Collateral Management Guide PART 9: Advantages and Disadvantages of Collateral Author: Financial-edu.com
There are both advantages and disadvantages to collaterizing OTC transactions:
Advantages of Collateral
- Reduced credit risk: mitigation of current and potential future exposure to losses due to nonpayment by a counterparty.
- Capital savings: collaterizing and netting counterparty exposures reduces the amount of economic capital required to cover credit risk and balance sheet protection (e.g. Basel II, Solvency II). This allows increased leverage and profit potential of a bank's assets.
- Increased competitiveness: the ability to trade in a wider variety of markets where the margins may be higher or profits more predictable.
- Improved market liquidity: increased opportunity to do more transactions in the markets, with less capital, and less time required for credit review and settlement.
- Access to higher risk trades: collaterization reduces the risk of illiquid or new trade types which have higher risk but higher profit margins.
- More efficient trading between counterparties: collaterization formalizes an ongoing relationship and makes transactions and payments smoother, with more opportunity to check valuations and balance the gains and losses in a standard, repeatable manner.
- Benefits to Buy Side (asset managers, corporate treasury, etc.)
- Minimize collateral amounts by cross-collaterization
- Minimize collateral movements and give/take collateral on a net basis
- Collaterize exposures by client
- Benefits to Sell Side (broker dealers, banks, etc.)
- reduces capital charge to allocate for asset liability management, etc.
Disadvantages of Collateral
- Increases Operational Risk (aka Murphy's Law): Collaterization is complicated. Failure to invest in the correct technologies, staff, third-party relationships, and operate collateral processes accurately and efficiently creates additional operational risk and a false sense of security.
- Legal Risks: How to structure, document, and manage the collateral agreements requires specialized legal skills, technologies, and trained staff.
- Legal procedures: proper documentation, storage, confidentiality, etc.
- Perfection risk: the possible risk of inability to "perfect a claim" to collateral (assert proper legal ownership) when default is imminent or default occurs.
- Recharacterization risk: the possibility that the collateral might be recharacterized as non-eligible under the jurisdiction's laws and "clawed back" in bankruptcy proceedings.
- Priority risk: the risk that some other counterparty has a prior claim on the collateral you hold, making the collateral ineligible.
- Enforcement risk: risk that the counterparty won't give back your collateral, and the jurisdiction does not honor the collateral agreements due to lax enforcement of contract laws, political pressures, or other reasons.
- Inactive CSA's: Maintaining inactive agreements that may be outdated, including the cost of review, storage, etc.
- Long CSA negotiation period while traders want to trade
- Concentration Risk: the overreliance on a single counterparty once a collateral relationship is established. This increases default correlation and leads to underestimation of single large risks such as a the counterparty going bankrupt suddenly.
- Settlement Risk: The possible failure of securities settlement procedures, including payments, custody, etc. (however this risk also exists in non-collaterized transactions).
- Pricing risk and model risk: Even though a transaction may be collaterized, deals that are complex or securities which are thinly traded rely heavily on pricing models for their valuation and resulting collateral required. Any errors or rapid market shocks during the valuation process can lead to under-collaterization (or over-collaterization) and subsequent losses or inefficient use of capital.
- Can Increase Market Risk: Market risk on securities held as collateral can contribute to the firm's Value-at-Risk by increasing correlations in the firm-wide portfolio under market stress. High correlations lead to increased market risk through the belief that you are adequately collaterized, but everything goes down in value at once, resulting in rapid under-collaterization. To account for this, the firm must include collateral securities and cash in portfolio-wide market risk and pricing calculations.
- Expensive: The solution is often to outsource to tri-party collateral service
- Can reduce trading activity: Collaterizing transactions can actually reduce trading activity by eliminating more risky counterparties. This occurs when there are:
- Overly high thresholds
- Delays in posting / receiving collateral
- Collateral Operations are highly manual and slower than the traders
- Trade eligibility is lowered based on low availability of a narrow and expensive range of acceptable collateral (e.g. Treasury Bonds)
<< BACK TO PART 8
CONTINUED IN PART 10 >>