Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

5.1 Introduction

Collateralisation (also known as margining) provides a further means to reduce credit exposure beyond the benefit achieved with netting and the other methods described in the previous chapter. Indeed, the use of collateral is essentially a natural extension of break clauses and resets. A break clause can be seen as a single payment of collateral and cancellation of the transaction. A reset feature is essentially the periodic payment of collateral to neutralise an exposure. Standard collateral terms simply take this further to much more frequent collateral posting. Collateral agreements may often be negotiated prior to any trading activity between counterparties or may be agreed or updated prior to an increase in trading volume or change in other conditions.

5.1.1 Rationale for Collateral

Suppose that a netted exposure (sum of all the values of transactions with the counterparty) is large and positive. There is clearly a strong risk if the counterparty is to default. A collateral agreement limits this exposure by specifying that collateral must be posted by one counterparty to the other to support such an exposure. The collateral receiver only becomes the economic owner of the collateral if the collateral giver defaults. Like netting agreements, collateral agreements may be two-way which means that either counterparty would be required to post collateral against a negative mark-to-market value (from their point of view). Both counterparties will periodically mark ...