Unpacked: Collateral Management

Narrator: Ever bought a house, car, or something else that required a loan from a bank? Then you have firsthand experience of using collateral to secure a loan. Collateral is a form of insurance for an investment. If you fail to pay your mortgage or car loan, the bank can seize the property or car to cover the cost of the unpaid loan. Banks and other financial institutions offer collateral management as a service to investors, helping them to monitor the protection in place on their investments and trading activity.

What is collateral management, and how does it work? This is Collateral Management: Unpacked. The reason protection on assets is necessary in the first place is because trading on financial markets is inherently risky. This risk mostly relates to the person or party you are trading with, and this is referred to as counterparty risk. There's no guarantee the counterparty you are dealing with will be around tomorrow to fulfill their part of the deal in a trading transaction or investment, so assets are posted as collateral to secure an investment or transaction, giving assurance for recourse in the event the counterparty is unable to fulfill its obligation. Collateral management verifies and manages the assets posted by one party to another to mitigate the effect of any potential default.

The kind of collateral investors request as protection can differ widely. But high-quality liquid assets, or HQLA, are generally preferred due to their relatively stable prices, making them easy to sell in the event of a default. HQLA could take the form of cash or fixed-income assets, such as government bonds. Some counterparties may consider riskier forms of collateral, such as equities that fluctuate in price, but may require a more diverse pool of assets along with other eligibility requirements for protection against market risk when negotiating the terms of a trade.

Market participants requiring collateral management services are classified as either buyside or sellside counterparties. Buyside counterparties are generally institutional investors, such as asset managers, insurance companies, public sector or government-related entities, and corporates, while the sellside refers primarily to the investment banking industry and broker dealers. Financial instruments, like derivatives, where market participants look to hedge market exposure have become more common, increasing the need for collateral management. The growth of the derivatives market means market participants are now more prudent when it comes to investing in technology, ensuring best practices are in place to handle the risk of a counterparty.

Collateral management has become a largely mandatory part of every institutional investor's risk management strategy in the aftermath of the global financial crisis in 2008 and the collapse of Lehman Brothers. Because of the scale of Lehman Brothers, many financial market participants were directly impacted by its bankruptcy. Prior to 2008, exchanging collateral was discretionary, meaning the collateral terms were commercially negotiated and agreed on by the counterparties. Regulation changes following the crisis have made the exchange of collateral mandatory between almost all counterparties.

Collateral management forms part of a larger service offered by global custodian banks known as security services, which includes everything from the custody and administration of funds for investors to foreign exchange and liquidity management. More recently, collateral management has shifted from being just a risk management exercise to become part of an institutional investor's asset allocation strategy. By using the right collateral at the right time, assets are then freed up for other trading activities.

Technology has improved the efficiency of collateral management, and collateral managers are automating more of their systems and reporting, so investors can access up-to-date information on their margin obligations and where and when collateral is needed. Collateral managers are starting to embrace emerging technologies, such as tokenization, blockchain, and AI, to future-proof collateral management strategies, ensuring their systems can keep up with the ever-evolving financial markets.