Collateral Management Guide PART 1: What is Collateral Management

Author: Financial-edu.com

This 13-Part Collateral Management Guide is written as a source of useful free information on all aspects of
collateral management. Each Part can be accessed by clicking the link at the bottom of the page.

What is Collateral Management?

At a high level, collateral management is the function responsible for reducing credit risk in unsecured
financial transactions. Collateral has been used for hundreds of years to provide security against
the possibility of payment default by the opposing party (or parties) in a trade. In our modern banking
industry collateral is used most prevalently as bilateral insurance in over the counter (OTC) financial
transactions. However, collateral management has evolved rapidly in the last 15-20 years with increasing
use of new technologies, competitive pressures in the institutional finance industry, and heightened
counterparty risk from the wide use of derivatives, securitization of asset pools, and leverage. As a result,
collateral management now encompasses multiple complex and interrelated functions, including repos, tri-
party / multilateral collateral, collateral outsourcing, collateral arbitrage, collateral tax treatment,
cross-border collateralization, credit risk, counterparty credit limits, and enhanced legal
protections using ISDA collateral agreements.

Credit risk exists in any transaction which is not executed on a strictly cash basis. An example of credit-risk
free transaction would be the outright purchase of a stock or bond on an exchange with a clearing house.
Examples of transactions involving credit risk include over the counter (OTC) derivative deals (swaps,
swaptions, credit default swaps, CDOs) and business-to-business loans (repos, total return swaps, money
market transactions, term loans, notes, etc.). Collateral of some sort is usually required by the
counterparties in these transactions because it mitigates the risk of payment default. Collateral can be in the
form of cash, securities (typically high grade government bonds or notes, stocks, and increasingly other
forms such as MBS or ABS pools, leases, real estate, art, etc.)

Collateral is typically required to wholly or partially secure derivative transactions between institutional
counterparties such as banks, broker-dealers, hedge funds, and lenders. Although collateral is also used in
consumer and small business lending (for example home loans, car loans, etc.), the focus of this article is on
collaterization of OTC derivative transactions.

Collaterization is the act of securing a transaction with collateral. It has multiple uses which fall under the
umbrella of collateral management:

- A credit enhancement technique allowing a net borrower to receive better borrowing rates or haircuts.

- A credit risk mitigation tool for private/OTC transactions -- offsets risk that counterparty will default on
deal obligations (in whole or part).

- Applied to secure individual deals or entire portfolios on a net basis.

- A trade facilitation tool which enable parties to trade with one another when they would otherwise be
prohibited from doing so due to credit risk limits or regulations (for example European pension fund
regulations or Islamic banking law).

- A component of firm wide portfolio risk and risk management including market risk (VaR, stress
testing), capital adequacy, regulatory compliance and operational risk (Basel II, MiFid, Solvency II, FAS
133, FAS 157, IAS 39, etc.), and asset-liability management (ALM).

- A money market investment (lending for short periods to earn interest on available cash or securities).
- A balance sheet management technique used to optimize bank capital, meet asset-liability coverage
rules, or earn extra income from lending excess assets to other institutions in need of additional assets.

- An arbitrage opportunity through the use of tri-party collateral transactions.

- An outsourced tri-party collateral / tri-party repo service for major broker-dealers to offer to their
clients.

Collateral Management Guide PART 2: Collateral Management Glossary

Author: Financial-edu.com

Collateral Management Glossary of Key Terms

The following key terms will be useful as you read through this Guide.

- Add-On: An additional currency amount added on to the mark to market value of an underlying trade or
security to offset the risk of non-payment. This represents the credit spread above the default-free rate
which one counterparty charges the other based on its internal calculations (often negotiated beforehand and
memorialized in a CSA).

- Call amount: the currency amount of collateral being requested by the Taker.

- Credit Support Annex (CSA): a legal agreement which sets forth the terms and conditions of the credit
arrangements between the counterparties. The trades are normally executed under an ISDA Master
Agreement then the credit terms are formalized separately in a CSA (SEE ALSO Collateral Support
Document).

- Collateral Support Document (CSD): a legal agreement which sets forth the terms and conditions that
collaterization will occur under in a bi-lateral or tri-lateral / multilateral relationship.

- Give: to transfer collateral to a counterparty to meet a collateral or margin demand. The counterparty
with negative mark-to-market (a loss) is usually the collateral Giver. (SEE ALSO Pledge).

- Haircut (SEE Valuation Percentage).

- Independent Amount: An additional amount which is paid above the mark-to-market value of the trade
or portfolio. The Independent Amount is required to offset the potential future exposure or credit risk
between margin call calculation periods. If daily calculations are used, the Independent Amount offsets the
overnight credit risk. If weekly calculations are done, the Independent Amount will usually be higher to
offset a large amount of potential mark-to-market movement that can occur in a week versus a day. Many
counterparties set the Independent Amount at zero then substitute the Minimum Transfer Amount (MTA)
as the Independent Amount on a counterparty-by-counterparty basis.

- Margin: Initial margin is the amount of collateral (in currency value) that must be posted up front to enter
into a deal on day 1. Variation margin (a.k.a. maintenance margin) is the amount of collateral that must be
posted by either party to offset changes in the value of the underlying deal. Initial margin is generally, but
not always, higher than variation margin.

- Margin Call: A request typically made by the party with a net positive gain to the party with a net
negative gain to post additional collateral to offset credit risk due to changes in deal value.

- Mark to Market (MTM): Currency valuation of a trade, security, or portfolio based on available
comparative trade prices in the open market within a stated time frame. MTM does not take into account
any price slippage or liquidity effect that might occur from exiting the deal in the open market, but uses the
same or similar transaction prices as indicators of value.

- Mark to Model: Currency valuation of a trade or security based on the output of a theoretical pricing
model (e.g. Black Scholes).

- Minimum Transfer Amount (MTA): The smallest amount of currency value that is allowable for
transfer as collateral. This is a lower threshold beneath which the transfer is more costly
than the benefits provided by collaterization. For large banks, the MTA is usually in the USD 100,000
range, but can be lower.

- Netting: the process of aggregating all open trades with a counterparty together to reach a net mark-to-
market portfolio value and exposure estimate. Netting facilitates operational efficiency and
reduced capital requirements by taking advantage of reduced risk exposures due to correlation effects of
portfolio diversification versus valuing all trades independently. However, netting relies upon efficient and
accurate pricing at a portfolio level to be effective.

- Pledge: to give collateral to your counterparty. (SEE ALSO Give).

- Potential Future Exposure (PFE): The estimated likelihood of loss due to nonpayment or other risk, in
this case the likelihood of default on a counterparty's obligations.

- Rehypothecation: the secondary trading of collateral. Rehypothecation is the cornerstone of tri-party

collateral management.

- Substitution: replacing one form of collateral (e.g. corporate bond) with another form of collateral (e.g.
Treasury bond) during the life of a particular deal or trading relationship.

- Take: to receive collateral from a counterparty to meet a collateral or margin demand. The counterparty
with positive mark-to-market (a gain) is usually the collateral Taker.

- Threshold Amount: the amount of unsecured credit risk that two counterparties are willing to accept
before a collateral demand will be made. The counterparties typically agree to a Threshold Amount prior to
dealing, but this is a source of ongoing friction between OTC counterparties and their brokers.

- Top-up: To give additional collateral to your counterparty to meet a margin call.

- Valuation Percentage: a percentage applied to the mark-to-market value of collateral which reduces its
value for collaterization purposes. Also known as a "haircut", the Valuation Percentage protects the
collateral Taker from drops in the collateral's MTM value between margin call periods. For example, if the
MTM value of the collateral is $100 and the Valuation Percentage = 98.5% then 1.5% is being charged to
offset period-to-period valuation risk and
the collateral amount counted is only $98.50. The Valuation Percentage offered by different counterparties
and brokers may vary in the market, so buy side participants often "haircut shop" for the best rate.

Collateral Management Guide PART 3: How Collateral Transfers Risk

Author: Financial-edu.com

How Collateral Transfers Risk

In OTC trading, counterparties are exposed to the risk that the other counterparty will not make required
payments when
they are due. The risk of non-payment is called credit risk. These types of payments include derivative
deal payments (e.g. interest rate swap payments, CDS premiums or default payments), dividend payments
for stocks, coupon payments for bonds, etc. The amount of credit risk varies in real time and must be
managed on a trade, counterparty, and net portfolio basis.

The primary purpose for collateralization is to transfer risk from the party in the net positive (gain)
position to the party in the net negative (loss) position during the life of a deal. This is done by requiring the
losing party to post or transfer an asset (cash, marketable securities) to the winning party as a form of
ongoing security. In the event of a default, the creditor party then has the right to keep the asset to
reduce his loss. The currency value of the collateral represents the estimated probability of payment default,
mulitplied by the notional value of the expected payment(s). This is known as Potential Future Exposure
or PFE.

Two simple examples demonstrate this dynamic:

Securities Collateral Example:

1) Net Exposure (single or multiple deals) = $100

2) Collateral posted previously = ($80)
3) Net collateral delivery requirement = $20 = CREDIT RISK
4) Collateral given = $20
5) Net exposure = $0 = NO CREDIT RISK REMAINS

Cash Collateral Example:

1) Net Exposure (single or multiple deals) = $100

2) Cash Collateral Posted = ($80)
3) Overnight interest earned on Cash ($0.10)
4) Net Collateral delivery requirement = $19.90 = CREDIT RISK
5) Collateral given = $15
6) Net exposure = $4.90 = REMAINING CREDIT RISK

There is an important difference between over the counter (OTC) deals and exchange-traded deals. OTC
transactions do not normally have a clearing house acting in a credit risk mitigation role between the
counterparties which guarantees and processes deal payments. An exchange clearing house insures that
buyers and sellers on the exchange will make and receive their payments by requiring traders to post daily
margin in the form of cash or marketable securities. Since this form of insurance is not available to OTC
counterparties, they need another form of insurance. Collateral acts as partial insurance to offset changes
in market value.

Credit risk can shift back and forth from one counterparty to the other on a constant basis. Mark-to-market
values on open positions change daily, weekly and monthly. The counterparty with a net positive gain is
exposed to unsecured credit risk in the amount of open uncollaterized gain. This credit risk can continue to
increase until the party has a large unsecured gain. By demanding additional collateral, this profit is "locked
in" or insured up to the market value of the collateral posted, less the transaction costs associated with
liquidating the collateral. In the event of a missed or delayed payment the Taker of collateral can keep the
collateral posted and sell it in the open market to offset the lost income.

Margin agreements typically provide a grace period for the counterparties to negotiate differences in
valuation, adjust collateral amounts, substitute one collateral form for another, etc. This provides some
flexibility in the relationship and keeps things running smoothly in the event that a particular type of
collateral (e.g. U.S. Treasury Bonds) are not easily available at a reasonable price at the time of the margin
call, or there is a disagreement on what the underlying deal value might be (this is common on illiquid OTC
structured deals).

Credit Risk vs. Collateral Requirements

Credit departments of banks, broker-dealers, lenders, and buy side institutions rely on a variety of
techniques to assess credit risk of their counterparties. These include:

- External credit ratings

- Internal credit ratings
- Payment histories
- Statistical default probabilities per counterparty, industry, or market
- CDS spreads (if the counterparty is an issuer with CDS written on its bonds)
- Equity prices (the counterparty's equity price is considered an accurate forward-looking gauge of financial
health)

Collateral requirements can increase or decrease depending on the factors above. In addition, two additional
factors can influence the amount of collateral required:

- Length of the deal: overnight repos have lower collateral requirements than 30 year swaps as there is far
less time in which to default.
- Quality of collateral: more collateral is required if the securities posted are rated less than AAA, or have
volatile prices (e.g. credit default swaps)

Deal Risk Still Remains

Even if a deal is properly collaterized, there still remain legal, operational, and other risks. In particular,
bankruptcy of a counterparty can pose extreme challenges in liquidating and collecting the cash value of
the collateral posted. In bankruptcy, it is possible that the collateral can be "clawed back" by the
bankruptcy court if it is found that another counterparty had a prior claim to the collateral posted by the
defaulting party. This situation can be complicated further in cross-border deals (domestic or
international) by differences in jurisdiction and legal systems.

It is critical that the Collateral Support Document between the counterparties address these issues and
provide for adequate assurance that the collateral posted will be capable of transfer and liquidation on
failure to pay, and will not be encumbered by prior pledges or debts. It is also critical that the jurisdiction in
which the transaction was completed fully enforces the collateral agreements and does not invalidate them.

Collateral Management Guide PART 4: The Collateral Landscape

Author: Financial-edu.com

The collateral management landscape has changed rapidly in recent years. While collateralization has
always been important in OTC transactions, the recent global credit crisis has put a spotlight on the need to
fully understand and protect against credit risk in highly leveraged OTC derivative transactions.

Growth of Collateralized Transactions

The following growth figures were obtained from ISDA. Post-2007 numbers may not be as accurate, since
many of the major reporting prime brokers have either gone under, cut their staff significantly, or are in the
midst of legal actions to recover or defend against giving back collateral. Since OTC transactions need not
be reported to regulatory authorities in most jurisdictions it is difficult to obtain accurate figures. However,
these numbers show 5x growth in collateral value since 2001.

Year Collateral Value (USD billions)

2001 $250
2002 $437
2003 $719
2004 $1017
2005 $1209
2006 $1329

Markets that are Widely Collaterized

- Fixed Income Repo

- Equity Finance
- Exchange Traded securities
- OTC derivatives
- Securities lending
- FX margining
- Cash payments
- Corporate bonds
- Asset Backed securities
- Equities
- Mutual Funds
- Bank Loans
- Commodities

Global Collateral Markets

- U.S. and Canada have highly developed collateral markets focused on cash and Treasury Bonds.

- Europe has highly efficient fixed income collaterization, fragmented equity markets, and historically
fragmented settlement and clearing infrastructures (this is improving rapidly). Europe still has fragmented
tax systems, legal systems and variations in collateral treatment during bankruptcy.

- The Middle East has a rapidly developing collateral market in a form which is acceptable under Sharia or
Islamic Law. Lending is largely illegal in Muslim countries, which includes lending securities. Under
Islamic banking law, most deals must be fully secured with collateral to ensure that no credit is extended
between counterparties.

- Latin America has a developing collateral market, but is hindered by inefficient legal systems, under-
developed custody and IT systems, and access to quality collateral. Commodities and government bonds
(including U.S. Treasuries) are the preferred form of collateral.

- Asia is a mix of rapid development in China, Malaysia, Indonesia, Korea, etc. and a mature and
sophisticated market in Japan. In general, credit (and hence the need for collateral) is used more
conservatively, and large banking relationships backed by government intervention tend to limit defaults.
China's adoption of common collateral definitions in 2005 was a major milestone to development of
efficient OTC and derivatives markets in Asia.

Key Technical and Legal Developments in Collateral Operations

- 2003 Electronic Data Interchange (EDI) standards developed to automate collateral transactions and
communications.
- 2003 ISDA Collateral Asset Definitions: standardized the definitions of eligible collateral.
- 2003 Enterprise Wide Collateral Management: Netting on a portfolio, customer, and enterprise-wide
basis is embraced to increase efficiency, cut costs, and include a wider range of risks.
- 2005 Chinese Market Collateral Glossary: The Chinese join with other trading powers in defining key
terms to use in collateral and credit agreements.
- 2005 ISDA Collateral Guidelines: ISDA embraces industry advances and lays out standard bi-lateral
and tri-lateral operational processes.
- Collateral Market Practices published
- Portfolio Reconciliation published to provide guidelines on managing complex collateral portfolios.
- July 31, 2008 Major Dealers in the Operation Management Group letter to the U.S. Federal Reserve: by
Dec 31, 2008 the major participating dealers agreed to a goal of weekly interdealer reconciliation of
collaterized portfolios with more than 5,000 trades, the provision of adequate resources to the collateral
management function to identify and resolve differences, collect and report metrics to supervisors (thus
driving increased demand for systems to capture data and report disputes and risk metrics).

Collateral Management Guide PART 5: Mechanics of Collateral Management

Author: Financial-edu.com

Managing financial collateral is a complex process involving multiple parties.

Parties involved

- Collateral Management Team: Does collateral calculations on spreadsheets and dedicated

software, delivers and receives collateral, runs the collateral operations, maintains customer and securities
data, issues and receives margin calls, and liaises with customers, service providers, Legal, Middle Office,
and other parties in the collateral chain.

- Credit Analysis / Approval Team: Researches, analyzes and sets collateral requirements for new and
existing counterparties. Typically this entails a preliminary review as well as ongoing periodic reviews of
the credit risk of each counterparty.

- Front Office Sales and Traders: Sales people develop new eligible trading relationships and manage
the onboarding process for new accounts, including signing of legal collateral documents, account
formation, and ongoing sales transactions. Traders may execute trades only with approved counterparties.

- Middle Office: Typically responsible for risk and valuation measures, the Middle Office interacts with
the Collateral Management team on a daily basis.

- Legal Department: Conducts negotiations, drafting and review of agreements. Enforces collateral and
margin agreements, including initiation of collections and lawsuits where appropriate. Legal is required to
sign off on all written agreements.

- Valuation Team: This group focuses on valuing illiquid or exotic collateral and underlying trade
position that must be collaterized. Typically, these types of collateral and deals are thinly traded rather
than liquid exchange-traded instruments.

- Accounting & Finance Team: Works with the Middle Office to calculate and account for P&L on
collateral posted and received. Also works with Tax and Auditors.

- Third Party Service Providers: Software providers, Consultants, Auditors, Tax Specialists, Tri-Party
Collateral Managers.

Creating a new collateral relationship

For OTC transactions, collateral is the norm rather than the exception. Prior to the widespread use of
derivatives, collateral was required by large banks only for smaller or riskier customers (such as hedge
funds or niche brokers), under the assumption that other large banks would rarely default on their
obligations. With the dramatically increased leverage built into the financial system through derivatives and
securitized pools, collaterization is now mandatory between almost all counterparties.

Once a new customer is identified by Sales, the first step is to conduct a basic credit analysis of that
customer. This is done by the Credit Analysis team. Only credit-worthy customers will be allowed to trade
on a non-collaterized basis.

The next step is to negotiate and enter into the appropriate legal agreements. In the world's major
trading centers, counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure
clear and effective contracts exist before transactions begin. These agreements cover 90% plus of the
information on eligible collateral, margin requirements, independent amounts (haircuts) calculation and
payment methods, etc. Negotiation and finalizing these agreements can take up the bulk of the time in
developing a new relationship, often extending weeks or months.

Then the collateral teams at each counterparty implement and automate the collateral
relationship. Bank codes, SWIFT codes, custodian and transfer relationships, key contacts and phone
numbers, report formats, margin call processes, etc. are all communicated and entered into the collateral
systems of both counterparties. This process may be done in a matter of days or take up to several weeks.

If the two parties want to trade right away, they will typically post some initial reciprocal collateral with
the other party (either cash or default-free Treasury bonds) to "open the account." This lays the groundwork
for new trades, which will only require "topping up" the collateral to meet initial margin requirements.

Once these items are in place, the Front Office Sales and Traders can begin negotiating trades. Once a
trade is agreed upon, the Collateral Team is notified of the deal, and the required Initial Margin is posted to
enable the trade to occur.

Daily Collateral Operations Process

The Collateral Management team's job is to continually track, value, and give or receive collateral during
the life of every OTC trade in the institution's portfolio. This is a large and complex task requiring
sophisticated systems and dedicated personnel. The general tasks on a day-to-day basis include:

- Managing Collateral Movements: tracking the net MTM valuation, making and fielding margin calls,
and giving / taking collateral to offset credit risk on a deal and net portfolio basis.

- Custody, Clearing and Settlement: Depending on how the legal relationship is structured, one or the
other counterparty may act as a custodian for cash and securities, or a third party custodian may be
hired. This requires segregated accounts strictly for collateral by customer (and often sub-account level).
The custodian manages collateral inflows and outflows, counterparty payments (top-ups, etc.), interest
calculations, haircuts, dividends, coupon payments, etc. as well as accounting for and reporting all
transactions accurately and timely. The custodian role is often outsourced, especially by hedge funds who
typically outsource this function to a custodian subsidiary of their prime broker.

- Valuations: The Valuation team (often part of the Collateral or Middle Office team) is responsible for
valuing all securities and cash positions held or posted as collateral. This duty is affected by the valuation
roles defined in the CSA -- for example, many smaller hedge funds delegate valuation to their prime brokers
who may have greater access to comparative valuation data, valuation models, and large teams of qualified
staff. Traditionally, valuation has been done on an end of day (EOD) basis, but is now moving
toward intraday and real time valuation where possible.

- Margin Calls: When the Collateral Team determines that the mark-to-market change of a particular deal
or net portfolio position has moved against the counterparty by at least the Minimum Amount, a margin call
is issued. Margin calls are made via telephone, fax, email, or SWIFT message, stating the amount of
collateral demand and often the type of collateral required, if defined in the relevant CSA. The
counterparty is then required to top-up its collateral account by delivering cash or securities, typically
by overnight wire transfer. If the counterparty does not meet its margin call, and the amount is large
enough, the Collateral team may issue a notice indicating the trading relationship is temporarily or
permanently halted until the account is brought to net zero exposure. If the counterparty does not respond
the custodian is notified, and the existing collateral may be seized, and the account turned over to the Legal
department for enforcement of any outstanding obligations. Typically, the Front Office will offer the
counterparty the opportunity to "break" the deal and pay a penalty before full legal action is taken. The
above dynamics are reversed if the first party is the net debtor (i.e. receives one or more margin calls).

- Substitutions: Often one party would like to substitute one form of collateral for another. For example,
cash rather than Treasury Bonds, or Corporate Bonds rather than Treasuries. The Collateral Team will then
look to the CSA for guidance on acceptable substitute collateral (if covered) or make a decision based on the
perceived value of the substitute collateral. Collateral substitution allows for flexibility in the relationship,
and the ability to deliver good collateral at a lower net price. Once a substitution is accepted, this must be
properly tracked in the Collateral Management system as well as communicated to all relevant parties
(custodians, valuation team, etc.), and followed up to ensure the substitution actually occurs.

- Processing: Payment and event processing is often outsourced to a dedicated third party. This function
includes:
- Coupon payments
- Dividend payments
- Corporate actions (splits, reverse splits, share buybacks, etc.)
- Payment delays (accruing, accounting and charging interest or lost capital gains/losses)
- Redemptions
- Taxes (accounting for and issuing the necessary tax documents for each tax jurisdiction so customers can
properly account for and pay their taxes)

Collateral Management Guide PART 6: Collateral Eligibility and Valuation

Author: Financial-edu.com

Collateral eligibility is one of the key steps in a stable trading relationship. Since the purpose of
collaterization is to secure or insure all or a portion of the counterparty credit risk in a trading relationship,
eligible collateral must be easily converted into economic value when needed (i.e. when a counterparty
defaults).

Basic Requirements for Collateral Eligibility

- Liquid: Securities used as collateral must be highly liquid (marketable) so they can be sold for cash in the
open market on short notice. This may also apply to certain currencies as well -- USD and EUR are liquid,
but Turkish Lira may not be.

- Easy to settle: Treasury bonds, AAA Corporate bonds, large-cap equities, and many mortgage-backed
bonds are easy to settle, typically taking no more than one day.

- High quality (default free): Collateral itself should not have significant embedded credit risk itself.
Major industrialized country government bonds are unlikely to default, whereas junk bonds and emerging
market bonds have significant and widely varying credit risk and are unlikely to be accepted as collateral.

- Approved by the Credit Department: The Credit Team must approve all securities offered as collateral
prior to acceptance. Guidance is taken from the Credit Support Annex (CSA), but the Credit Team should
have final say since their credit analysis is often more up to date than the legal documents.

Types of Collateral

According to ISDA, the following types of collateral are most predominant:

- Cash (73% of USD and EUR trades according to ISDA 2005). Cash is easy to hold, easy to transfer,
requires little or no valuation.

- Fixed Income Securities: Predominantly Government Securities (Treasury Bonds, Agency Bonds, etc.),
but also includes other types such as MBS, ABS, corporate bonds, sovereign bonds, etc.

- Bank Guarantees
- Equities (stocks): Usually large-cap and highly liquid shares listed on major exchanges.

- Real Estate: Commercial buildings, land, etc. if deemed sufficiently liquid. This collateral is more
relevant to structured project financing transactions.

- Convertible Bonds: These must be issued by a credible company with low default risk, and must convert
into marketable common stock or premium stock at a significant discount.

- Exchange Traded Funds (ETFs)

- Mutual Fund Shares: This can be very complicated due to interactions between custody, taxes, trading
limitations, ownership concentrations, and redemption rights.

Considerations in Valuing Eligible Collateral

The ability to quickly and accurately value collateral is a critical element of its eligibility, without which
the collateral has little use. Collateral provides no security if it cannot be valued or traded for a known
value. When deciding whether collateral is eligible, the following factors are important:

- Who values the collateral? This is usually governed by either the CSA or trade documents (deal term
sheet). The choices are: 1) you, 2) me, 3) both, or 4) third party. Two banks will typically push for
either 2) me or 3) both, so that each has a hand in the final determination and can bring their valuation
expertise to bear. Smaller hedge funds without dedicated valuation teams usually choose 1) you or 4) third
party. This gives valuation control to the prime broker which typically has dedicated valuation personnel
and a wider view of market prices.

- How is it valued? Depending on the type of trade, the valuation may be done on a mark to market
(MTM) or mark to model (theoretical valuation) basis. Where the trade is fairly vanilla and there are
plenty of comparative market prices, mark to market is selected. For more exotic or complex transactions,
mark to model may be necessary, and the determination of a) the model used, and b) who does the
valuation, becomes extremely important. These factors should be decided up front before doing a deal, or at
least subject to approval by the Collateral or Valuation teams before a deal is completed.

- How often is it valued? Traditional valuation is done on an end of day basis (EOD) after the market
closes. However, with the advancement of collateral systems, electronic order networks, and other
technology, there is a movement toward periodic intraday (i.e. 30 or 60 minute intervals) or real time
valuation. Illiquid trades are still valued on a daily basis and sometimes weekly or monthly for highly
structured deals.

- Independent valuation required? In some instances a deal is so unique or illiquid that a third party
valuator or appraiser is required to theoretically price a deal for collateral and PnL purposes. Where this
is necessary, the issue becomes cost, the number of independent valuators used, and how to decide on a final
value from multiple different estimates without proceeding to litigation.

Collateral Management Guide PART 7: Margin Calls and Collateral Disputes

Author: Financial-edu.com

The Margin Call is the primary mechanism which ensures adequate collateral is posted during the life of a
deal. Occasionally counterparties may disagree on whether a margin call is appropriate, or the amount of
collateral requested.

Margin Call mechanics

 1) All trades are marked to market (daily, weekly, monthly).
2) All collateral is marked to market.
3) Net collateral requirement is calculated internally by each party
4) Credit risk exposure is compared to a pre-defined acceptable exposure level.
5) A margin call is made to counterparty if exposure limit exceeded.
6) Counterparties net their collateral calculations (if both have posted / received collateral from the other).
Otherwise, the
party receiving a margin call either accepts the call on its face or analyzes it and determines how much
needs to be posted by looking at market prices, collateral agreements, etc.
7) The counterparties come to an agreement on how much needs to be posted.
8) The undisputed portion of collateral required (imbalance) is posted by the losing counterparty to the
winning counterparty. The disputed portion (if any) may be negotiated.
9) Collateral posting settles T+1 (next normal business day). This may take longer for non-standard
collateral or international transactions.

Collateral Disputes

There are several types of collateral disputes which occur most frequently. These include:

- Ineligible collateral / collateral recharacterization: The losing counterparty attempts to post securities
having less quality than required, or the quality of the collateral has dropped below the required threshold
(e.g. an investment grade bond has dropped to B-rated and is no longer eligible).

- Payment delays

- Valuation disagreements: Curves or prices may be captured at different times, from different data
sources, using different price samples, or the theoretical valuation done using different valuation models or
settings.

- Portfolio mismatches: Missing trades are not included in the portfolio which creates net exposure
calculation differences. This is quite common, especially where the Front Office has failed to properly enter
trades at one of the counterparties.

Dispute Procedure

Resolving collateral disputes generally takes the following path:

1) Check the collateral value using market data such as FX rates, interest rates, bond prices, etc.
2) Make sure the Credit Support Annex (CSA) covers the specific securities or locations/branches in
question.
3) Check the net collateral requirement vs. thresholds (specific and general).
4) Check rounding amounts (rounding up or down at a specified level of granularity).
6) Perform price change analysis walk-through with counterparty. This helps determine the source of
the valuation issue over time.
7) If the counterparties still cannot agree on the correct amounts, then implement formal dispute resolution
procedures. These should be governed by the appropriate CSA:
a) get additional external quotes (3rd party dealers, banks, valuation consultants, etc.)
b) get one or more appraisals done.
Collateral Management Guide PART 8: Rehypothecation and Tri-Party Collateral
Management

Author: Financial-edu.com

Collateral Trading: Rehypothecation of Collateral

When a net creditor in a deal receives marketable collateral from the debtor counterparty, the creditor may
then turn around and pledge that collateral for another transaction with a second counterparty. This is
known as "rehypothecation", an odd word meaning the secondary re-use of collateral.

The basic function of rehypothecation is to provide counterparties with a broader array of collateral
availability and the ability to enter into a wider breadth of trade types. In certain transactions with
credit risk such as credit default swaps, the quality and marketability of collateral is essential to be able to
enter into and maintain a deal over its life. A trader who is able to access different types of collateral from
other transaction has a greater ability to get into trades where collateral security is required, and to obtain
and post additional collateral as needed by leveraging other profitable deals. The trader may also earn an
interest rate spread between the haircut charged and the haircut paid to two different counterparties.

Rehypothecation has been traditionally used in bi-lateral trading relationships. However, to

rehypothecate collateral efficiently and on a larger scale is very complex and requires dedicated staff,
inventory and accounting systems, and legal support unavailable to many smaller institutions such as hedge
funds. Without the proper systems and procedures, there is a risk of double-committing collateral or not
being able to obtain the collateral back when needed. These factors have led to the rapid growth of the
tri-party collateral business.

Tri-Party Collateral Management

Tri-Party or multi-party collateral managers provide a central service to manage, clear, and
rehypothecate collateral among many different OTC counterparties in the market. With tri-party
management, collateralization can be done at a net portfolio level and rolled up into a single statement in
near real time. Collateral agreements are standardized in ISDA format across the entire pool of trading
counterparties, eliminating inefficiencies caused by differences in contractual interpretations.

Collateral rehypothecation is the foundation of tri-party collateral management services. In exchange for
providing access to different markets and collateral types to the service membership, the tri-party manager
acts as a central broker, taking a small portion of each collateral transaction as a fee or trading spread.
Usually this is in the form of a haircut differential between the haircut paid to the collateral giver (lower),
and the haircut received from the collateral taker (higher). Facilitation of tri-party repos and total return
swaps provides access to a common pool of collateral posted by a wide variety of market participants from
different locations around the world, across a broad array of products. For this valuable service, the tri-party
manager takes a small cut of each collateral movement.

Additional services provided by tri-party collateral managers include:

- Securities Lending Escrow (SLE): Manages securities received from borrowers for the benefit of
lenders.

- Holding securities (security, safekeeping, accounting)

- Mark-to-market and mark-to-model valuation

- Reporting and recordkeeping

- Substitution of collateral
- Delivery and receipt of collateral postings

- Collateral eligibility testing

- Margin calls: issuing and managing responses versus margin agreements

- Rehypothecation tracking: Accounting for and managing the movement of collateral through the chain
of trading counterparty accounts.

- Asset servicing: Processing bond coupons, interest payments and receipts, interest accruals, dividends,
stock voting, etc.

- Trust services: Calculation and payment of interest on cash collateral in the form of trust assets, at
negotiated interest rates

The benefits of using a tri-party collateral manager include:

- Reduced overhead: There is no need to maintain a large back office team and IT investments required to
process, rehypothecate, and account for collateral on OTC positions.

- Technology: Tri-party collateral managers utilize the latest sophisticated real-time processing and
communication systems.

- Concentrating on core business: The counterparties can concentrate on their core businesses of trading,
financing or lending, instead of managing collateral.

- Enables higher trading volume: By outsourcing the back office functions of collateral to a highly
efficient and automated service provider, a common bottleneck is removed, and the trading instution can
trade at much higher volumes without overwhelming the back office function.

- Enables diversification into more instruments: The typical bi-lateral trading relationship is limited to 2-5
unique instruments. Tri-party member institutions can have access to 50 or more different transaction types
to choose from.

- Arbitrage rates of borrowing and lending across different collateral types (e.g. Treasury Bonds vs.
Corporate Bonds): Trading institutions can use the collateral function as a source of arbitrage or directional
trading, as if they purchased and sold deals directly with an OTC counterparty.

- Segregated reserve bank accounts under SEC Rule 15c3-3: The SEC Act of 1934 requires broker
dealers to maintain "special reserve bank accounts" strictly for customers which are separated from the
broker dealer's own accounts. Cash deposits may be invested in "qualified securities" or held as cash
deposits. There is no limitation to a broker dealer placing client cash in such accounts, and there are no
limits on the number of withdrawals. This compares to 50% of excess net capital for money market deposit
accounts. Similar segregation is provided pursuant to rules of the Investment Industry Regulatory
Organization of Canada (IIROC).

- No cost to the Lender: Lenders do not pay for the tri-party collateral management service

- Access new forms of collateral at competitive rates

- Commodity Futures segregated accounts: CFTC Rule 1.20 Commodity Customer Segregated
Account and CFTC Rule 30.7 Secured Amount Bank Account: Futures Commission Merchants
(FCMs) must invest customer cash in a way to protect client assets. Accounts must accept and maintain
only cash, with no securities allowed. Segregation is required to prevent cash assets from begin mixed with
securities payments and failures to pay. Cash deposited is held in a segregated trust acccount which is
FDIC-insured and accounted for on the trust ledger of the bank. Accounts can accomodate multiple
currencies.

Tri-Party Service Providers include:

- JPMorgan

- Bank of New York Mellon

- Clearstream

- Depository Trust and Clearing Corporation (DTCC)

- Deutsche Bank

- Euroclear

- Northern Trust

- State Street Bank and Trust

- SWIFT

Collateral Management Guide PART 9: Advantages and Disadvantages of Collateral

Author: Financial-edu.com

There are both advantages and disadvantages to collaterizing OTC transactions:

Advantages of Collateral

- Reduced credit risk: mitigation of current and potential future exposure to losses due to nonpayment by
a counterparty.

- Capital savings: collaterizing and netting counterparty exposures reduces the amount of economic capital
required to cover credit risk and balance sheet protection (e.g. Basel II, Solvency II). This allows increased
leverage and profit potential of a bank's assets.

- Increased competitiveness: the ability to trade in a wider variety of markets where the margins may be
higher or profits more predictable.

- Improved market liquidity: increased opportunity to do more transactions in the markets, with less
capital, and less time required for credit review and settlement.

- Access to higher risk trades: collaterization reduces the risk of illiquid or new trade types which have
higher risk but higher profit margins.

- More efficient trading between counterparties: collaterization formalizes an ongoing relationship and
makes transactions and payments smoother, with more opportunity to check valuations and balance the
gains and losses in a standard, repeatable manner.

- Benefits to Buy Side (asset managers, corporate treasury, etc.)

- Minimize collateral amounts by cross-collaterization
- Minimize collateral movements and give/take collateral on a net basis
- Collaterize exposures by client

- Benefits to Sell Side (broker dealers, banks, etc.)

- reduces capital charge to allocate for asset liability management, etc.

Disadvantages of Collateral

- Increases Operational Risk (aka Murphy's Law): Collaterization is complicated. Failure to invest
in the correct technologies, staff, third-party relationships, and operate collateral processes accurately and
efficiently creates additional operational risk and a false sense of security.

- Legal Risks: How to structure, document, and manage the collateral agreements requires specialized legal
skills, technologies, and trained staff.
- Legal procedures: proper documentation, storage, confidentiality, etc.
- Perfection risk: the possible risk of inability to "perfect a claim" to collateral (assert proper legal
ownership) when default is imminent or default occurs.
- Recharacterization risk: the possibility that the collateral might be recharacterized as non-eligible under
the jurisdiction's laws and "clawed back" in bankruptcy proceedings.
- Priority risk: the risk that some other counterparty has a prior claim on the collateral you hold, making the
collateral ineligible.
- Enforcement risk: risk that the counterparty won't give back your collateral, and the jurisdiction does not
honor the collateral agreements due to lax enforcement of contract laws, political pressures, or other
reasons.
- Inactive CSA's: Maintaining inactive agreements that may be outdated, including the cost of review,
storage, etc.
- Long CSA negotiation period while traders want to trade

- Concentration Risk: the overreliance on a single counterparty once a collateral relationship is

established. This increases default correlation and leads to underestimation of single large risks such as a
the counterparty going bankrupt suddenly.

- Settlement Risk: The possible failure of securities settlement procedures, including payments, custody,
etc. (however this risk also exists in non-collaterized transactions).

- Pricing risk and model risk: Even though a transaction may be collaterized, deals that are complex or
securities which are thinly traded rely heavily on pricing models for their valuation and resulting collateral
required. Any errors or rapid market shocks during the valuation process can lead to under-collaterization
(or over-collaterization) and subsequent losses or inefficient use of capital.

- Can Increase Market Risk: Market risk on securities held as collateral can contribute to the firm's
Value-at-Risk by increasing correlations in the firm-wide portfolio under market stress. High correlations
lead to increased market risk through the belief that you are adequately collaterized, but everything goes
down in value at once, resulting in rapid under-collaterization. To account for this, the firm must include
collateral securities and cash in portfolio-wide market risk and pricing calculations.

- Expensive: The solution is often to outsource to tri-party collateral service

- Can reduce trading activity: Collaterizing transactions can actually reduce trading activity by
eliminating more risky counterparties. This occurs when there are:
- Overly high thresholds
- Delays in posting / receiving collateral
- Collateral Operations are highly manual and slower than the traders
- Trade eligibility is lowered based on low availability of a narrow and expensive range of acceptable
collateral (e.g. Treasury Bonds)
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:

Uncollaterized Transactions

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.

Clearing House

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.
Break Clauses

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.

Collateral Management Guide PART 11: Checklist for Building a Collateral Management
Function

Author: Financial-edu.com

The following checklist is helpful for building a basic collateral management function.

Business Plan:
- Goals
- Costs vs. Savings vs. Risk
- Budgets
- Authority and Buy In from Key Constituents (Trading, Sales, Treasury, Accounting, Risk, Senior
Management)
- Management Support and Enforcement

Technology:
- Data feeds
- Data and document storage
- Collateral Software
- Accounting Software
- Risk Management Software
- Outsourcing?

People and Skills:

- Collateral Manager: Operations, relationship management, regulatory / legal skills
- Credit Manager: Credit analysis skills
- Valuation Specialist: Valuation, simulation tools, research, mathematics or financial engineering skills
- Accounting Manager
- Cash Manager
- IT Support: Database, SWIFT messaging, data feed skills

Legal Agreements:
- Key Factors: Correct form, accurate, comprehensive, enforceable
- Collateral Agreements (SEE ISDA, UK, Europe, Asia authorities)
- Credit Support Annex (CSA)
- New York Law (pledge) = used by 54%
 - English Law (transfer) = used by 22%
- English Law (deed) = used by < 1%
- 2003 ISDA Collateral Asset Definitions
- Other Country Definitions: China, Japan, Dubai, etc.
- Margin Agreement
- Tri-party agreements
- Document management processes and systems

Processes:
- Daily process / workflow design
- Systems and technologies in place
- Dispute process: identification, escalation, negotiation, resolution, use of 3rd parties
- Process oversight / control: fully documented, approval processes
- Use of third party providers: custodians, accountants, valuation, software, regulatory, industry groups

Collateral Management Guide PART 12: Collateral Software and Systems

Author: Financial-edu.com

The correct software and systems are crucial for operating an effective collateral management function, due
to the high complexity, large amounts of data, and criticality of the function to the financial and operational
health of the organization.

Key Features of Modern Collateral Management Systems

The following features are considered mandatory for an effective collateral management system. These
should be fully integrated in a single package, and integrated into all existing upstream and downstream
software platforms, such as Trading, Risk, Valuation, Accounting, Know Your Customer, Payment
Processing, etc.

- Collateral selection tools: The ability to select collateral from an eligible and available pool.

- Collateral allocation engine: A controlled and accurate matching engine between collateral posted /
taken, customer, trader, deal number, and trade type.

- Sophisticated trade matching algorithms (especially for tri-party systems)

- Speed (real time or near real time)

- Connectivity to multiple dealers and venues: The ability to connect to multiple external systems, both
bi-lateral and tri-lateral, through a common interface.

- Collateral eligibility: Tools to analyze, calculate, and record collateral eligibility under varying
conditions and inventory levels.

- Simulations (exposures with/without different collateral, exposure over time)

- Intraday optimization and rebalancing

- Valuation (real time or EOD, based on various market data inputs, standard valuation models, custom
models)

- Monitoring (via blotters, reports, messages, and alerts)

- Rehypothecation

- Inventory management

- Connectivity with other systems: confirmation, settlement engines, trade management systems

- Straight through processing: price, book, confirm, margin calls, collateral inventory, settlements

- Access to underlying data: collateral statements, trade files, reconciliations, market data, trade data,
histories, audit logs

- Management tools: dashboards, etc.

- Reconciliations: Reconciliation between Ours and Theirs view of the portfolio and collateral is
automatically done and messaged/emailed/saved to shared messaging queues.

- Scalable

- Standardized: Cmmunication protocols (e.g. SWIFT), trade/securities definition components, market

and static data, ISDA terms and definitions, etc.

Collateral Management Software and Systems Providers

The following companies offer dedicated collateral management software. Listing here is not a
recommendation to purchase.

- AcadiaSoft = Collateral messaging and workflow

- Algorithmics = Algo Collateral

- Allustra = Kyros solution. Acquired by Omgeo (http://www.omgeo.com) in Sept 2008.

- Lombard Risk = Colline Collateral Management

- SunGard = Adaptiv Collateral

- SWIFT = Messaging using ISO 15022 securites standards on FIN, message validation, non-repudiation,
guarantee of sender, STP. Swift is a major provider of standardized messaging systems. Has connectivity
to more than 8,300 institutions globally.

Collateral Management Guide PART 13: SWIFT Messages for Collateral Management

Author: Financial-edu.com

The following SWIFT messages are standard for all collateral transactions.

Bilateral Collateral SWIFT messages

MT503 - Collateral Claim

From: Collateral Taker
To: Collateral Giver
Purpose: Initiation: Taker initiates a new or additional collateral request from the Giver.

MT503 - Collateral Claim return

From: Collateral Giver
To: Collateral Taker
Purpose: Initiation: Giver responds to Taker's new/additional collateral request

MT504 - Collateral Proposal

From: Collateral Giver
To: Collateral Taker
Purpose: Initiation: Giver proposes new collateral

MT505 - Collateral Substitution

From: Both
To: Both
Purpose: Settlement: Either party substitutes new collateral for existing collateral.

MT506 - Collateral & Exposure Statement

From: Both
To: Both
Purpose: Administration: Shows net exposure and details by collateral position

MT507 - Collateral status & processing advice

From: Both
To: Both
Purpose: Shows collateral transactions and status.

Tri-Party Collateral / Tri-Party Repo SWIFT messages

MT527 - Tri-Party Collateral Instruction

From: Collateral Taker/Giver
To: Tri-Party Agent
Purpose: Initiation: Giver notifies Agent of available collateral. Taker notifies Agent of collateral demand.

MT558 - Tri-Party Collateral Status & Processing Advice

From: Tri-Party Agent
To: Collateral Taker/Giver
Purpose: Initiation: Agent responds to MT558 from either Giver or Taker.

MT569 - Tri-Party Collateral & Exposure Statement

From: Tri-Party Agent
To: Collateral Taker/Giver
Purpose: Settlement: Shows net mark-to-market for collateral and underlying exposure and details by
collateral position.