What Is Collateral Call?
A collateral call is a demand from a lender to a borrower to post additional collateral to cover potential losses on a loan or trading position. This typically occurs in financial markets when the market value of the assets held as collateral falls below a certain threshold, known as the maintenance margin. The primary purpose of a collateral call within the broader category of risk management is to protect the lender from suffering losses due to adverse price movements in the underlying securities or assets that secure the loan. If the borrower fails to meet the collateral call, the lender has the right to liquidate the existing collateral to cover the shortfall.
History and Origin
The concept of requiring collateral for credit extensions is ancient, but formal regulations surrounding margin and collateral calls in securities markets gained prominence in the 20th century, particularly after periods of market instability. In the United States, federal regulation of purchasing securities on margin was mandated by the Securities Exchange Act of 1934. This legislation tasked the Federal Reserve with setting initial margin requirements for securities purchases, with the Securities and Exchange Commission (SEC) directed to enforce these regulations.6 The Federal Reserve's Regulation T governs the extension of credit by broker-dealers and primarily controls margin requirements for stocks bought on margin. While the Federal Reserve sets initial margin requirements, maintenance margin requirements, which dictate when a collateral call might be triggered, are typically set by exchanges and individual brokers.5
Key Takeaways
- A collateral call is a demand for additional assets from a borrower by a lender when the value of existing collateral falls.
- It serves to protect the lender from potential losses on leveraged positions.
- Failure to meet a collateral call can result in the automatic liquidation of the underlying assets.
- Collateral calls are common in various financial activities, including margin trading, derivatives, and repurchase agreements.
- They are a critical component of counterparty risk mitigation for financial institutions.
Interpreting the Collateral Call
A collateral call signifies that the borrower's leveraged position has moved against them to a degree where the initial collateral is no longer sufficient to cover the lender's exposure. For investors, receiving a collateral call indicates significant unrealized losses on a portfolio and necessitates immediate action. The call implies that the market value of the collateral supporting a loan or a derivative position has declined, increasing the lender's risk. From the lender's perspective, issuing a collateral call is a routine risk management procedure to rebalance their exposure and ensure the loan remains adequately secured. The urgency and size of the collateral call often reflect the volatility of the underlying securities and the extent of the market move.
Hypothetical Example
Consider an investor, Sarah, who uses a margin account to purchase $100,000 worth of shares in Company XYZ. Her broker requires an initial margin of 50%, meaning Sarah pays $50,000 and borrows $50,000 from the broker. The broker also sets a maintenance margin requirement of 30%. This means Sarah's equity in the account must remain at least 30% of the total market value of the securities.
Initially, Sarah's equity is $50,000, and the total market value is $100,000. Her equity percentage is (\frac{$50,000}{$100,000} = 50%), which is above the 30% maintenance margin.
Now, imagine Company XYZ's stock price drops significantly, causing the total market value of Sarah's shares to fall to $60,000. Sarah still owes the broker $50,000. Her current equity is now ( $60,000 - $50,000 = $10,000 ). The new equity percentage is (\frac{$10,000}{$60,000} \approx 16.67%).
Since 16.67% is below the 30% maintenance margin, the broker issues a collateral call. The broker calculates the amount of additional collateral (cash or marketable securities) Sarah needs to deposit to bring her equity back up to the maintenance margin level. To meet the 30% maintenance margin on $60,000, her equity needs to be ( 0.30 \times $60,000 = $18,000 ). Since her current equity is $10,000, Sarah would receive a collateral call for ( $18,000 - $10,000 = $8,000 ). If she fails to deposit this amount, the broker may sell a portion of her shares to cover the shortfall.
Practical Applications
Collateral calls are integral to various aspects of finance, particularly where leverage is employed. In investment banking, they are a routine mechanism for managing credit exposure in derivatives trading, such as futures contracts, options contracts, and over-the-counter (OTC) derivatives like total return swaps.4 Investment banks and clearing houses use collateral calls to ensure that counterparties have sufficient funds to cover potential losses.
A notable example of collateral calls in practice is the collapse of Archegos Capital Management in March 2021. Archegos, a family office, had accumulated massive, highly leveraged positions in certain stocks through swaps with various prime brokers. When the value of these underlying stocks sharply declined, the prime brokers issued collateral calls. Archegos was unable to meet these demands, leading to a rapid, forced liquidation of over $20 billion in positions by the banks, causing significant losses for firms like Credit Suisse and Nomura.3 This event highlighted how quickly collateral calls can escalate and their systemic importance in financial markets.
Limitations and Criticisms
While essential for risk management, collateral calls have limitations and can exacerbate market stress. During periods of extreme market volatility, a rapid decline in asset prices can trigger widespread collateral calls across multiple firms or accounts simultaneously. This can lead to a "fire sale" effect, where entities are forced to sell assets to meet calls, further driving down prices and triggering more calls, creating a negative feedback loop.
The bankruptcy of Lehman Brothers in 2008 serves as a stark illustration. While multiple factors contributed to its failure, immediate collateral calls from its clearing banks, particularly JPMorgan, to cover intraday exposures were a direct catalyst for its ultimate demise.2 Lehman's inability to provide sufficient collateral for its highly leveraged positions, coupled with a lack of confidence from lenders, meant it could not roll over its short-term debt, leading to its collapse.1 This event underscored how liquidity pressures, amplified by collateral calls, can quickly destabilize even large financial institutions and contribute to systemic risk. Critics argue that opaque markets, particularly for OTC derivatives and complex financial products, can obscure the true extent of leverage and interconnectedness, making it difficult for regulators and market participants to anticipate and manage the cascade effect of widespread collateral calls.
Collateral Call vs. Margin Call
The terms "collateral call" and "margin call" are often used interchangeably in general financial discourse, as both refer to a demand for additional assets from a client by a broker or lender. However, there can be subtle distinctions depending on the specific context and type of financial instrument.
A margin call specifically pertains to transactions executed in a margin account, primarily for buying securities on credit. It is triggered when the equity in the account falls below the maintenance margin requirement set by the broker or a self-regulatory organization like FINRA. The purpose is to ensure the borrower maintains a minimum percentage of equity relative to the total value of the securities held on margin.
A collateral call, while encompassing margin calls, can be a broader term. It applies to any financial arrangement where assets are pledged as security for a loan or an obligation, not just margin accounts. This includes, but is not limited to, derivatives contracts (like futures, options, and swaps), repurchase agreements (repos), or secured lending agreements. In these contexts, if the value of the pledged collateral deteriorates below a pre-agreed threshold, the lender will make a collateral call to restore the required coverage. While the underlying principle of demanding more security is the same, "collateral call" is often used when discussing more complex or institutional financial arrangements beyond standard retail margin trading.
FAQs
What happens if I can't meet a collateral call?
If you fail to meet a collateral call within the specified timeframe, the lender or broker typically has the right to immediately sell or liquidate some or all of your pledged assets to cover the shortfall. This forced sale often occurs at unfavorable market prices, leading to substantial losses for the borrower.
Who issues collateral calls?
Collateral calls are issued by the party extending credit or facing exposure, which can include brokers, banks, clearing houses, or other financial institutions acting as counterparties in a leveraged transaction.
Are collateral calls only for stock trading?
No, while common in stock margin trading, collateral calls apply to any financial activity where assets are pledged as security. This includes trading in futures, options, swaps, or other derivatives, as well as secured loans and repurchase agreements.
How can I avoid a collateral call?
To avoid a collateral call, investors should manage their leverage prudently, monitor their positions closely, and maintain sufficient cash or readily marketable securities in their accounts. Diversifying a portfolio can also help mitigate the impact of adverse price movements in a single asset. Setting stop-loss orders or reducing positions before they approach maintenance margin levels are proactive measures.