Within the financial services industry, on a daily basis cash and securities are lent to borrowers on a temporary basis. In order to mitigate (reduce) the lender’s risk of the borrower failing to return the lent cash or securities, other assets of value are given by the borrower to the lender. Such other assets are generically known as ‘collateral’.
Additionally, collateral plays a major role in mitigating counterparty risk associated with OTC derivative transactions, in products such as interest rate swaps and credit default swaps.
Transactions including cash lending, securities lending and OTC derivatives are executed by buy-side firms (including pension funds, insurance companies, asset managers and other corporate entities) and sell-side firms (including investment banks and brokers). Consequently, collateral is relevant to both the buy side and the sell-side of the business.
For a number of years prior to the autumn of 2008, collateral had been used for OTC derivatives with the passing of collateral between trading parties occurring, in some cases, weekly or every 2 weeks or even monthly. Up to that point in time, usually only the larger financial services firms identified exposures and then gave or received collateral as frequently as daily.
Then came the Global Financial Crisis and the financial industry turmoil in October/November ...