Collateralization of credit exposures generated by bilateral OTC Derivatives is a key risk mitigant broadly used in the market. The benefits are broadly acknowledged and affect dealers and end users, as well as the financial system generally.
However, it is worth noting that in the very early stages of their development, the OTC derivative markets operated on a largely uncollateralized basis. The number of collateralized arrangements as a proportion of the market has evolved as the market itself has grown. (1)
Operational and Procedural Burdens
The first type of consideration for non-collateralization is the operational complexity associated with collateralization (negotiating a legal document, monitoring exposures, making cash transfers, etc.), which imposes a minimum requirement of volume of activity to make it economical for infrequent market participants. Counterparties affected by those considerations may include corporate clients, local authorities, and generally smaller institutions.
At a different level, the complexity of some products or organizational structures and processes (e.g. investment advisor acting on behalf of hundreds of funds/accounts) may also significantly increase the cost and resource requirements. (2)
The second type of consideration refers to the requirement for parties to be able to access cash or securities to be posted as collateral in addition to their payment and delivery obligations under the terms of the derivative transactions. As an example of how this type of liquidity management issue might affect a specific group of market participants, it is worth noting references to this issue in the “Corporate concerns about OTC Derivative Regulation” paper published by the European Association of Corporate Treasurers in September 2009. (3) This paper produced by the European Association of Corporate Treasurers (EACT) includes the following statement: “Increased cashflow risk from margining or alternatively not hedging identified risks would require companies to hold more risk capital and available lines of credit. Corporate activity would be reduced with obvious consequences for the real economy, employment etc.” (page 3)
The third type of consideration is “external” restrictions that are imposed on market participants in the interest of protecting other stakeholders. This could include:
- Credit agreements protecting other creditors. For example, many loan agreements have negative pledge language with only limited carve outs19 or may have cash flow sweeps for the benefit of the providers of revolving credit facilities.
- Regulators protecting investors in retail investment products. For example, in certain jurisdictions some types of regulated funds cannot post collateral due to limits on concentration risk or as an absolute prohibition.
- Budget or other constraints imposed on local authorities or other public or sovereign entities to control their indebtedness and expenses in order to protect the broader public. This type of mechanism is designed to protect public finances and/or ensure prudent spending but may indirectly force dealers to only trade on an entirely unsecured basis.
- Legal concerns may also inhibit the provision of collateral in relation to particular types of
institution in certain jurisdictions where the enforceability of collateral arrangements is not
- Tax issues arising in certain jurisdictions may prevent more widespread adoption of collateral arrangements. (4)
- Market Review of OTC Derivative Bilateral Collateralization Practices. International Swaps and Derivatives Association – March 1, 2010
- Financial Risk
- Collateral Asset
- Credit Risk
- Prime Brokerage
- Credit Support
- Collateral Dispute
- Commercial Risk
- Back-To-Back Letter Of Credit
- Interbank Market