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Derivative credit management & enhancement

01 October 2004

In the second of a three part series, Satyajit Das looks at bilateral collateralisation structures

Bilateral collateral is probably the single most important form of counterparty credit risk enhancement used in derivative markets.

The basic concept is to secure the performance of the counterparty's obligations under derivative transactions, by using high quality collateral such as cash or government securities, to cover any mark to market exposure on the transaction. The assumption is that in the event of default under the transaction by the counterparty, the dealer would realise the collateral (which is assumed to be relatively risk free). The collateral would cover the replacement cost of the defaulted transaction. Bilateral collateralisation is used to enhance the ability of the counterparty to perform its contractual obligations, rather than alter the derivative credit exposure.

Collateralisation of the obligations of a party under derivative transactions is a relatively recent development. The practice became prevalent in the early 1990s. Collateralisation has its origins in the participation of lower credit rated US financial institutions, primarily saving and loan associations and smaller regional banks, in the swap market.The practice became more common with the entry of hedge funds into the derivatives market.An additional factor in the use of bilateral collateral is the need to manage inter-bank/dealer trading lines and regulatory credit capital benefits of collateral under certain conditions. Collateralisation was originally a feature of the US derivative (particularly) swap market. However, it has become a feature of the global derivatives market.

The structure of collateralisation arrangements is similar to the operation of organised futures and options exchanges, entailing the posting of deposits and margin calls on open futures or options contracts.The major difference is the absence of the clearinghouse to act as a counterparty to each transaction and guarantee performance. Bilateral collateral is a private contractual arrangement designed to secure the performance obligations under the contract.

Bilateral collateral mechanics

Bilateral collateral agreements enable the counterparties to pass collateral between each other, to cover the mark to market exposure of the specified transactions. The collateral is typically posted where the mark to market exposure exceeds a pre-specified level (referred to as the collateral threshold). Collateralisation arrangements are structured in a number of alternative ways.

One/two way collateral

Under one way collateral arrangements, the collateralisation obligation is only applicable to one of the counterparties (generally the counterparty with the weaker credit quality/rating). Under a two-way agreement, the collateralisation obligation is mutual and applicable to both counterparties.

Initial collateral

Collateral arrangements can be structured with or without initial collateral. If there is no initial collateral requirement, then the counterparties do not need to lodge any collateral at the time of entry into the transaction. Collateral is only required where the transaction has a mark to market value. If there is an initial collateral requirement then one or both counterparties must lodge a pre-specified amount of collateral. This collateral amount is adjusted as the mark to market of the contract changes. The credit exposure is constantly monitored and if the level of collateral falls below a certain level of the termination exposure, then the counterparty would be required to post further collateral to maintain the collateral cover. The initial collateral requirement is used with counterparties of weaker credit quality. It is designed to cover the risk that the counterparty is not able to meet a future collateral call.The failure to produce collateral is an event of default. However, in the event of no initial collateral, the counterparty may fail to meet a collateral call resulting in a loss to the counterparty as its exposure is not covered by collateral. The initial margin is structured so that the exposure under the derivative on termination is covered by the value of the collateral posted (initial plus mark to market payments).

Threshold levels

Typical collateral arrangements operate so that one or both counterparties must post collateral where the mark to market exposure exceeds a pre-agreed amount. The threshold can be set at an amount taking into account the likely exposure under the transaction and the credit

quality of the counterparty. The use of a threshold amount is designed to ensure that either counterparty requires the other to provide collateral against the exposure under the transaction in the event that the exposure increases beyond expected levels. The approach used is similar to that described in relation to recouponing. Different threshold levels for the two counterparties under a two way collateral agreement can be utilised.

Mark to market frequency

The mark to mark calculations are generally done daily. However, the mark to market frequency for the purposes of collateral calculations is variable. Typically, collateral mark to market frequency will depend upon the complexity of the transaction and the credit quality of the counterparty. It will typically be daily,weekly or monthly.The mark to market frequency affects two aspects of collateral.The first is the mark to market of the derivative transaction itself. The second is the mark to market value of the collateral itself, this is important for any security other than cash or very short dated securities.

Type of collateral

The types of collateral traditionally utilised include, cash, government securities, other high quality marketable assets and standby letters of credit or guarantees from an acceptable bank/financial institution. The major types of collateral utilised are cash and government securities. This reflects a number of factors including, credit quality of the obligations, liquidity of the securities in the event that they must be realised, credit capital rules whereby only transactions secured by cash or government securities qualify for credit capital relief.The value of collateral securities ascribed is the current mark to market value. Consistent with general collateral/repo market practice, a haircut (over collateralisation) rule is applied. This means that for term securities an excess amount of securities (102-110% depending on the price volatility of the securities2) must be lodged to cover exposure. This is designed to cover the problem of changes in value of the security as a result of market price/rate movements.

A typical collateralised derivative arrangement would operate as follows:

  • The counterparty would be required to lodge collateral equivalent to 0-5% of the notional principal value of the transaction at the commencement of the transaction
  • Over the life of the transaction, the transaction would be marked to market typically at daily, weekly or monthly intervals.The mark to market calculation would be used to determine the replacement cost of the derivative as at the relevant date.Where the derivative has a positive replacement cost, the other counterparty would lodge additional collateral with the dealer equal to the replacement cost. Collateral would only be lodged where the mark to market exceeds a threshold level (if applicable under the collateral terms). This mark to market procedure would be repeated as at each of the relevant dates over the life of the transaction
  • The counterparty lodging collateral receives interest on the initial collateral and subsequent mark to market collateral payments at a negotiated rate.This rate is typically based on prevailing short term money market rates such as overnight dollar Libor.

It is important to note that where the counterparty has more than one transaction with the dealer, collateralisation is undertaken on a portfolio basis. This means that the mark to market calculation is generally performed on a portfolio basis. This ensures that the counterparty gets the benefit of negative as well as positive replacement costs, thereby reducing the amount of total collateral that may need to be maintained. Portfolio approaches to collateral will generally only be applicable where the conditions (such as netting) for a portfolio basis of derivative credit exposure calculation are satisfied. The exact structure of the collateralisation arrangement is negotiated on a bilateral basis between the counterparty and dealer. Additional features of collateralisation arrangements that are sometimes used include:

Trigger collateral

This entails a trigger mechanism whereby the counterparty may be required to post collateral in between mark to market dates where the mark to market (replacement cost) and therefore credit exposure exceeds a pre-specified amount. For example, assume a five-year swap with monthly mark to market arrangements. In the event that the credit exposure to the dealer exceeds a fixed amount (say of 2% of notional principal or a monetary amount $1m) then the dealer has the right to ask the counterparty to post additional collateral. The additional collateral would be equivalent to the mark to market value at that time.

Credit triggers

This entails a transaction that is not subject to collateral requirements becoming subject to collateral where the counterparty is downgraded below a specified credit rating. This is similar to the credit termination options outlined above.

Advance payment options

An additional feature utilised by some dealers requires the counterparty to make settlements under the derivative in advance under specified condition. Under this structure, the counterparty, where it is required to make a settlement payment to the counterparty at the end of any interest rate period, is required to make the payment at the time of calculation on a discounted present value basis. This type of structure is designed to further reduce the dealer's exposure to the default of the counterparty. The structure and cost of collateralisation arrangements is analysed in Exhibit 1. The example used is an interest rate swap.The structure and process is identical for all derivative transactions.

Documentation

Collateral documentation under current market practice is based on the standard version of Isda's Credit Support Annex. There are a number of forms including New York law New York Credit Support Annex (a pledge), English law Credit Support Deed (a charge) or Credit Support Annex (a transfer document) and Japanese law Credit Support Annex (loan and pledge). The different versions reflect differences in law as between the jurisdictions. New York and English law based structures are most commonly used in practice. The structure of the collateral documentation is similar in each case and covers:

Provision of security to cover the mark to market exposure on the relevant transactions

Provision of a basis for periodic adjustments to collateral with changes in the mark to market value of the transactions Assume the dealer enters into a dollar interest rate swap for $100m with company X for a term of five years. Under the swap, dealer pays fixed rates at 5.96% pa quarterly and receives dollar three-month Libor. X is non-investment grade. The dealer requires the swap be collateralised (one way collateral by X).

The bilateral collateral terms are as follows:

  • Initial collateral equal to 2.5% of the notional principal amount of the swap . The swap will be marked to market on a quarterly basis. X is required to lodge collateral where the replacement value of the swap is positive for the counterparty as a result of market rate movements . The dealer has the ability to call for additional collateral to be posted in between quarterly mark to market dates where the market value of the swap changes (negatively for X) by 1% of notional principal amount (effectively reducing the amount of collateral cover to 1.5%)
  • Collateral is specified as cash or equivalent in government securities
  • The dealer agrees to pay interest at overnight Libor flat to X on all collateral required to be lodged.

Cost of collateralisation

The cost of the collateralisation arrangement to X is the negative spread between its cost of funding and the interest rate received on collateral funds. Assuming a cost of funds to X of Libor plus 2% per annum this negative spread is 200 basis points pa. This analysis ignores yield curve effects. X would typically borrow over three, or six-month Libor, whereas it is receiving overnight Libor. This means it would suffer an additional cost under a positively sloped yield curve. The cost of collateralisation covers two components, these are, financing the initial collateral and financing the periodic mark to market collateral.

The cost of financing the deposit can be estimated with accuracy. The cost of financing the mark to market collateral is difficult. This reflects the fact that it requires assumptions about the future swap rate movements, changes in the shape of the swap curve (to adjust for the fact that the actual maturity of the swap declines) and timing of swap rate changes. In this case, X will need to make mark to market collateral payments where rates rise. This is because rate increases will increase the replacement cost of the swap to the dealer. Assume that swap rates are estimated to increase to 9.88% pa (quarterly) over the term of the swap in equal increments over the 20 quarters.

The collateral required and the cost of collateralisation based on quarterly sampling can be estimated using the data in the following table. All calculations are in per cent on notional principal.

The cost of the initial collateral is 5.0bp pa (quarterly) and the cost of mark to market collateral is 25.1bp in present value terms, which is equivalent to 5.8bp pa (quarterly). Based on these assumptions, the cost of collateralisation is as left: This equates to an effective net rate received under the swap by X of 5.85% pa (quarterly). The maximum cash required to be committed under the collateralisation arrangement is estimated at $6.9m (6.9% of notional principal). The cost of mark to market collateral is only an estimate as the pattern of future swap rates is not known with certainty.

  • Identification of allowable collateral which can be used including the haircut to be used with each type of collateral asset
  • Specification of minimum transfer amounts designed to avoid the need to transfer very small amounts of collateral for reason of administrative convenience
  • Specification of the relevant business days to facilitate transfer on days when it is practically feasible to transfer the assets as required.

Key documentary issues include:

The mechanics of the collateral arrangement including the ability to handle collateral in different currencies must be considered.

The nature of the security interest created and its enforceability in the relevant jurisdiction is different under the different structures available.The different versions of the Credit Support Annex operate in different ways.The New York version creates a pledge of the collateral asset. The English Credit Support Deed creates a security charge. The English Credit Support Annex establishes an outright transfer of the collateral. In cases where a charge or security interest is created the security interest may need to be perfected (ie by registration). There may also be issues of whether charges can be created on asset held within a clearing system. In the case of transfer, since asset ownership changes, the holder of the collateral has the ability to deal with the assets with very few restrictions.

However, the collateral holder in the case of transfer has an obligation to return the collateral asset where there is no default. This alters the risk of the collateral transaction itself as the party lodging the collateral is now exposed to the credit risk of the counterparty to which collateral has been transferred .The interaction of the collateral agreement with other legal agreements of the parties (such as negative pledges or other restrictions on provision of security) must be considered .

The incidental impact of such collateral arrangements in terms of tax (realisation of gains and losses as a result of the transfer of the asset), stamp/transfer taxes (as a result of the transfer ownership of the assets) and tax position on asset income (treatment of interest or dividend income).

The appropriate documentation for collateral arrangements must be carefully structured to ensure the efficacy of the arrangement within the legal framework in each jurisdiction.

Application of collateral

The impact of bilateral collateral arrangements is to alter the credit risk of the derivative transaction.This will typically be to reduce the derivatives credit exposure.The exact impact of the collateral will depend upon the specific structure utilised. The general impact can be summarised as follows:

  • Where any mark to market amount is fully collateralised (ie no threshold3), the derivative credit exposure is changed from any exposure to the counterparty to an exposure to the collateral. Where the permitted collateral assets are cash or government securities, the risk is substantially reduced
  • In the case where the collateral arrangements entail a threshold (exposure in excess of the threshold is to be collateralised), the derivatives credit exposure to the counterparty is limited to the threshold amount
  • Where the collateral is based on a periodic mark to market process (other then daily), the derivative credit exposure is limited to the potential exposure as between the mark to market dates. If there is a provision to require collateral to be posted in between mark to market dates, then the derivatives credit exposure is limited to the trigger amount (the amount beyond which the dealer can call for collateral).

Benefits and risks of bilateral collateral

The benefits include:

Access to derivative credit lines

Collateral allows high credit quality derivative counterparties to increase access to derivative credit lines. This is through freeing up existing lines as the use of collateral has the effect reducing risk to the counterparty.This has been an important factor in the use of collateral by dealers to free up trading lines and also to free up lines with large trading clients. Collateral also allows lower quality counterparties to transact in derivative products to which access might be difficult without collateral. The use of collateral also has the benefit of increasing the maturity of transactions that are feasible for all counterparties. Collateral arrangements also facilitate continuation of access to trading credit lines during periods of market volatility and uncertainty. During such periods, trading access is difficult for all but the highest credit quality counterparties.

Diversification of counterparty risk

The use of collateral reduces concentration risk within credit portfolios. This is because the credit risk is shifted to the collateral reducing credit risk exposure to the counterparty. This may improve the overall diversification of the portfolio.

Capital efficiency

The use of collateral can improve the capital allocation of dealers. This is because collateralisation, using cash or government securities, may reduce the risk weighting of the transaction to zero4. This would have the effect of enabling the dealer to release regulatory credit capital held against the credit exposure. This would have the effect of reducing the credit capital cost of the transaction.

Exhibit 2. Impact of bilateral

Pricing

The reduction in exposure, the improved diversification of counterparty risk and higher regulatory capital efficiency may be reflected in improved pricing of derivative transactions.

Collateral management

The efficient use of collateral can be an attractive source of incremental income for dealers. This is the case where the dealer has systems in place to optimise collateral use. The costs of bilateral collateral include: Cost of collateralisation - the requirement to lodge collateral results in counterparty's incurring additional costs. The major source of cost is the negative funding spread incurred. This reflects the differential between the income on the collateral lodged and the cost of financing the collateral

Liquidity requirement - the counterparty must have access to cash, government securities or other eligible securities.

his will result in a use of liquidity for the counterparty that will deprive it of required financing resources for other activities. The risks of bilateral collateral include:

Residual credit risk

The collateral arrangement will generally leave some residual credit risks that must be managed including:

  • Unsecured threshold - where collateral is required only where the mark to market is in excess of a minimum specified amount there is an exposure up to the threshold amount
  • Periodic mark to market - where mark to market calculations are undertaken on a weekly,monthly or quarterly basis there is credit exposure to changes in mark to market in between the mark to market dates. This can be reduced by the trigger collateral provision noted above
  • Exposure to lodgement of collateral - where no initial collateral is provided there will an exposure to the counterparty for the collateral due to cover the mark to market as at each mark to market date.This is because in the event that there is a collateral payment due and it is not lodged there is an inherent exposure to the collateral due. The initial collateral (where it is set at a level sufficient to cover potential single day mark to market changes) covers this risk. In the case of non-payment of collateral, the transaction would be terminated and the initial collateral used to cover the mark to market loss
  • Timing - this refers to the interval between a default event, recognition of the default and realisation of collateral. This incurs risk in various ways. The non-lodgement of collateral is itself an event of default. However, it may take some time for the failure to lodge collateral to be detected. During this period, the mark to market of the transaction may increase exacerbating the loss. Where default is recognised, there may be delays in realisation of the collateral. During this period there is exposure to the risk of adverse mark to market changes in both the derivative transaction and the collateral securities. This problem may be worsened by the legal requirement for a stay period or cure period prior to the capacity to take actions to liquidate collateral
  • Re-hypothecation risks - this refers to the reuse of collateral. A counterparty receiving collateral under one transaction may reuse the collateral by using it as collateral on a separate transaction with another unrelated counterparty. This reuse of collateral is known as rehypothecation. This creates certain risks. If a counterparty has delivered more collateral than needed to cover the specific exposure, it is now exposed to the bankruptcy of the counterparty as it may not be able to recover the over collateralisation amount other than a general creditor. The process of rehypothecation may alter the legal position of the secured party in relation to the collateral.These risks are difficult to quantify and assess.

Documentation/legal risks

The process of collateralisation is legally complex. It assumes the effectiveness of the security over the collateral and also the rights of the counterparty to realise the assets to cover mark to market losses in the event of default by the other party. However, the enforceability of the collateral agreement is not free from doubt in all jurisdictions. In particular, even where the collateral arrangements are enforceable under normal circumstances, specific actions by the counterparty in dealing with the collateral may inadvertently alter the rights in relation to the collateral.The fact that the legal risks in relation to collateral often entail multi-jurisdictional legal issues (based on where the collateral is located, the domicile of the counterparties and the governing law) adds significantly to the complexity.

Operational risks

Collateralisation entails a variety of complex and often difficult to monitor operational steps. This creates exposures to operational errors. Major areas of risk in operations relating to collateral include:

  • Mark to market calculations - the mark to market calculations on both derivative transactions and the collateral assets must be accurate to avoid inadvertent assumption of risk through over or under collateralisation.This is difficult for complex transactions or portfolios
  • Verification/monitoring of collateral assets - the lodgement/receipt, registration (if required) and other mechanical aspects of collateral operations must be properly executed to ensure efficacy of the collateral arrangements. This can be difficult where multiple jurisdiction or different asset classes are dealt with under a single integrated collateral arrangement .
  • Dealing with collateral assets - dealings with collateral assets must be monitored carefully to avoid triggering unintended tax, legal or regulatory consequences that have financial costs or expose the counterparty to risk
  • Compliance with collateral agreement and legal requirements - the often complex nature of highly customised collateral agreements and the related legal requirements are inherently difficult to monitor

Collateral management

In recent years, as the volume of collateral used in relation to derivative products has increased, there has been increased focus on the management of collateral. Initially, collateral was regarded as primarily an operational activity. However, as the volume of collateral has grown dealers have realised the necessity to establish dedicated units focused on the management of collateral. The collateral management function works closely with related functions such as repo/finance functions. It also supports credit risk management. Collateral management can be defined as a series of integrated processes designed to manage collateral portfolios to maximise value through focus on two areas of activity:

Risk management

The focus is on efficient management of collateral to reduce credit risk as intended through collateralisation and also maximise the efficiency of collateral use.

This will include: Compliance with collateral terms - this focuses on ensuring that all collateral requirements are monitored with a view to ensuring compliance with agreements. This covers monitoring mark to market values of derivatives and collateral to ensure that collateral levels are adequate and no delays or lags are experienced creating credit risks. It also includes ensuring satisfaction of legal/documentation, regulatory and tax requirements. It includes realisation of collateral and close-out of positions as required in case of default

Collateral information management - this focuses on ensuring that collateral information is made available to manage credit risk lines and regulatory capital requirements

Reduce collateral requirements - this focuses on minimising the amount of collateral required through various strategies including monitoring collateral levels (to avoid over collateralisation), avoidance of double margining (centralising collateral arrangements with counterparties) and cross collateralisation (minimising separate collateralisation of different products through cross product netting).

Economic management of collateral

The focus is on managing collateral operations to reduce the cost of collateral and generate income from collateral.This will include:

  • Reduction of collateral costs - this is focused on strategies designed to maximise the cash or financing (repo) value of securities available or efficient repledging of collateral to reduce the cash committed to collateral. It also seeks to ensure the cheapest eligible securities are used for collateral within the applicable constraints. It covers the netting of positions internally to ensure minimisation of transaction costs of trading in the collateral
  • Capital management - this is focused on ensuring collateral operations are run to ensure the reduction of regulatory capital and increased returns on risk capital
  • Generating returns from collateral - this is focused on generating earning from the collateral pool. It requires the ability to reuse collateral and use the repo markets efficiently to maximise returns on collateral. It also requires the ability to consolidate positions through aggregation to generate higher returns. It may also incorporate tax based strategies to enhance earnings on collateral assets. Collateral management is increasingly important in dealer firms. This has led to significant investment in skilled staff and systems to maximise the value of collateral management.

Footnotes 1 This paper is based on material from Das, Satyajit, Swaps/Financial Derivatives - Third Edition, John Wiley & Sons. For detailed source references, please refer to the book.

2 The amount of any over collateralisation can be based on the expected price volatility calculated using VaR approaches.

3 In practice, there will be a small exposure based on the minimum transfer amount used in the documentation.

4 The position will depend upon the specific regulatory capital provision applicable to the dealer.


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