Understanding the Concept of Collateral Management
Are you worried that unsecured transactions will cause you financial loss? If so, then it is time that you explore the concept of collateral management.
Collateral management is a process that aims to reduce credit risk in unsecured financial transactions.
The concept of collateral has been used for quite some time. For example, in order to obtain a loan, you might have put up some collateral, such as a car or your home, in order to provide the lender with some security in case you defaulted on the loan.
Collateral management, however, has evolved from that simple concept, mostly thanks to advancements in technology. We’re going to discuss some of its complexities in this article.
Understanding Collateral Management with an Example
Lots of people find the concept of collateral management quite complex and difficult to understand. Perhaps the following example will make things clearer.
Banks recognize over-the-counter derivatives, including options and swaps. The problem is that swaps and options can give rise to counterparty credit exposure. Let us assume that two parties enter into a swap.
The interest rate changes during the course of the deal. In this situation, one party will be able to get the mark-to-market (MTM) profit on the deal while the other party will suffer a loss.
In our example, the party that is on the verge of losing the deal defaults, and chooses instead to opt for a replacement deal at the current market price. The MTM value is the credit exposure.
This risk may not be so threatening for the short-term deal, but for long-term deals, the risk gradually increases.
There is also a risk that the counterparty will not be able to maintain a prime credit rating in the near future.
What the banks do is that they record the credit risk on the swap. This is what we call collateral management. You can reduce your credit risk by opting for a break clause, which would allow you to end the deal early. However, collateral management is preferable.
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The Process of Collateral Management
One can easily use collateral management for options and swaps.
When two parties enter into the collateralization, they need to negotiate. They also execute a document called the CSD. CSD stands for “central securities depository.” It refers to an institution that holds securities for clients, often in electronic form. This CSD document lays out the terms and conditions of the collateralization.
You will notice that trades undergoing collateralization are regularly MTM trades. This is why the two parties have to agree on the net valuation.
The party that will have the negative MTM on the trade will deliver the collateral to the party having the positive MTM. When new deals are added to the valuation, and the prices change, then the portfolio of the trade will change as well.
In accordance with the agreement, the valuation repeats monthly, weekly or daily. After the valuation, the collateral position changes so that it can easily reflect the new valuation.
The party that suffers an MTM loss has to post the collateral.
If you feel that collateral management is a problem for you, then seek the assistance of a professional collateral management company. They can help you in this regard.