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

5.4 The Risks of Collateralisation

Whilst collateral management is a very useful tool for mitigating counterparty risk, it has significant limitations that must be considered. Essentially, the counterparty risk is converted into other forms of financial risk, such as legal risk (for example, if the terms defined in a CSA cannot be upheld within the relevant jurisdiction). Correlation risk (where collateral is adversely correlated to the underlying exposure), credit risk (where the collateral may default or suffer an adverse credit effect) and FX risk (due to collateral being posted in a different currency) are also important. However, the three most important risks to consider are market, operational and liquidity risk.

5.4.1 Market Risk and the Margin Period of Risk

Collateral can never completely eradicate counterparty risk and we must consider the residual risk that remains under the collateral agreement. This is mainly due to contractual parameters such as thresholds and minimum transfer amounts that effectively delay the collateral process, in addition to the normal delay since collateral cannot be received immediately. This can be considered a market risk as it is related to the extent of market movements after the counterparty last posted collateral. Whilst the residual risk may be only a fraction of the uncollateralised risk, it may be more difficult to quantify (Section 9.7) and indeed hedge (see Section 16.6.3, which discusses the impact of collateral on hedging).

Whilst ...