In finance, collateral management is known as the process that yields a collateral agreement. Collateral is used as a pledge given to a lender to secure borrowing, generally in the form of an asset or an object of value agreed upon before a contract is signed.
Some examples of collateral include: stocks, bonds, real estate, commodities, cash, equities or mortgage-backed securities. For instance, a stock may be given to a bank as collateral for a loan that must be repaid at a later date.
Collateral management is most commonly used to mitigate the risk of a credit default in over-the-counter (OTC) trades. In this sense, the use of collateral management is intended to protect both parties—the lender reduces credit risk and earns interest while the borrower is able to finance needs.
The use of collateral management in OTC derivatives increased from about $200 billion in 2000 to about $2.1 trillion in 2008, according to the International Swaps and Derivatives Association (ISDA). Many suggest that this growth is a result of the expansion in securities markets and the heightened precautionary measures corporations are taking in order to mitigate risk.
If a borrower fails to repay the loan by the agreed time, the lender then has the right to sell the collateral to offset the borrower defaulting on the loan. The value of the collateral is often determined by the mark-to-market (MTM) methodology, also known as “fair value.”
The simplest type of collateral management is a proprietary collateral agreement, which is when the borrower and lender make an agreement without the help of an external agent. This type of agreement has two steps: initiation and termination. In the first stage, the borrower and lender agree on a form of collateral and the lender gives the borrower the cash or loan. In the second phase, the borrower returns the cash, plus interest and the lender returns the collateral.
Since this bi-party collateral agreement still involves risks, many banks now use third parties in order to securitize the agreement, known as tri-party collateral management. The third party is responsible for making the exchange and holding on to the collateral during the loan period.
The management process of the contract, which encompasses initiation, transaction, and finalization, typically includes many parties. Apart from a collateral management team, collateral management also involves the middle, front, and back office throughout the duration of the contract.
Collateral management for major financial transactions dates back to the 1980’s when Bankers Trust and Salomon Brothers began using collateral to protect against credit exposure.