Collateral Management: The Front Line of Defense Against Credit Risk
This article appeared in Citi’s Investment Management Review
Issue 10, March 2009 Edition
Collateral management has become an indispensable part of the financial world’s answer to
the practical mitigation of credit risk. Increasingly, it has replaced the simple default risk of the
counterparty with the more complex, yet more diversified and more readily managed combination
of counterparty default risk, collateral issuer default risk, and legal and operational risks. At the
same time, collateral management programs are increasingly touching and affecting more and more
trading products, from securities lending to OTC derivatives.
The case for investors conducting business on a secured, or collateralized, basis grows stronger and
more compelling with each crisis or default in the market. A direct consequence of this explosion in the
use of collateral is the need to access a larger pool of collateral types and consequently to manage it.
The International Swaps and Derivatives Association (ISDA)
estimates that the gross amount of collateral in use stood
at $2.1 trillion by the end of 2007 (the most current data
available), a significant increase from the $200 billion
in use in 2000. ISDA also estimates that the number of
collateral agreements in place grew by 34% in 2006 and
grew by a further 24% in 2007.
Portfolio managers increasingly use derivatives in traditional
investment portfolios to enhance returns and reduce market
risk and, as a result, have augmented the use of collateral to
manage risk. Collateral for open derivative positions (including
listed options, credit derivatives and interest rate swaps) is
a critical component to mitigate risk of counterparty credit
exposure. According to ISDA, the OTC Derivatives collateral
market has seen exponential growth since the late 1990s,
with approximately 149,000 CSA (Credit Support Annex)
agreements in the market at the end of 2007.
A major reason for this expansion is the growing importance
of credit risk management. High-profile corporate failures
during the last few years have heightened the need for robust
credit risk processes, as have the growing volumes in today’s
securities markets. Once the current credit crunch is added to
this combination, it is easy to see why collateral management
has emerged as a vital technique for mitigating credit risk.
Increasing risk of future settlement for trading products
makes the underlying collateral, and a solid collateral
program, much more important. In fact, many institutions
will only deal with counterparties that can support complex
collateralized arrangements and manage large and diverse
trading portfolios. They must also be able to handle daily
margin calls according to tight schedules, evaluated
according to credit rating-related rules and supported by
strong reconciliation capabilities in the event of disputes.
Collateralization creates its own set of legal, market and
operational risks that must be managed in order for it
to successfully mitigate counterparty credit risk. These
include the structure of collateral agreements made
between counterparties, exposure monitoring control,
the changing market value of collateral, the settlement of
collateral transactions, and concentration and correlation
risks within a collateral portfolio.
Background
In its most basic form, an asset (cash or security) is pledged
to a counterparty to support exposure generated by some
form of trading. This asset (i.e., the collateral) can, if the
holder is given the right, be used to support other exposure
with a different counterparty. The holder can also use it to
try and generate additional returns. This can be done through
collateral substitution or through various types of financing
transactions, such as repurchasing agreements or securities
lending. With these relationships, the collateral transactions
are governed by an executed agreement that can detail what
types and what mix of collateral is acceptable.
Historically, collateral movements have been processed
by custodian banks in traditional custody accounts, as an
accommodation to their clients, but this response is proving
increasingly untenable. As the sheer number of market
participants and volumes increase, the account setup
(whether bilateral or tri-party agreements) is straining under
the volume of negotiating individual tri-party agreements
and developing unique account setups for clients.
As a result of the current credit crisis, both buy- and
sell-side firms are increasing their oversight of existing
trading relationships, reevaluating their counterparties’
creditworthiness and reexamining the rationale of even the
smallest trading relationships. There has been a renewed
focus on improving risk-management policies and procedures
governing Treasury operations at sell-side firms responsible
for financing trading activities through securities lending
programs. Liquidity in today’s global markets is dependent
on these financing activities, through which securities firms
finance trading operations by lending and borrowing securities
to/from counterparties, customers and competitors. Critical to
the efficient operation of global capital markets, these activities
allow sell-side firms to finance widespread trading activities by
lending securities held in custody.
The same applies to buy-side firms, which are also realizing
that efficient collateral management is not only prudent
but also can provide a critical competitive advantage,
especially given today’s credit environment.
Managing this complexity through spreadsheets is no longer
feasible. As trading operations have become more complex,
the process of managing financing activities has become
increasingly complicated as well. Managing balance sheet
exposure to multiple counterparties in multiple jurisdictions
and across multiple asset classes is a major effort. Additional
attention—and resources—are being invested in the systems
and processes to make these processes more efficient,
while at the same time mitigating the risk associated with
the lending and borrowing of the underlying collateral.
Adhering to disparate regulatory requirements associated
with lending securities originated in different countries. Legal
jurisdictions differ widely as well. So margining rules and
requirements also differ from one marketplace to the next as
well as from one product to the next. But that being said, the
overall concept of margin application, or “haircuts,” relates
specifically to the asset class under discussion: securities
(equities or fixed-income), derivatives or commodities.
Other complexities may include issues around the ability
for both parties to book trades in an accurate and timely
fashion, valuations of complex trades, and managing the
collateral received and pledged to ensure the efficient
reduction of costs of raising collateral.
Marketplace Trends
Beyond question, the level of collateral management
activity will increase as soon as the market turns.
In the future, resources will be devoted to the effort of
efficiently managing collateral, not only to handle the
increased complexity of the underlying markets but also
to make the process more efficient and to provide a
competitive edge. Leading firms with global operations
encompassing multiple asset classes will increasingly
seek to leverage their complex operations. The capability
to efficiently manage counterparty trading exposures to
maximize returns not only provides another means to beat
a competitor, but also serves to minimize overall risk.
Other trends in the collateral management marketplace include:
A broadening of the use of nonstandard collateral, such
as securities (equities or fixed-income, local or not) over
cash and U.S. Treasuries.
More proactivity by market participants in managing
counterparty risk—that is, the risk against banks and
brokers, which were once believed to be “bulletproof.”
A desire to segregate unencumbered (excess) collateral
away from collateral-linked accounts, such as prime
brokerage accounts.
The collateralization of an increasing number of types of
products, including cross-product margining.
Going forward, the entire business model for collateral
management will need to be analyzed and changed. As
one potential development, change agreements that are in
place will need to be more collateral-specific. Or possibly
securities lending will be only cash-based or, in non-cash,
only available in the securities of the lender’s home country.
The overriding trend is “The simpler it is, the better it is.”
