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Weigh collateralization as practised in OTC trading against the margining system, covering the role it plays there.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.h

The idea

Collateralisation in the OTC market is the bilateral counterpart of exchange margining. Under a credit support annex to the ISDA master, the party whose net position is negative posts collateral, usually daily, to cover the other side's mark-to-market exposure. The terms are negotiated. They are the threshold, the minimum transfer amount, eligible assets, haircuts, and whether posting is one-way or two-way. The collateral call is: Call = max(exposure − threshold, 0) − collateral held. A transfer happens only if the call exceeds the minimum transfer amount. Unlike a CCP's margin, which is standardised and always two-way, OTC collateral leaves residual exposure from the threshold and from the margin period of risk. The margin period of risk is the days between the last call and close-out. Posted collateral may be reused by the receiver, so the poster can become an unsecured creditor. Large dealers also exchange initial margin on non-cleared trades.

Formulas

Collateral call under a credit support annex

collateral call = max(exposure − threshold, 0) − collateral held

exposure
the mark-to-market exposure to the counterparty
threshold
the exposure that may stay uncollateralised
collateral held
collateral already received

A transfer is made only if the call exceeds the minimum transfer amount. The threshold, and any move over the margin period of risk, remain unsecured.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the main role of collateral in OTC derivatives dealing?

  1. To remove all market risk from the derivative positionWhy not: Collateral secures credit exposure; the position's market risk is unchanged.
  2. To set the price at which the contract is executedWhy not: Execution price comes from negotiation, not collateral.
  3. To guarantee a CCP's solvencyWhy not: This describes a clearing house default fund, not bilateral collateral.
  4. To secure the mark-to-market value owed - correct

The party with a negative mark-to-market posts collateral to the party with a positive value, so a default leaves a smaller unsecured claim.

A harder one

Under a credit support annex, the dealer's mark-to-market exposure to a counterparty is USD 9.2 million. The threshold is USD 3.0 million, the minimum transfer amount is USD 0.5 million, and USD 4.0 million of collateral is held. What collateral call is made, closest to?

  1. USD 6.2 millionWhy not: Ignores the collateral already held.
  2. USD 2.2 million - correct
  3. USD 5.2 millionWhy not: Ignores the threshold and subtracts only the collateral held.
  4. USD 1.7 millionWhy not: Subtracts the minimum transfer amount from the call, which is only a trigger.

Required collateral = 9.2 - 3.0 = 6.2. Less 4.0 held leaves a call of 2.2, which exceeds the 0.5 minimum transfer amount, so it is made in full.

The hardest tier

Under a credit support annex, a dealer posted collateral that the receiving party was permitted to reuse. The receiver later becomes insolvent. What is the dealer's position?

  1. Fully protected, because title always remains with the posterWhy not: If reuse is permitted, the poster has only a claim to return, not title to specific assets.
  2. A priority claimant ahead of the receiver's other creditorsWhy not: Rights of reuse lose the protection of a specific secured claim, so priority is not assured.
  3. Protected by the CCP, which guarantees return of bilateral collateralWhy not: No CCP is involved in bilateral collateral arrangements.
  4. An unsecured creditor for return of the collateral - correct

Collateral meant to reduce credit risk can create new risk when it can be reused. This is one reason regulators require initial margin on uncleared trades to be segregated.

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