Collateral
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Collateral Management
Collateral is a property or an asset that a borrower offers as a way for a lender to secure the loan. Collateral arrangement is a risk reduction tool that mitigates risk by reducing credit exposure. Collateral doesn’t turn a bad counterparty into a good one and doesn’t eliminate credit risk. Instead, it just reduces the loss at the time of default. Collateral arrangement is an essential element in the plumbing of the financial system.
In the derivatives world, collateral posting is a risk reduction tool that mitigates risk by reducing credit exposure. It allows financial institutions to reduce economic capital and credit risk, free up lines of credit, and expand the range of counterparties.
The collateral methodology is to calculate the gross and collateralized counterparty exposure. It is designed to reflect both regulatory and internal monitoring requirements. It captures the margin call process, collateral asset pricing, and the correlation between collateral and OTC derivatives.
The method is built on a series of assumptions which partially reflect the real-world collateralization procedure, regulatory requirements and implementation limitations. The principle of conservativeness is applied through the model design. It captures the settlement risk, liquidity period of risk, and correlation between derivatives and collaterals. Risk parameters are calibrated to reflect historical or current trends, and remain adjustable according to different calculation purposes.
The model is used to measure the exposure for all OTC derivatives and Security Financing Transactions (SFT). The exposures are used for both regulatory capital calculation and internal risk management purpose. The regulatory capital affects the operating cost of the Bank trading activities. The internal risk management monitors the current portfolio exposure and provides important information for the Bank to make strategic decisions.
The counterparty exposures are significantly affected by the existence of collateral agreement (unilateral or bilateral), the type of derivatives and collateral assets, and the definition of collateral agreements (margin call frequency, threshold, etc.). This collateral methodology provides a testing platform to check the impact of these factors, and provides the guidance for the Bank to make decisions regarding trading activities and collateral agreements.
the margin period of risk (MPOR) is divided into two sub-periods, i.e. the period after last collateral exchange and the liquidation period. A exposure reporting time t is in the middle of the two sub-periods. The main risk in the first sub-period is under-collateral (when the Bank receiving) or over-collateral (when the Bank pledging) at t. The main risk in the second sub-period is price divergence between portfolio and collateral during the liquidation.
The MPOR is defined at netting set level and reflects the risk characteristic of counterparty exposure. It should meet the regulatory requirements at minimum, while higher standard should apply for risk control purpose when it is necessary. For example, Basel III requires that the MPOR needs to be at least F+N-1 days, where F and N are supervisory floor and margin call frequency respectively. To meet this requirement, the liquidation period may be set no shorter than F, while the last collateral exchange day can be set no shorter than N-1 days ago. The sum of the two sub-periods adds up to F+N-1 or more days.
The survival status of the counterparty is assumed to be uncertain during the settlement period, while in default during the liquidation period. This assumption is consistent with the logical time sequence of the trading activities and margin calls.
Since counterparties are given a grace period to fulfill the derivative cash flow payments and margin calls, it is uncertain whether they in default or not during this period. At the exposure reporting time t, the Bank realized that the counterparty is in default. The liquidation happens only after t, i.e. the counterparty default time.
The simulation of collateral in CCR, as the internal risk management system, is conditional on counterparty default. Because the counterparty is in default during the liquidation period, the collaterals and derivatives should be priced conditional on counterparty default. On the other hand, the collateral is pledged before t, so its quantity is calculated conditional on counterparty not in default.
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