What Are Collateral Calls?
A collateral call is a demand by one party in a financial agreement for additional assets, known as collateral, from the other party. This demand is triggered when the value of the existing collateral falls below a predetermined level, or when the underlying asset's price movement or the counterparty's creditworthiness changes, increasing the counterparty risk. Collateral calls are a fundamental component of risk management in leveraged transactions and derivative contracts, ensuring that potential losses are adequately covered and maintaining financial stability within the broader financial system.
History and Origin
The practice of requiring collateral has existed for centuries in various forms of secured lending. However, the widespread and systematic use of collateral calls in modern finance, particularly within derivatives markets, gained prominence with the growth of complex financial instruments. Over-the-counter (OTC) derivatives, which were historically less regulated and often bilaterally negotiated, increasingly incorporated collateral agreements to mitigate risk between parties.
The 2008 global financial crisis starkly highlighted the systemic risks associated with uncollateralized or undercollateralized positions, especially in the Over-the-Counter (OTC) Markets. During the crisis, sharp movements in asset prices led to significant collateral calls that drained liquidity buffers from financial institutions, provoking forced sales of assets that amplified market volatility.4 The collapse of major institutions, notably Lehman Brothers, underscored the interconnectedness of the financial system through such exposures. Following this, regulatory reforms, such as the Dodd-Frank Act in the United States, were enacted to mandate central clearing and standardized collateral requirements for a significant portion of the derivatives market, transforming how collateral calls are managed.
Key Takeaways
- Collateral calls are demands for additional assets to cover potential losses in leveraged financial positions.
- They are crucial for mitigating counterparty risk in agreements like derivatives and secured lending.
- Triggers for collateral calls include declines in collateral value, adverse price movements of underlying assets, or changes in counterparty creditworthiness.
- These calls help maintain financial stability by ensuring that exposures are adequately collateralized.
- Regulatory reforms after the 2008 financial crisis significantly tightened rules around collateral requirements and collateral calls, particularly for derivatives.
Formula and Calculation
While there isn't a single "formula" for a collateral call itself, the call arises from the calculation of the exposure that needs to be covered and the available collateral. This often involves daily mark-to-market valuations of positions and collateral.
Consider a derivative contract where Party A owes Party B based on market movements. The amount of additional collateral required ($C_{call}$) can be determined by:
Where:
- (EMR) = Effective Margin Requirement (the total collateral required based on the current market value of the position and predefined risk parameters)
- (C_{posted}) = Current Collateral Posted (the value of collateral already held by Party B)
- (A) = Any additional amount agreed upon due to changes in credit risk or specific agreement terms.
If (EMR - C_{posted}) results in a positive value exceeding a certain threshold, a collateral call is issued for that amount.
Interpreting Collateral Calls
Collateral calls indicate an increased risk exposure for one party in a financial transaction. When a party receives a collateral call, it means their counterparty's position has deteriorated, or the value of the assets they provided as collateral has declined. Conversely, issuing a collateral call means the caller's exposure to the counterparty has increased, and they require more protection.
The size and frequency of collateral calls can be an indicator of market volatility or a specific counterparty's financial health. Frequent or large collateral calls received by a firm can signal underlying financial stress, potentially impacting its liquidity risk. Effective management of collateral, including understanding acceptable types of collateral and the application of a haircut to its value, is crucial for financial institutions.
Hypothetical Example
Imagine two investment banks, Alpha Bank and Beta Bank, enter into an interest rate swap agreement. To mitigate counterparty risk, they agree to post initial collateral of $10 million each and to make daily collateral calls if the mark-to-market value of the swap moves by more than $1 million against either party.
On Monday, the swap's value is neutral. On Tuesday, interest rates shift significantly, causing the mark-to-market value of the swap to move $2 million in favor of Alpha Bank. This means Beta Bank now owes Alpha Bank $2 million if the swap were to be closed out immediately.
Since the movement ($2 million) exceeds the $1 million threshold, Alpha Bank issues a collateral call to Beta Bank for the difference. Beta Bank must then post an additional $2 million in eligible collateral to Alpha Bank to cover this increased exposure. This ensures that Alpha Bank is protected in case Beta Bank defaults on its obligations. If Beta Bank fails to meet this collateral call, Alpha Bank could liquidate the existing collateral and potentially close out the swap position.
Practical Applications
Collateral calls are pervasive across various segments of the financial markets:
- Derivatives Trading: In cleared derivatives, such as those traded through a Central Counterparty (CCP), collateral (known as margin requirements) is exchanged daily based on price movements. For uncleared OTC derivatives, bilateral agreements specify the triggers and amounts for collateral calls. Regulators like the U.S. Securities and Exchange Commission (SEC) have adopted rules establishing capital, margin, and segregation requirements for security-based swap dealers to enhance risk mitigation.3
- Secured Lending: In secured lending, such as repurchase agreements (repos) or securities lending, collateral is pledged by the borrower to the lender. If the value of the pledged collateral falls, the lender may issue a collateral call to restore the agreed-upon collateralization level. The Office of Financial Research provides a map illustrating how collateral functions in secured funding and derivatives activity.2
- Central Bank Operations: Central banks utilize collateral frameworks in their monetary operations to lend liquidity to commercial banks. These frameworks involve specific eligibility criteria and valuation methods for collateral, and central banks may expand these frameworks during times of financial stress to ensure adequate liquidity in the system.1 This reflects the importance of collateral calls in broader economic stability.
- Prime Brokerage: Prime brokers provide services to hedge funds, including financing and securities lending. They often require their clients to post collateral and issue collateral calls when positions move adversely or leverage levels become too high.
Limitations and Criticisms
While essential for managing credit risk, collateral calls are not without limitations and can even contribute to market stress during periods of high volatility. One primary criticism is their procyclical nature: during market downturns, falling asset prices lead to more frequent and larger collateral calls, forcing firms to sell assets to meet these demands. This "fire sale" dynamic can further depress prices, creating a feedback loop that exacerbates market instability and increases systemic risk.
Moreover, the operational complexities of managing collateral across numerous counterparties and jurisdictions can be substantial. Discrepancies in valuations, legal enforceability across borders, and the sheer volume of daily collateral movements can pose challenges. While regulatory frameworks aim to standardize processes, the ability of firms to quickly mobilize eligible collateral can be strained during a crisis, potentially leading to defaults even when underlying solvency might otherwise exist.
Collateral Calls vs. Margin Calls
The terms "collateral call" and "margin call" are often used interchangeably, particularly in discussions about futures and options trading. However, a "collateral call" is a broader term that encompasses all demands for additional security, whereas a "margin call" is a specific type of collateral call related to margin accounts.
| Feature | Collateral Call | Margin Call |
|---|---|---|
| Scope | Broad, applies to any leveraged or secured transaction where additional assets are required. | Specific to futures, options, and other margin-based trading accounts. |
| Trigger | Decline in existing collateral value, adverse asset price movement, increase in counterparty risk. | Insufficient margin in a trading account due to adverse price movements. |
| Context | Derivatives (cleared & uncleared), secured lending, prime brokerage agreements, certain repo transactions. | Brokerage accounts for trading securities, commodities, or currencies on leverage. |
| Purpose | Maintain adequate security against potential losses for the calling party. | Ensure sufficient funds are in the account to cover potential losses on open leveraged positions. |
Essentially, all margin calls are a type of collateral call, but not all collateral calls are margin calls. For example, a bank making a demand for more security on a secured loan due to the borrower's deteriorating creditworthiness would be a collateral call, but not typically referred to as a margin call.
FAQs
Why are collateral calls important?
Collateral calls are critical for managing counterparty risk in financial transactions. They ensure that if one party defaults, the other party has sufficient assets (collateral) to cover potential losses. This mechanism helps to maintain trust and stability within the financial system, especially in markets involving leverage.
What types of assets can be used as collateral?
Eligible collateral can vary depending on the agreement and market. Commonly accepted forms include cash, highly liquid government securities (like U.S. Treasury bonds), investment-grade corporate bonds, and certain money market instruments. The value of these assets is often discounted through a "haircut" to account for potential price fluctuations or liquidity issues.
What happens if a firm cannot meet a collateral call?
If a firm fails to meet a collateral call, the party that issued the call has the right to take possession of the existing collateral and may liquidate it to cover their exposure. This failure can trigger a default event, leading to the termination of the underlying financial agreement and potentially significant losses for the defaulting party. It can also signal financial distress and have broader implications for market confidence.
How do regulations impact collateral calls?
Regulations, particularly since the 2008 financial crisis, have increased the standardization and mandatory nature of collateral requirements, especially for derivatives. Measures like mandatory central clearing for standardized swaps mean that collateral calls are processed through robust Central Counterparty (CCP) mechanisms, aiming to reduce systemic risk and increase transparency in financial markets.