Collateral

This chapter discusses the use of collateral, in over-the-counter (OTC) derivatives transactions, which is a crucial method to reduce counterparty risk. Collateral, which is also known as margin, is an asset supporting a risk in a legally enforceable way. A collateral agreement reduces risk by specifying that collateral must be posted by one counterparty to another in order to support such an exposure. Collateral also has funding implications. A significant aspect of liquidity risk stems from the funding needs that arise due to collateral terms, especially when collateral needs to be segregated and/or cannot be re-hypothecated. It is referred to as funding liquidity risk. The issue with collateral is that it converts counterparty risk into funding liquidity risk. This conversion may be advantageous in normal, liquid markets where funding costs are low. However, in abnormal markets where liquidity is poor, funding costs can become significant and may put extreme pressure on a party.