CHAPTER 2
The Nature and Characteristics of Collateral Types

This chapter is targeted at readers that have had no exposure or limited exposure as to how cash and bond assets are handled within the financial services industry. The chapter is designed to provide an overview of the two primary collateral types, namely cash and bonds. In particular, the nature of bonds must be understood in order to appreciate their behaviour as collateral. Furthermore, the way that cash is paid and received and the way that bonds are delivered and received must be well understood in order for a firm to avoid incurring exposures.

The two most common types of collateral used within financial services are cash and bonds.

2.1 CASH COLLATERAL: OVERVIEW

2.1.1 Introduction

The most commonly accepted currencies as collateral are US Dollars (USD), Euros (EUR) and British Pounds (GBP).

If a firm's exposure is in for example USD, and USD cash collateral is taken from the counterparty, there is no foreign exchange (FX) risk, as there is no conversion to be made between currencies. Conversely, if that same firm has the same USD exposure, but receives another currency (e.g. EUR) as collateral, the firm is exposed to FX currency rate movements thereafter and this could result in collateral taken having a lower value than the firm's exposure. Should such exposure occur, the exposed firm would need to make a margin call on its counterparty in order to cover the shortfall and mitigate its exposure.

To clarify, either the original collateral giver or the collateral taker could be exposed due to exchange rate movements.

2.1.2 Eligible Collateral

The legal documentation signed between the two trading parties (preferably in advance of executing the first trade between the parties) should specify the currencies acceptable as collateral to each party. Generically, acceptable collateral is known as eligible collateral.

If a firm that needs to give collateral attempts to remit a currency outside of the legally documented eligible currencies, the taking firm is not obliged to accept that currency and is within their rights to refuse acceptance.

2.1.3 Haircut

Providing cash given/taken is in an eligible currency, no haircut should be applied. For example, if party B has an exposure of USD 5,000,000.00, party A should pay USD 5,000,000.00 of cash collateral, meaning 100% of the exposure amount and no more than that amount should be paid (because zero haircut is applicable).

Therefore, the market value of a major currency cash amount is equal to its collateral value, providing the exposure and the collateral are in the same currency. (Note: other currencies may be classified as eligible collateral, but the involved parties may have agreed that a certain percentage haircut is to be applied.)

2.1.4 Settlement

Generically, cash payments are made by a firm by initially appointing a cash correspondent (or nostro) for a particular currency, then issuing a settlement instruction to that nostro for individual cash payments.

Deadlines are applied by nostros for the receipt of settlement instructions relative to the due date (or value date) of payment. The firm must ensure it meets such deadlines in order to make payment on time. If the deadline is missed, the counterparty (payee) will not receive payment on time; for cash collateral, a late payment means 1) that the exposed party's risk has not been mitigated, and 2) that the legal agreement will have been breached.

In order to facilitate the payment of cash to a counterparty, it is common practice for standing settlement instructions (SSIs) to be stored within a firm's static data repository. SSIs are a generic name for bank account details, which are effectively standing orders provided by each counterparty to facilitate cash payments; they avoid the paying firm needing to contact the counterparty each time a payment needs to be made. When needing to make a payment, the paying firm simply instructs its nostro for payment to be made to the counterparty's nostro according to the SSI information held within the paying firm's static data.

The issuance of settlement instructions is a highly risky aspect of settlement; if instructions are not issued by a secure mechanism the risk exists that a third party could fraudulently effect payments out of a firm's bank account. The global standard for issuance of secure settlement instructions is S.W.I.F.T. which, for those firms that subscribe, provide high levels of message encryption designed to prevent third-party deciphering of secret coding structures intended for use only by sender and recipient of settlement instructions.

Note: to avoid any confusion as to the purpose and use of a standing settlement instruction, as opposed to the purpose and use of a settlement instruction:

• a standing settlement instruction is a piece of information containing bank account details and which is held within a firm's static data repository. A firm needs to hold its own bank account details for a particular currency (known as 'our SSI'), as well as bank account details for a particular currency for each of its counterparties (known as 'their SSI'). Such SSI information is used to generate individual settlement instructions in an efficient and (usually) electronic manner
• a settlement instruction is issued to a paying firm's nostro for payment of a particular cash amount, and which needs to contain currency, amount, value date, in addition to 'our SSI' and 'their SSI' (both of which are copied from the payer's static data repository).

It is important to note that the payment and receipt of cash requires no pre-matching of settlement instructions between payer and payee, before payment is actually made. Therefore the risk exists that, should a payer make a mistake when creating a settlement instruction (e.g. cash amount of EUR 10,000,000.00 rather than the correct amount of EUR 1,000,000.00), the payment of the incorrect amount will be made, assuming that adequate balance is held within the payer's account at its nostro. The firm should have internal procedures in place that identify such errors at source and before the settlement instruction is transmitted to its nostro, and post-payment reconciliation that verifies cash amounts that should have been paid versus actual amounts paid by the firm's nostro. It is not recommended that a firm relies on its counterparties to advise them that such errors have occurred.

When a firm is due to receive a payment from a counterparty, its nostro may require the firm to issue a funds preadvice, which advises the nostro to expect receipt of a specific cash amount on a particular value date. Should a payment be made by a counterparty to a firm, but the firm fails to issue a funds preadvice to its nostro (where the nostro requires such advices), although the nostro will have received the funds on value date on behalf of the firm, the nostro is unlikely to credit the funds on value date, and instead apply 'next day' value. This means the receiving firm will 1) not have their exposure mitigated on time, and 2) suffer a loss of interest on those funds for 1 night as a minimum; if the payment due date were a Friday, a minimum of 3 nights' interest will be lost. Under these circumstances, the paying counterparty will not be in breach of the legal documentation as they paid on the due date. It is also important to note that those nostros requiring receipt of funds preadvices for incoming cash also apply deadlines to the receipt of such preadvices.

2.2 BOND COLLATERAL: OVERVIEW

2.2.1 Introduction

AUTHOR'S COMMENT

This sub-section describes a number of important factors that must be taken into account when receiving and delivering bond collateral.

Bonds are classified as securities (along with equity) and have the following characteristics:

• bonds raise temporary capital for the issuer (the issuing entity)
• issuing entities include:
  • governments (e.g. US Treasury, German Government, UK Government)
  • government agencies (e.g. Federal National Mortgage Association)
  • supranational organisations (e.g. World Bank, EBRD, Asian Development Bank), and
  • corporations (e.g. Siemens A.G., IBM, Qantas)
• the issuer borrows cash from investors (bondholders)
• the issuer typically pays a fixed rate of interest to bondholders as the cost of borrowing capital
• bonds have maturity dates typically up to 30 years
• investors typically include:
  • some individuals
  • institutional investors (e.g. mutual funds, pension funds)
  • corporations and
  • investment banks
• individual bond issues are issued:
  • by a particular issuer
  • to raise a specified cash amount (e.g. USD 1,000,000,000.00)
  • for a fixed* annual coupon rate (e.g....