SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

CHALLENGES & OPPORTUNITIES

3.4

Mastering collateral management in an evolving environment

3.4.1

Reminder of basic collateral principles

In securities lending as in repo transactions, the collateral received by the lender/seller is a kind of insurance against the borrower/buyer default.

The eligible collateral (taking into account criteria such as credit rating, market, type of security, country, etc.) is agreed between the parties, as well as other parameters linked to collateral:

> Notional limits, i.e. the absolute value of any asset to be accepted as collateral;

> Concentration limits, i.e. the maximum percentage of any issue to be acceptable, for ex- ample less than 5% of daily traded volume, or the maximum percentage of collateral pool that can be taken against the same issuer. > Margin or haircut, i.e. the amount of over-collateralisation required by the cash seller (repo) or the securities lender (securities lending) to protect itself from the price volatility of the underlying securities and the counterparty risk. This amount varies with the size and term of the transaction, the securities type and maturity, as well as with the counter- party creditworthiness.

> Initial margin, i.e. the margin required at the outset of a transaction;

> Maintenance margin, i.e. the minimum margin level to be maintained throughout the transaction; It involves the regular and frequent revaluation of collateral.

Throughout the term of the transaction, the market value of securities and collateral may fluctuate. That is why a regular marking-to-market (daily or even intraday) is carried out to monitor the margin calls that the parties exchange between themselves in order to maintain sufficient levels of collateralisation and mitigate market and credit risk. Collateral can be managed in pool (in that case, there is a global margin call for a given counterpart for n transactions, for a given investor) or on a unitary basis (in that case, mar- gin calls are processed transaction by transaction). Before the crisis, there were recognised benchmarks for margins (e.g. 2% for eurozone government bonds in the European market and 5% or more for equities) but things have changed and some margins are higher today. In addition to increased haircuts, investors have also tightened their collateral schedules and excluded certain collateral. They devel- oped more conservative approach to market procedures, collateral evaluation, collateral correlation and concentration of collateral.

3.4.2

Marking collateral to market and collateral optimisation, 2 key challenges

The responsibilities of valuing the collateral daily, of issuing collateral margin calls or re- turning excess collateral, as well as making substitutions when securities used as collateral are needed to fulfil trading obligations or before a corporate action, can be cumbersome

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