Collateral Management Guide PART 10: Alternatives to Using Collateral Author: Financial-edu.com
Collaterizing every OTC transaction is not always necessary. There are several alternatives to collaterization which are widely used:
Trading without the use of collateral is still effective where the credit risk between the counterparties is low or non-existent. For example, trading with a government or quasi-government entity which has an explicit government guarantee on its transactions is normally considered risk-free. A multinational corporation in a low risk industry with high cash balances, a history of payment, AAA credit rating, operating in a reliable legal jurisdiction would also be considered nearly default-free.
Other factors that may lead to choosing an uncollaterized relationship include:
- Length of deal (less than 1 month)
- Length of the trading relationship and history of payments
- Current and projected market conditions
- How automated the relationship is (e.g. SWIFT messaging setup with reliable third-party custodians, etc.)
- How profitable the deal is without collaterization: If the deal has a large built-in risk free arbitrage profit and is fully hedged already, this may make any effort to collaterize the deal more costly than the potential gain.
- Loss-Leader transactions: If the trading relationship is designed to be a loss-leader, for example to generate highly lucrative investment banking deals, then requiring collateral may be counter-productive to the end goal by driving customers away.
Prepaid Exchange of Notional Plus Profits
Some deals are structured to essentially pay the estimated profits and notional amount up-front in an all-cash deal. For example, a common emerging market cross-border structured deal involves the transfer by the borrowing party (Emerging Government) of a specified amount of that country's currency X, including all expected notional and interest payments over the life of the deal. In return, the lending party (International Aid Bank, backed by Industrialized Countries Syndicate) transfers a specified amount of developed market currency Y (e.g. EUR) to Emerging Government up-front. Emerging Government uses the Euros to purchase necessary inputs (steel, concrete, engineering services, etc.) for its infrastructure project. International Aid Bank then hedges its interest rate and currency risk in the open markets and, hopefully, locks in a profit on the deal. The deal is essentially all cash up front with no collateral required between the original counterparties.
If two counterparties do not want to enter into a collateral relationship, they can hire a Clearing House to risk-manage the transactions for them. The role of a Clearing House (compared to using in-house collateral management with a credit team) is to act as a middle man and a single point of netting for trade payments. Collateral must be posted with the Clearing House on an ongoing basis as a guarantee of cash payment, just as if the deal was done on a exchange. The Clearing House is responsible for processing payments between counterparties, provides a net collateral position across counterparties and instruments, and concentrates risk management and processing into one efficient location. The Clearing House is one function offered by Tri-Party Collateral service providers, but may not offer rehypothecation.
For a Clearing House to operate properly requires clear regulation, control, transparency, standardization of contract terms for both counterparties. Using a Clearing House reduces the burden on internal credit departments. However, it can add costs, especially if the counterparties do not trade frequently.
A break clause permits one or other of the counterparties to terminate a trade on specified dates. A break clause
can provide for complete freedom to terminate the deal, or only allow for termination under specific conditions. When a break occurs, the parties settle the difference in MTM value and go their separate ways.
Break clauses reduce counterparty risk by allowing termination when the deal valuation has moved significantly in one direction to the benefit of one party and detriment of the other. By breaking the trade, the counterparty holding a losing position is able to prevent further losses without having to go out in the market and find another counterparty to offset the trade, which can be difficult and expensive for customized OTC trades. However, like a non-breakable trade, one counterparty may not make the required payment even if the break process is followed. Collateral provides further insurance against non-payment beyond the ability to back out of a losing trade
and take losses before they get bigger.
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