Collateral Asset

Collateral Asset


According to the International Swaps and Derivatives Association:

As the use of collateral assets for credit enhancement in the derivatives market
has grown over the past decade, collateral practitioners have witnessed increasing
convergence of market practice in relation to the assets that are commonly given and
accepted as eligible collateral. At one extreme, collateral agreements may specify a very
limited range of assets as eligible collateral; for example, “USD cash and US Treasury
Securities”. At the other extreme, much more specialized and exotic assets are
increasingly being specified as eligible collateral.

The observation of practitioners, however, is that the vast majority of collateral
agreements employ a relatively narrow subset of assets as eligible collateral.
Even for the most commonly used collateral assets, different market participants
use descriptions that vary substantially from one another to describe the same collateral
assets. These discrepancies lead to increased time spent negotiating what amount to
semantic rather than substantive differences.

From an operational perspective, these semantic differences also reduce efficiency
and increase operational and legal risk. For example, anecdotally there are many
examples of collateral receivers who have inadvertently accepted collateral assets that are
not in fact eligible collateral because of a failure to verify the incoming collateral asset
against the relevant definition of eligible collateral in a collateral agreement. Few (if
any) collateral management systems are able to reduce this risk, because they tend to
capture the description of eligible collateral at a very high level, and cannot typically
reflect the specific language that is used in each collateral agreement. Even where the
collateral agreement itself is consulted, there are still situations where the “wrong”
collateral asset has been accepted because of a failure to understand the intended meaning
of the description of eligible collateral included in a collateral agreement.

This introduces another issue: use of imprecise language to specify assets as
eligible collateral. For example, the parties to a collateral agreement may specify that
“US Agency Securities” are eligible collateral. But which agencies does this definition
refer to? Not all agencies have the same degree of backing from the United States
Government. In addition, are all securities issued by a particular agency included? Some
agencies issue custom bonds that may include derivative or unusual features and are often
issued in a small amount, and, therefore, lack the liquidity of most types of standard
collateral assets.

As the amount by value of collateral assets in circulation in the derivatives market
exceeds the half-trillion dollar benchmark, collateral practitioners felt that it was time to
address these issues.






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