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Mitigate Your Collateral Risk

Mitigate Your Collateral Risk

Mitigate your collateral risk

Counterparty credit exposure (CCE) is a big issue it’s why you have credit limits. When you lend money the risk is clear, will you get repaid? But with over the counter derivatives (like swaps) credit exposures are harder to see but nevertheless they are real. Derivatives with positive mark-to-market values generate credit risk.  Why? Because default by the counterparty puts your profit at risk. One solution is collateral management. This involves a regular trade portfolio valuation and a net exchange of margin or collateral between the two parties involved.

Collateral management is a process; it mitigates your credit risk but at the same time increases your operational risks. It’s too easy to focus on the credit aspect of collateral without identifying what else could go wrong. Let’s have a look at ten of the main concerns. It’s not an exhaustive list but it may help you identify where improvements can be made.

1. Collateral - cash is king: Collateral should be liquid, easy to value and maintain. That’s why over 80% of collateral is cash and many firms with limited resources only use cash.

2. Collateral - securities: If you decide to widen the scope stick to the rules. The collateral needs to be liquid; can you see an actively traded market? How regularly do you value the collateral and how realistic are those valuations on a forced sale basis? Can you sell your position without moving the market price? Don’t take the counterparty’s opinion. Do your own research and make provisions to review your decision.

3. Haircuts can protect you: If you take securities as collateral apply suitable haircuts. Attempt to make an estimate of what the haircut needs to be to reflect price volatility, market liquidity and the time it would take for disposal. Do not be railroaded into accepting haircuts that are lower than you think are necessary. Review your documentation to ensure that any reference to valuation percentages reflect current market conditions and not those that prevailed two years ago. Where applicable renegotiate.

4. Record credit exposures: If you take collateral it reduces your counterparty credit exposure. How do you adjust your credit limit utilisation to take this into account? Do you use the market value of the collateral before or after any haircut? (The conservative position is to adjust the collateral value by the amount of the haircut). When do you recognise the mitigating effect of the collateral? When it’s called or when it’s received? It’s easy to see that a simple system error could lead to you assuming mitigation before delivery.

5. Haircuts create credit exposures: If you give haircuts (overcollateralise) the securities you provide have a market value in excess of the counterparty’s credit risk on you. Make sure you recognise the credit risk you have now incurred within your credit risk reporting– some firms forget.

6. Do your own valuations: Some firms still rely on their counterparties for trade valuation. This is not good practice and should be avoided. You need to ensure your valuations are independent to make certain the margin call is correct and to trigger returns due to you.

7. Resolve disputes with urgency: Disputes can be frequent and need investigating. They may show up weaknesses in your valuation processes, they may highlight errors in trade data they could even uncover false trades or deliberate mismarking. Furthermore the undisputed amount becomes the basis for collateral transfer and this means one party is potentially under-collateralised.  Is that party you and what can you do about it? One solution is frequent (daily) reconciliation of the trade portfolio with your counterparty. This may sound onerous but automation reduces the work. It also spots trade errors before they upset the margining process.

8. Build in escalation processes:  If you don’t receive collateral when it’s due or a dispute is ongoing how do you find out about it? By introducing escalation processes that raise issues to the next level. This way you keep on top of things and initiate steps to resolve the difficulty. Above all stress the importance of timely escalation to those involved.


9. Check documentation before it’s tested: You probably use an ISDA credit support document or agreement. When was it signed and what does it contain? Are you certain that netting is enforceable? Do you have council’s opinion? Do those minimum transfer amounts, thresholds and valuation percentages need revising (particularly if ratings have changed)? If you deposit an independent amount think again. Can you reduce it or negotiate it away?

10. Do the credit analysis: Collateral management does not reduce the probability of your counterparty defaulting. It can however improve your recovery rate should default occur. So make sure you still do the appropriate credit analysis on your counterparty.

First Published by Barbican Consulting Limited 2009

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