cost, the number of independent valuators used, and how to decide on a final value from multiple different estimates without proceeding to litigation.

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