# LO 26.6: Explain the features o f a collateralization agreement.

LO 26.6: Explain the features o f a collateralization agreement.
Collateral agreements are typically negotiated prior to any trading, and they are often updated prior to an increase in trading. Parameters must be clearly defined, and parties must balance the work involved in calling and returning collateral with the benefits of risk mitigation.
Terms of a collateral agreement may be linked to the credit quality of counterparties in order to minimize operational workload while maintaining the ability to tighten collateral terms when a partys credit quality declines. Counterparties most commonly link a tightening of collateral terms to changes in credit rating (e.g., to a downgrade in rating to below investment grade). While this approach is easy to set up, it can lead to issues by requiring the downgraded counterparty to post collateral exactly at a time when it is experiencing credit issues. This can lead to a death spiral of the affected counterparty, as the counterparty faces multiple collateral calls. As a result, it may be preferable to link collateral terms not to the credit rating of entities, but to credit spreads, the market value of equity, or net asset values.
Margin calls should be done at least daily. Products like repos and swaps that are cleared via central counterparties most often have intraday margining. While longer margin frequencies likely reduce operational workloads, daily margining has, more or less, become the market norm.
Threshold in margining refers to the level of exposure below which collateral will not be called. As a result, threshold represents the level of uncollateralized exposure, and only the incremental amount above the threshold would be collateralized. Thresholds generally aim to reduce the operational burden of calling collateral too frequently. A threshold of zero means any exposure is collateralized, while a threshold of infinity means all exposure is uncollateralized. Thresholds are most often linked to credit ratings in a tiered manner, with lower credit ratings corresponding to lower or zero threshold amounts.
Initial margin is the collateral amount that is posted upfront and is independent of any subsequent collateralization. It is often used to mitigate the widening of credit spreads or declines in equity values. Initial margin is typically required by stronger credit quality counterparties or by the counterparty more likely to have positive exposures and represents a level of overcollateralization. Initial margins are also typically linked to the credit rating of counterparties in a tiered manner; however, as opposed to thresholds, the level of intitial margin increases with lower ratings. Intiail margins can be thought of as converting counterparty risk into gap risk, ensuring that the less risky counterparty always remains
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overcollateralized by this amount without incurring losses, even when the risky counterparty defaults. Initial margins should, therefore, be large enough to minimize the gap from large value movements of trades should the risky counterparty default.
A minimum transfer amount represents the smallest amount of collateral that can be transferred. A minimum transfer amount is used to reduce the operational workload of frequent transfers for small amounts of collateral, which must be balanced against the benefits of risk mitigation. It is important to note that the threshold and minimum transfer amount are additive; that is, exposure must exceed the sum of both before a collateral call can be made. Minimum transfer amounts are also typically tied to credit ratings, with higher ratings corresponding to higher amounts.
Collateral amounts typically use rounding (e.g., to the nearest thousand) to avoid transferring very small amounts during collateral calls or returns.
A haircut is essentially a discount to the value of posted collateral. In other words, a haircut of x% means that for every unit of collateral posted, only (1 x)% of credit will be given. This credit is also referred to as valuation percentage. Cash typically has a haircut of 0% and a valuation of 100%, while riskier securities have higher haircut percentages and lower corresponding valuation percentages.
For example, if a particular sovereign bond has a haircut of 2% and a collateral call of $100,000 is made, only 98% of the collaterals value is credited for collateral purposes. That is, in order to satisfy a$100,000 collateral call, $102,041 ($100,000 / 0.98) of the sovereign bond must be posted (or \$100,000 in cash).
It is easy to see that riskier securities have greater haircuts to account for their volatility, which may lead to a decline in their value. In the order of increasing riskiness and higher haircuts, cash typically has no haircuts, followed by high-quality government bonds, triple-A rated corporate bonds, structured notes or products, and, finally, equities and commodities. Key factors to consider when assessing haircuts are time to liquidate collateral, volatility of the collaterals underlying market, and the default risk, maturity, and liquidity of the security. Assessing haircuts will often depend on current market conditions using sophisticated value at risk (VaR) calculations.
Entities usually pay interest, coupons, dividends, and other cash flows to counterparties posting collateral as long as the counterparty is not in default. Interest on cash collateral is paid at an overnight market rate. During times of high volatility and illiquid markets, cash collateral is generally preferred, and entities may pay higher-than-market interest rates as an incentive to the entity posting collateral.
We will now look at substitution, reuse, and rehypothecation of collateral. Counterparties sometimes require that the original posted collateral be returned to them for various reasons, including meeting certain delivery commitments. In this case, they can make a substitution request by posting an equivalent value of some other eligible collateral. Substitution requests cannot be refused by the other party if the substituted collateral meets all eligibility criteria. Noncash collateral may also be sold, used in repo transactions, or rehypothecated.
Rehypothecation refers to transferring posted collateral to other counterparties as collateral. While widespread, rehypothecation carries two related risks. Consider a scenario where
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party A pledges collateral to party B; party B rehypothecates this collateral to party C. If party C defaults, then party B will not only have a loss from not receiving the collateral from party C, it will also have a liability to party A for not returning its collateral. The practice of rehypothecation was relatively widespread prior to the 2007-08 credit crisis; however, it has been significantly less popular following the crisis. Parties now increasingly prefer cash collateral.
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