Collateral Management Overview- Agenda

Introduction to Collateral & Terminologies

Mitigating Credit Risk

Collateral Management Activities

Regulations in Collateral Management

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Introduction to Collateral Management & Terminologies

Collateral - overview Collateral is typically an asset that is used by borrowers to offer

lenders as security over a loan. The collateral serves as protection for the lender against the

borrowers in the event that the borrower defaults. Should the borrower not able to pay back the loan, then the lenders has the right to sell the collateral (asset) to recoup potential losses that are owed by them

Examples of Collateral(Acceptable Securities)

Products/Transactions that need Collateralization: (Markets widely Collateralized) Repurchase Agreements (Repo) Equity Finance Exchange Traded Securities Securities Borrowing & Lending FX margining Asset Backed Securities Equities Credit Derivatives Bank Loans Commodities

Govt. BondsCash, T-bills, TFRN, Tnotes, Tbonds. Corporate Bonds

Equities

ABS, TIPS, TSTRIPS Money Market FundsGold & other Commodities

Collateral Management - overview Collateral Management is the continuous process of providing,

taking and evaluating collateral to cover against the credit risk faced with relating to counterparty credit exposures.

Efficient collateral management assists counterparties to mitigate credit risk, by identifying and allocating a similar valued asset in return for the loan/assets/cash that were lent.

Collateral process is very similar to futures variation margining. The party that has a MTM loss must post collateral.

Collateral Management Environment Parties involved- Collateral Management Team- Credit Analysis / Approval Team- Front Office Sales and Traders- Middle Office- Legal Department- Valuation Team- Accounting & Finance Team- Third Party Service Providers

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Growth in Value of reported & estimated Collateral

(USD Billions)

as per ISDA Margin

survey2014

Factors considered for selecting collateral assets: Volatility Liquidity Credit Quality Custody and Settlement efficiency Pricing ease and transparency Collateral asset Correlation Collateral asset Concentration Legal Consideration

Terminology Call Amount: The currency amount of collateral being requested by the

taker. Threshold Amount: The threshold amount is an unsecured credit

exposure that the parties are prepared to accept before asking for collateral.

Minimum Transfer Amount (MTAs): Minimum transfer amount is an amount of collateral below which counterparty is not required to transfer collateral even if the collateral agreement would otherwise provide for a transfer.

- Typically the MTA will lie in the range of $50,000 - $1,000,000. Netting: Process of aggregating all open trades with a counterparty

together to reach a net mark-to-market portfolio value and exposure estimate.

- Netting permits individual trade values to be added together to provide a single exposure at a client level. Haircut margin (Valuation Percentage): A percentage applied to the

mark-to-market value of collateral which reduces its value for collaterization purposes.

- The collateral value is discounted relative to current market value. In most cases, haircut is determined by the volatility of the price security over the time that would be required (in normal market conditions) to liquidate it on the default of a counterparty. Valuation: A methodology for marking both the obligation and the

collateral to market must be agreed upon.

Terminology continued… Rehypothication: The secured party may wish to have use of posted

collateral possibly lending it to the another party or posting it as collateral for its own obligations to another party, called Rehypothication.

Initial Margin: Initial Margin is an additional credit support amount that is required to cater for changes in the market value of the trades between collateral calls. This initial margin can be a fixed amount or a percentage of the nominal size of the portfolio.

Margin Call: When margin is posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor now either has to increase the margin that he has deposited, or he can close out his position. He an do this by selling the securities, options or futures if he is long and by buying them back if he is short.

Unilateral Agreement: In this kind of an arrangement only one party posts collateral

Bilateral Agreement: In this kind of an arrangement both the parties to the contract post collateral. The net obligation is then collateralized, at any point in time the party who is a net obligator posts collateral.

Repo (Repurchase Agreement, Currency repo): Sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original price.

Advantages & Dis advantages of Collateral

. Disadvantages of Collateral Increase Operational Risk

Legal Risks - Legal procedures - Perfection Risk - Priority risk - Enforcement Risk Concentration Risk

Settlement Risk

Pricing Risk and Model Risk

Can Increase Market Risk

Expensive

Can reduce trading activity

Advantages of Collateral

Reduced Credit Risk

Capital Savings

Increased Competitiveness

Improved Market Liquidity

Access to higher risk trades

More efficient trading between counterparties

Benefits to Buy side (Asset Managers, Corporate Treasury etc..)

- Minimize collateral amount by Cross- collaterization - Minimize collateral movements and give/take collateral on a net basis - Collaterize exposure by client

Benefits to Sell Side (Broker dealers, Banks, etc.) reduces capital charged to allocate for asset liability mgmt.

Mitigating Credit Riskwith Collateral Management

CM mitigates Credit Risk

Credit Risk (Default Risk):The potential for loss due to failure of a borrower to meet it’s contractual obligation to repay a debt in accordance with the agreed terms

Ex: A homeowner stops making mortgage paymentsCredit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated to loan payments.

. Expected Loss = Probability of Default * Exposure at Def. * Loss

Given DefaultPresence of Collateral reduces ‘Loss given default’

1: Aim to reduce the Probability & size of default: Ex: Credit Appraisal, Scoring

Models, Ceiling based on borrowers Equity

Similar to bank checking credit scores & income before given car loan

2: Aim to Recover losses (should a default occur)Similar to bank hypothecating car. Should the person default, bank could re-posses the car, sell it recover it losses Collateral Management falls

under 2nd category

Credit Risk mitigation with CM mechanism fall one of 2 categories:

Example for Collateral dynamics

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Securities Collateral Example

1. Net exposure (single or multiple deals) =$100

2. Collateral posted previously = ($80)

3. Net Collateral delivery requirement = $ 20 = Credit Risk

4. Collateral given = $ 20

5. Net exposure=$0 = NO CREDIT RISK REMAINSCash Collateral Example

1. Net Exposure (single or multiple deals) = $100

2 .Cash Collateral posted = ($80)

3. Overnight interest earned on Cash = ($0.10)

4. Net Collateral delivery requirement = $19.90 = Credit Risk

5. Collateral given = $15

6. Net exposure = $4.90 = REMAINIG CREDIT RISK

Collateral Management Activities

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Reference: Collateral process, as mapped by Depository Trust & Clearing Corp. (DTCC)