September 12th, 2012
Collateral In lending agreements is a borrower’s pledge to a lender of specific property of an agreed upon value, which the lender has demanded in order to secure or contribute to assuring repayment of the loan made to the borrower. Collateral serves as protection for a lender against a borrower’s default – that is, any borrower failing to pay principal or interest under the terms of a loan obligation-contract. If a borrower defaults on the loan, borrower forfeits (gives up) the property pledged as collateral. In turn the lender then becomes the owner of the collateral, which isn’t always very liquid, meaning which enjoys an active, deep financial market into which the lender is interested to sell the instrument to attempt to obtain the proceeds equaling in value the loan or borrowing that the borrower had had.
Complex-structured vehicles (a security contrived from financial engineering of many securities which packages these different types of securities by maturity, ‘type’, quality or geography into layers or ‘tranches’ with sometimes many layers combined into these ‘vehicles’), often are used as collateral to secure trade transactions. This is known as a capital market collateralization). Vehicles or Special Purpose Vehicles, or Special Purpose Entities often represents unilateral obligations, which are secured in the form of property, surety, guarantee or other collateral. Capital Market Collateralizations are bilateral obligations which often are secured by more liquid assets such as cash or securities, or margin. Another example might be to ask for collateral In exchange for holding something of value until it is returned. (Information Source: Wikipedia)
In today’s banking industry collateral is used most prevalently as bilateral insurance in over-the-counter (OTC) financial transactions. Collateral is typically required to wholly or partially secure derivative transactions between institutional counter parties such as banks, broker-dealers, hedge funds and lenders. Most financial institutions use collateral to reduce credit risk exposure. As a result, collateral management has evolved rapidly in the last 20 years with increasing use of new technologies, competitive pressures in the institutional finance industry and heightened counter-party risk from the wide use of derivatives, securitization of asset pools and leverage.
Collateral management now encompasses multiple complex and interrelated functions, including repos, tri-party/multilateral collateral, collateral outsourcing, collateral arbitrage, collateral tax treatment, cross-border collateralization, credit risk, counter party credit limits and enhanced legal protection using ISDA collateral agreements. Once viewed as a support function, it is now in the forefront because of the failure of several high profile financial institutions and investment banks. All financial institutions are now more aware and concerned of the risks they face and tighter and stricter regulations required to demonstrate control of their own and their clients’ assets.
For most financial firms, collateral management is a function of the Credit Risk Department (Risk Managers) who decide on the amount of collateral required by counter-parties to minimize the risk exposure to the firm.
Capital Markets Advisors’ professionals have years of practical experience in Securities Finance and Collateral Management. CMA has worked within many Securities Finance departments whereby you can benefit from our experience. Also, we can help you realize the benefits of the new regulatory landscape to profit from these changes.
