Collateral, a financial market instrument

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”Collateral management” represents all assets, securities or cash, pledged by the borrowing counterparty to the creditor counterparty to cover credit risk resulting from financial transactions negotiated between two parties. In the event of default by the debtor, the creditor has the right to retain the collateral assets in order to compensate for the financial loss incurred.

The use of collateral has grown steadily in recent years. The last financial crisis certainly made it possible to increase this development. The implementation of the Basel 2 agreements, which reduce the capital requirement for transactions covered by collateral, is also a factor of interest for this practice. The management of available collateral, i.e. collateral that can be used as collateral, therefore becomes a strategic issue for the players.

How do financial markets use collateral (collateral management)?
Collateral can be a repo, loan or derivative market instrument.

Collat can be given in several ways: it can be the subject of a repo. In market finance, players often use delivered repo.

collateral management

Let us illustrate with an example: When a debtor counterparty A makes a repo with a creditor counterparty B, A temporarily sells a security to B in exchange for cash and undertakes to repurchase the security at maturity. If, in the meantime, A fails to do so, B may sell the securities to compensate itself for the financial loss caused by the failure to repay its debt.

Collateral can also be used in a securities lending and borrowing transaction. Example: Counterparty A lends a security in exchange for another security. This can be changed by cash, which makes the transaction similar to a delivered repo. The only difference is that in a Repo transaction, the main motivation for the transaction is the acquisition of cash, whereas in a securities loan transaction, it is the obtaining of the security that is the primary motivation.

Collateral is not subject to Repo or Loan/Borrowing transactions. It can also be a hedge tool and thus hedge risk on derivative transactions. More specifically, it is used to hedge future cash flows. If the counterparty that will eventually have to pay its flows (derivative contract) goes bankrupt, the collateral is supposed to cover the losses.

OTC derivatives that are standardised enough to go through a clearing house, such as EMIR and the Dodd-Frank law, also require collateral. This can often be the case for uncleared OTC derivatives as well.

Collateral has other virtues. It can be extremely useful in triggering the securities settlement system or the settlement of cash payments. But also to guarantee a good protection against credit risk (collateral transforms a credit risk into a legal and operational risk).

It can also be an instrument of short selling. For example, an actor sells a security that he does not yet own. With the cash recovered from this sale, he can go to the repo market, lend the money to another counterparty and receive the missing security in exchange.

In conclusion, collateral can take many forms: bonds, stocks and even bank receivables. It is a guarantee to cover credit risk. While it is mainly used in repurchase agreements (repos), it remains an unavoidable element of flows and exchanges on derivatives markets.

Alexandre CASTRO


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