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See also repo.

In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan [1][2]

The collateral serves as protection for a lender against a borrower's risk of default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation.

If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral.

In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to pay the loan under the mortgage loan agreement, the ownership of the real estate is transferred to the bank. The bank uses a legal process called foreclosure to obtain real estate from a borrower who defaults on a mortgage loan obligation.


Concept of collateral

Collateral, especially within banking, may traditionally refer to secured lending (also known as asset-based lending).

More recently, complex collateralization arrangements are used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations, secured in the form of property, surety, guarantee or other as collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more liquid assets such as cash or securities, often known as margin.

Another example might be to ask for collateral in exchange for holding something of value until it is returned (e.g., I'll hold onto your wallet while you borrow my cell phone).

In many developing countries, the use of collateral is the main way to secure bank financing. The ease of acquiring a loan depends on the ability to use assets, whether real estate or any other; as collateral.

Central bank frameworks for collateral


In response to the turmoil in global financial markets which began in the second half of 2007, central banks have changed the way in which they implement monetary policy. This has drawn particular attention to the type of collateral used for backing central banks’ temporary open market operations and the range of counterparties which can participate in these operations. This paper provides an overview of the features of the different operational and collateral frameworks of three central banks that have been signifi cantly affected by the crisis:

  • the Eurosystem,
  • the Federal Reserve System
  • and the Bank of England.

The paper describes the factors that shaped the three frameworks prior to the turmoil. It then describes the actions the three central banks took in response to the turmoil and analyses to what extent these actions were dependent on the initial design of the operational and collateral framework.


Prior to the fi nancial market turmoil that began in 2007, the Eurosystem, the Federal Reserve System and the Bank of England had very different operational frameworks for the implementation of monetary policy, in particular regarding the type of securities that were eligible as collateral for obtaining credit from the central bank. The Eurosystem, on the one hand, accepted a very broad range of collateral in its main open market operations, and also allowed a broad range of banks to participate.

Furthermore, Eurosystem open market operations were of large size and there was no differentiation in the interest rate charged in the auctions depending on the type of collateral. The Federal Reserve, in contrast, only accepted government and quasi-government securities as collateral in its temporary operations, operating with a narrow group of less than 20 counterparties.

Furthermore, its temporary operations were of a small size, and the Federal Reserve even charged different interest rates in the auctions depending on the type of collateral in order to minimise any impact of its operations on asset prices. The Bank of England ranged somewhat between these two extremes, but clearly closer to the Federal Reserve’s model than the Eurosystem’s.

This paper explains what factors, both external and internal, may have affected the choice of collateral and other differences in the operational frameworks. External factors include the legal constraints under which the central bank operates, as well as the depth and liquidity of the country’s capital markets and the structure of its banking system. Internal factors include how the central bank chooses to supply liquidity to the banking sector (i.e. whether mainly through outright or temporary operations), the importance the central bank places on not affecting market prices of assets, whether the central bank differentiates collateral eligibility according to the type of operation, and whether it applies large or small reserve requirements.

Following the start of the financial market turmoil, which turned into the equivalent of a traditional bank run but taking place in the wholesale funding markets, it became clear that central banks needed to provide banks with funds against less liquid collateral in order to prevent a systemic crisis. The Federal Reserve and the Bank of England, which at the outset of the turmoil had a narrower range of counterparties and collateral, expanded their operations significantly.

In particular, both central banks started to accept asset-backed securities issued by the private sector as collateral, the asset class which had triggered the turmoil and had turned the most illiquid due to uncertainties about credit quality and valuation.

The Eurosystem’s framework, in contrast, which had already for many years accepted asset-backed securities as collateral in its liquidity-providing operations, was flexible enough to accommodate banks’ additional demand for liquidity with relatively few adjustments.

By the spring of 2009, the Federal Reserve had adopted such a large range of new facilities that the amount of liquidity provision – measured by four criteria: the size of the operations, the type of collateral, the range of eligible counterparties and the interest rate – was equivalent or arguably more ‘accommodative’ than the Eurosystem’s. However, this turned out to be a temporary phenomenon, as many of the Federal Reserve’s programmes began to automatically unwind as market conditions started to improve during the summer and autumn of 2009 and the provision of liquidity decreased quite markedly. At the same time, with the introduction of the Eurosystem’s one-year main refi nancing operation in the summer of 2009, the Eurosystem’s liquidity provision continued to remain rather accommodative.

The high level of what might be called “liquidity insurance” provided by the Eurosystem both before and after the start of the crisis certainly has benefi ts in terms of an immediate crisis mitigation tool. There was no time delay necessary before implementing new facilities, and the framework provided a very high degree of fl exibility for banks to minimise their funding liquidity risk, without prompting fire sales. Of course, these benefi ts of a “broad” framework have to be weighed against potential disadvantages, in particular the higher risks of accepting more illiquid collateral and the associated challenges for the risk control framework. Furthermore, the acceptance of a broad range of collateral in regular, large scale temporary central bank operations may undermine the incentive for banks prudently to manage liquidity risk.

Greece and ECB collateral rules

A shift in the European Central Bank's collateral rules appears more likely after President Jean-Claude Trichet on Thursday failed to confirm the central bank's intention to revert to previous rules at the end of this year.

There may even be more fundamental changes looming in rating procedure for collateral that is eligible for the ECB refi operations.

Asked last January in the context of Greece's eroded credit rating whether the ECB still intended to revert to the old collateral rules at the end of this year, Trichet replied, "We will not change our collateral framework for the sake of any particular country."

However, a similar question at this Thursday's press conference elicited an ambiguous response from the president: "The convincing decisions, which have been taken by the Greek government" should restore credibility in the country and its finances.

Probed a second time to "repeat the comment that you gave earlier this year and late last year that you wouldn't change the collateral rules to suit Greece", Trichet said: "On the collateral, again, I said what I was expecting, taking into account the very convincing decisions taken by Greece."

Rather than rejecting the possibility of a change in the rules, Trichet only addressed the potential need. The shift in language suggests the ECB may be rethinking its commitment to return to the pre-crisis framework by next year.

Under existing rules, a country must have at least one credit rating above the ECB's threshold in order for its bonds to be eligible as collateral. Following the collapse of Lehman Brothers, the ECB had lowered this threshold from A- to BBB- as part of its non-conventional support measures, with the intention of returning to the old framework at the start of next year.

Greek debt would still qualify under the old rules, since it has an A2 rating from Moody's. However, now that Standard & Poor's and Fitch have cut their rating to BBB+, a downward revision from Moody's would create problems if the ECB returned to its initial threshold.

This situation illustrates the tremendous influence a single rating agency could have in determining whether Greece -- or any other Eurozone country facing credibility problems in future -- would qualify under the ECB's collateral rules.

In the view of Governing Council member Ewald Nowotny this is "an unacceptable situation." Raising issue a few days before the Council meeting, he said, "The destiny of Greece and, to be dramatic, the destiny of Europe, depends really on one rating agency."

Asked at the press conference whether he shared Nowotny's concerns about "the role rating agencies continue to play in [the ECB's] collateral arrangements," Trichet again dodged the question, saying he had no comment to make "at this stage."

Pressed on the idea that the ECB could develop its own set of ratings for countries, Trichet again equivocated: "I have no particular comment on your question on rating agencies at this stage."

The repeated use of the phrase "at this stage" suggests that the central bank is reviewing the situation and needs time to come up with a solution.

How a new rating system might look is unclear.

One idea is for the ECB to introduce a sliding scale, whereby collateral with lower ratings would be accepted, but with a larger haircut. While cushioning the impact of downgrades, this option would still leave much control in the hands of the U.S. rating agencies, whose credibility has been undermined during the crisis.

Earlier this week the German business daily Handelsblatt reported that Eurozone finance ministers would like the ECB to develop its own credit ratings. In cases where independent ratings are not available for some financial instruments, the ECB already relies on those provided by the Eurozone national central banks.

However, ECB authorities may well be reluctant to take on the role of sole arbiter of a member country's eligibility for central bank credit, as it would place it in a very delicate position, potentially subject to enormous political and public pressure.

Rather than remaining above the political fray, the ECB could be seen as the task-master imposing unpopular austerity measures, a role monetary officials would no doubt prefer to leave to the European Commission and the Eurozone finance ministers.

It is much more comfortable for Trichet to insist, as he does with increasing vehemence, that Eurozone governments must adhere strictly to the rules they have imposed themselves via the Growth and Stability Pact.

But as the Greek credit crisis has once again focused attention on the exorbitant influence of a handful of rating agencies, the ECB will have to grapple with the problem at some point.

Bank of England broadens collateral eligibility

The Bank of England, it turns out, is looking to change the type of collateral it accepts at its discount window facility (DWF), according to a consultative paper published on Wednesday.

The main proposal is focused on expanding the pool of eligible collateral to include loan portfolios– a move the Bank says would make the majority of assets held by commercial banks eligible for use as collateral.

It’s worth remembering that pre-crisis, the Bank of England was always seen as a cautious central bank when it came to collateral policy. Unlike the ECB, for example, the BoE never accepted RMBS or ABS securities until 2007, when the credit crunch forced it to reconsider the breadth and scope of its eligible collateral pool.

Even so, these changes were only ever meant to be temporary, with the BoE stating back in October 2008 that a more permanent operational policy would be announced by 2010.

In which case, it might seem curious that the BoE should be looking to widen rather than contract its eligible collateral pool, given that markets are supposedly normalising.

But bear with us. There is method in the BoE’s apparent madness. As the following extract highlights, the Bank is apparently concerned that some collateral abuse might be going on (our emphasis):

Counterparties are currently able to deliver securitisations of loans they have originated themselves (‘own name’ ABS) in the DWF, but the process of securitising own-name loan portfolios can be both costly and time consuming.

Furthermore, not all counterparties may be able to undertake such transactions. In extending DWF eligibility to include loan portfolios, the Bank believes that the majority of assets held by commercial banks would become eligible for use as collateral.

Loan portfolios would be subject to the same rigorous eligibility and risk management standards as any other DWF collateral; the Bank plans to ensure this by requiring pre-positioning of loan portfolios.

Accepting raw loans would also ensure that securities taken in the Bank’s operations have a genuine private sector demand rather than comprising ‘phantom’ securities created only for use in central bank operations. The Bank is interested in obtaining the views of counterparties on accepting loan portfolios as eligible collateral in the DWF based on the criteria and processes outlined in this paper.

The BoE’s thinking presumably is that if you allow genuine bank loans to be pledged instead of synthetic securities this may in some way help liquidity flow through to where it is really needed. On one level at least, this is in fact “normalisation,’ post crisis.

As for phantom securities being created by the banks for the sole purpose of accessing BoE liquidity, should be we really be surprised?

Derivatives collateral falls to $3.2 trln in 2009-ISDA

"Collateral posted against derivatives fell to $3.2 trillion in 2009, after almost doubling in size in 2008 to $4 trillion, when the price of many derivatives spiked and banks and other counterparties suffered rating downgrades, the International Swaps and Derivatives Association said.

The percent of agreements that required collateral to be posted against trades grew by 14 percent, and 93 percent of credit derivatives trades were backed by cash or other assets, while 70 percent of all over-the-counter derivatives were backed by collateral, ISDA said.

The largest 15 derivative dealers also reported higher collateral, with 97 percent of credit derivatives having margin arrangements and 78 percent of all derivatives being backed by assets.

Banks and asset managers post collateral against derivatives in an effort to limit losses if their counterparty to the trade is unable to meet their obligations.

Payments between large dealers are typically evaluated daily and are based on the contract price and the credit ratings of trading counterparties.

"Collateralization remains among the most widely used methods to mitigate counterparty credit risk," Conrad Voldstad, chief executive officer at ISDA said in a statement.

The amount of assets posted against derivatives has come under close examination since American International Group (AIG.N) needed a government bailout as a result of large exposures the insurer took to risky mortgages while having > marginal assets to back up its obligations.

Legislators globally are readying legislation that will bring more derivatives into central clearing houses, and require that higher margins are posted against contracts that are left on bank balance sheets.

Cash represented 83 percent of the collateral given to back up credit, interest rate, foreign exchange and equity derivatives, and government securities comprised another 14 percent, ISDA said.

Study: OTC derivatives need better collateral management

Valuations and collateral management are the top two post-trade functions in the life cycle of an over-the-counter derivatives transaction that must be improved to reduce risk, according to a research report released on Wednesday by Needham, Mass.-based TowerGroup.

Commissioned by data software vendor SunGard Data Systems, the report showed that of the 63 buy and sell-side firms polled, 71 percent cited valuations while 58 percent cited collateral management as the two areas of concern.

The report, entitled “Addressing End-to-End Risks and Inefficiencies in OTC Derivatives” was written in February but made available to the press by SunGard on Wednesday.

About eighty percent of the respondents cited risk management as the top driver compelling their organizations to improve processing of OTC derivatives.

“In OTC derivatives, the valuations process is inadequate for present and future demands,” wrote Stephen Bruel, director of the securities and capital markets group at TowerGroup who authored the report. “Regardless of the complexity of the instrument or volumes traded, arriving at an acceptable value for both vanilla and esoteric derivatives has become more difficult since the global financial turmoil began.”

Traders and risk officers require correct valuations to make the right trading decisions and risk calculations while collateral managers require them to ensure the efficient use of collateral. Because no “single” valuation may be correct, firms must have a process by which to reconcile different valuations and ensure consistency among users.

In the case of collateral management, too many processes are manually intensive. “Asset managers and their custodians often initiate movement of collateral by e-mail, phone or fax,” wrote Bruel. “The inefficiency in this process leads to errors and fails.”

Although procedures at interdealers have improved, there is plenty of room for improvement among broker-dealers, their fund manager clients and their custodian banks. Among the recommendations made by Bruel were: automating communications on collateral calls; reconciling portfolios proactively on a continuous rather than sporadic basis; and ensuring more efficient resolution of disputes between counterparties.

ISDA publishes review of OTC bilateral collateralization practices

The International Swaps and Derivatives Association, Inc. (ISDA) today announced that it has published the ISDA Independent Amount Whitepaper and Market Review of OTC Bilateral Collateralization Practices. Both documents have been developed by the ISDA Collateral Steering Committee under the auspices of the ISDA Industry Governance Committee.

“Collateralization has become a key method of mitigating counterparty credit risk in the derivative markets,” said Julian Day, Head of Trading Infrastructure, ISDA. “ISDA and the industry continue to work toward the increased smooth functioning of the collateralization process of OTC derivatives transactions through its efforts in relation to standards and best practices, and collateral law reform efforts across the globe.”

The documents are designed to provide better understanding of current market practices. In these documents, a number of recommendations were made for market participants to enhance practice or understanding in the collateral management arena.

The Independent Amount Whitepaper examines the risks associated with under-collateralization or over-collateralization associated with Independent Amounts under ISDA Credit Support Annexes, and the potential alternatives that may be developed by the derivatives market to protect participants. The Whitepaper was jointly produced by ISDA, the Managed Funds Association (MFA) and the Securities Industry and Financial Markets Association (SIFMA). It was one of the commitments outlined in the derivative industry letter global supervisors dated June 2, 2009.

The Market Review of OTC Bilateral Collateralization Practices is a broad market review of bilateral collateralization practices for OTC derivatives to facilitate better understanding of current market practice, especially as it relates to the different types of counterparties active in the market. The objective of the review is to enable a more complete appreciation of the use of collateral as a credit risk mitigant across the diverse OTC derivative market, including some of the motivations, capabilities, limitations, and typical practices of market participants engaging in collateralization. ISDA has worked collaboratively with regulators to determine the appropriate scope of this analysis.

The Independent Amount Whitepaper and the Market Review are both key publications from the ISDA Collateral Steering Committee that provide the context for collateralization as a risk reduction technique across market participants.

Additionally, on March 1, 2010 the industry set new goals in the areas of Portfolio Reconciliations and Dispute Resolution, updated the roadmap for improving collateral management and re-affirmed its intention to complete development of an enhanced industry framework for resolving disputed margin calls. Each of these initiatives take into account risk, liquidity, default management and other processes with a goal of securing operational efficiency, mitigating operational risk and increasing the netting and clearing potential for appropriate products.

Both the ISDA Independent Amount Whitepaper and Market Review of OTC Bilateral Collateralization Practices are available on the “Collateral Committee” page.

Global banks, swaps collateral and funding advantages

-- Goldman Sachs Group Inc. and JPMorgan Chase & Co., two of the biggest traders of over-the- counter derivatives, are exploiting their growing clout in that market to secure cheap funding in addition to billions in revenue from the business.

Both New York-based banks are demanding unequal arrangements with hedge-fund firms, forcing them to post more cash collateral to offset risks on trades while putting up less on their own wagers. At the end of December this imbalance furnished Goldman Sachs with $110 billion, according to a filing. That’s money it can reinvest in higher-yielding assets.

“If you’re seen as a major player and you have a product that people can’t get elsewhere, you have the negotiating power,” said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who ran the prime brokerage unit at Bear Stearns Cos. from 1999 to 2006. “Goldman and a handful of other banks are the places where people can get over-the-counter products today.”

The collapse of American International Group Inc. in 2008 was hastened by the insurer’s inability to meet $20 billion in collateral demands after its credit-default swaps lost value and its credit rating was lowered, Treasury Secretary Timothy F. Geithner, president of the Federal Reserve Bank of New York at the time of the bailout, testified on Jan. 27. Goldman Sachs was among AIG’s biggest counterparties.

Goldman Sachs Chief Financial Officer David Viniar has said that his firm’s stringent collateral agreements would have helped protect the firm against a default by AIG. Instead, a $182.3 billion taxpayer bailout of AIG ensured that Goldman Sachs and others were repaid in full.

Extracting Collateral

Over the last three years, Goldman Sachs has extracted more collateral from counterparties in the $605 trillion over-the- counter derivatives markets, according to filings with the SEC.

The firm led by Chief Executive Officer Lloyd C. Blankfein collected cash collateral that represented 57 percent of outstanding over-the-counter derivatives assets as of December 2009, while it posted just 16 percent on liabilities, the firm said in a filing this month. That gap has widened from rates of 45 percent versus 18 percent in 2008 and 32 percent versus 19 percent in 2007, company filings show.

“That’s classic collateral arbitrage,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who previously worked as treasurer at Morgan Stanley and chief financial officer at Lehman Brothers Holdings Inc. “You always want to enter into something where you’re getting more collateral in than what you’re putting out.”

Using the Cash

The banks get to use the cash collateral, said Robert Claassen, a Palo Alto, California-based partner in the corporate and capital markets practice at law firm Paul, Hastings, Janofsky & Walker LLP.

“They do have to pay interest on it, usually at the Fed funds rate, but that’s a low rate,” Claassen said.

Goldman Sachs’s $110 billion net collateral balance in December was almost three times the amount it had attracted from depositors at its regulated bank subsidiaries. The collateral could earn the bank an annual return of $439 million, assuming it’s financed at the current Fed funds effective rate of 0.15 percent and that half is reinvested at the same rate and half in two-year Treasury notes yielding 0.948 percent.

“We manage our collateral arrangements as part of our overall risk-management discipline and not as a driver of profits,” said Michael DuVally, a spokesman for Goldman Sachs. He said that Bloomberg’s estimates of the firm’s potential returns on collateral were “flawed” and declined to provide further explanation.

JPMorgan, Citigroup

JPMorgan received cash collateral equal to 57 percent of the fair value of its derivatives receivables after accounting for offsetting positions, according to data contained in the firm’s most recent annual filing. It posted collateral equal to 45 percent of the comparable payables, leaving it with a $37 billion net cash collateral balance, the filing shows.

In 2008 the cash collateral received by JPMorgan made up 47 percent of derivative assets, while the amount posted was 37 percent of liabilities. The percentages were 47 percent and 26 percent in 2007, according to data in company filings.

By contrast, New York-based Citigroup Inc., a bank that’s 27 percent owned by the U.S. government, paid out $11 billion more in collateral on over-the-counter derivatives than it collected at the end of 2009, a company filing shows.

Brian Marchiony, a spokesman for JPMorgan, and Alexander Samuelson, a spokesman for Citigroup, both declined to comment.

Derivatives Market

The five biggest U.S. commercial banks in the derivatives market -- Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo & Co. -- account for 97 percent of the notional value of derivatives held in the banking industry, according to the Office of the Comptroller of the Currency.

In credit-default swaps, the world’s five biggest dealers are JPMorgan, Goldman Sachs, Morgan Stanley, Frankfurt-based Deutsche Bank AG and London-based Barclays Plc, according to a report by Deutsche Bank Research that cited the European Central Bank and filings with the SEC.

Goldman Sachs and JPMorgan had combined revenue of $29.1 billion from trading derivatives and cash securities in the first nine months of 2009, according to Federal Reserve reports.

The U.S. Congress is considering bills that would require more derivatives deals be processed through clearinghouses, privately owned third parties that guarantee transactions and keep track of collateral and margin. A clearinghouse that includes both banks and hedge funds would erode the banks’ collateral balances, said Kevin McPartland, a senior analyst at research firm Tabb Group in New York.

‘Level Playing Field’

When contracts are negotiated between two parties, collateral arrangements are determined by the relative credit ratings of the two companies and other factors in the relationship, such as how much trading a fund does with a bank, McPartland said. When trades are cleared, the requirements have “nothing to do with credit so much as the mark-to-market value of your current net position.”

“Once you’re able to use a clearinghouse, presumably everyone’s on a level playing field,” he said.

Still, banks may maintain their advantage in parts of the market that aren’t standardized or liquid enough for clearing, McPartland said. JPMorgan CEO Jamie Dimon and Goldman Sachs’s Blankfein both told the Financial Crisis Inquiry Commission in January that they support central clearing for all standardized over-the-counter derivatives.

“The percentage of products that are suitable for central clearing is relatively small in comparison to the entire OTC derivatives market,” McPartland said.

Bilateral Agreements

A report this month by the New York-based International Swaps & Derivatives Association found that 84 percent of collateral agreements are bilateral, meaning collateral is exchanged in two directions.

Banks have an advantage in dealing with asset managers because they can require collateral when initiating a trade, sometimes amounting to as much as 20 percent of the notional value, said Craig Stein, a partner at law firm Schulte Roth & Zabel LLP in New York who represents hedge-fund clients.

JPMorgan’s filing shows that these initiation amounts provided the firm with about $11 billion of its $37.4 billion net collateral balance at the end of December, down from about $22 billion a year earlier and $17 billion at the end of 2007. Goldman Sachs doesn’t break out that category.

A bank’s net collateral balance doesn’t get included in its capital calculations and has to be held in liquid products because it can change quickly, according to an executive at one of the biggest U.S. banks who declined to be identified because he wasn’t authorized to speak publicly.

Counterparty Demands

Counterparties demanding collateral helped speed the collapse of Bear Stearns and Lehman Brothers, according to a New York Fed report published in January. Those that had posted collateral with Lehman were often in the same position as unsecured creditors when they tried to recover funds from the bankrupt firm, the report said.

“When the collateral is posted to a derivatives dealer like Goldman or any of the others, those funds are not segregated, which means that the dealer bank gets to use them to finance itself,” said Darrell Duffie, a professor of finance at Stanford University in Palo Alto. “That’s all fine until a crisis comes along and counterparties pull back and the money that dealer banks thought they had disappears.”

‘Greater Push Back’

While some hedge-fund firms have pushed for banks to put up more cash after the collapse of Lehman Brothers, Goldman Sachs and other survivors of the credit crisis have benefited from the drop in competition.

“When the crisis started developing, I definitely thought it was going to be an opportunity for our fund clients to make some headway in negotiating, and actually the exact opposite has happened,” said Schulte Roth’s Stein. “Post-financial crisis, I’ve definitely seen a greater push back on their side.”

Hedge-fund firms that don’t have the negotiating power to strike two-way collateral agreements with banks have more to gain from a clearinghouse than those that do, said Stein.

Regulators should encourage banks to post more collateral to their counterparties to lower the impact of a single bank’s failure, according to the January New York Fed report. Pressure from regulators and a move to greater use of clearinghouses may mean the banks’ advantage has peaked.

“Before the financial crisis, collateral was very unevenly demanded and somewhat insufficiently demanded,” Stanford’s Duffie said. A clearinghouse “should reduce the asymmetry and raise the total amount of collateral.”

Wrong way risk

I am sure that clients want as broad a range of collateral as possible: I’d like to be able to repo out my dry cleaning receipts too. But for a security to be good collateral it must be high quality, low volatility, have low correlation with the exposure (the reverse situation – where the collateral value declines when the counterparty owes more money is wrong way risk), and be subject to an appropriate haircut.

CCPs are rushing to gain new business at the moment as it is clear that there will be only a small number of winners in each asset class, perhaps only one. Everyone wants to be the winner.

There are two obvious ways to compete: lower initial margin, and accepting a wider range of collateral with lower haircuts. Both of these have the potential to increase systemic risk – you can imagine the implications of posting a corporate bond as collateral against a CDS on a highly correlated underlying, for instance, or equities as collateral against equity derivatives.

Banks are subject to strict supervision to control this, with the Basel accords containing firm language about wrong way risk. But it seems that things may be a little laxer in the world of CCPs.


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