Incremental collateral

What Is Incremental Collateral?

Incremental collateral refers to the additional assets, typically cash or securities, that a borrower is required to post to a lender to cover an increase in exposure or to restore the value of previously posted collateral. This concept is central to collateral management, a critical component of financial risk management that aims to mitigate credit risk and counterparty risk in financial transactions. When the value of existing collateral falls below an agreed-upon threshold, or the underlying exposure increases, lenders demand incremental collateral to maintain their secured position. This practice is especially prevalent in over-the-counter (OTC derivatives) markets, repurchase agreement (repo) transactions, and securities lending.

History and Origin

The practice of using collateral to secure loans dates back millennia, with some of the earliest recorded instances in Mesopotamia around 3200 BC, where farmers pledged crops for financing. Over centuries, collateral evolved from tangible assets like crops and sheep to real estate, and eventually, to financial instruments. The modern concept of incremental collateral, particularly in its current sophisticated form, largely gained prominence with the growth of complex financial instruments and the need for dynamic risk management.

The standardization of collateralization arrangements, especially for derivatives exposures, became widespread in the early 1990s, notably with the first International Swaps and Derivatives Association (ISDA) documentation in 1994. Regulatory initiatives following the 2008 global financial crisis further solidified the importance of incremental collateral. For instance, the European Market Infrastructure Regulation (EMIR) introduced stringent requirements for the bilateral exchange of initial and variation margins for non-centrally cleared OTC derivative contracts, explicitly stipulating the need for timely and appropriate collateral exchanges.⁸ Similarly, the Dodd-Frank Act in the United States, while initially focused on segregation, also spurred regulations around margin requirements for uncleared swaps, impacting how and when incremental collateral must be posted.⁷ These regulations aimed to enhance financial stability by reducing systemic risk.

Key Takeaways

• Incremental collateral is additional security posted by a borrower to a lender.
• It is typically required when the value of existing collateral depreciates or the underlying exposure increases.
• It is crucial in derivatives, repurchase agreement markets, and securities lending to manage credit risk.
• Regulatory frameworks like EMIR and the Dodd-Frank Act have formalized and mandated the exchange of incremental collateral in many financial transactions.
• The calculation often involves daily marking-to-market of exposures and collateral values.

Formula and Calculation

Incremental collateral is not a standalone formula but rather the resulting amount from a comparison between the required collateral and the collateral already held. The core principle involves continuously valuing the exposure to a counterparty and the collateral held against that exposure.

The general process for determining incremental collateral involves:

1. Marking-to-Market (MtM) Exposure: Daily (or more frequent) revaluation of the underlying financial contract (e.g., a derivative position) to determine the current credit risk exposure.
2. Valuing Posted Collateral: Daily revaluation of the collateral assets already posted, applying any agreed-upon haircut percentages.
3. Calculating Net Exposure: Comparing the MtM exposure to the value of the collateral held.

If the net exposure (current exposure minus effective collateral value) exceeds a pre-defined threshold or if the collateral held falls below a minimum requirement, incremental collateral is demanded.

The amount of incremental collateral ($IC$) can be broadly represented as:

Where:

• Required Collateral: The amount of collateral needed to cover the current exposure, often based on a calculated initial margin and/or variation margin.
• Current Collateral Value: The market value of the collateral currently held by the lender, adjusted for haircuts.

This calculation ensures that the lender's exposure remains adequately covered, minimizing potential losses in case of a default by the borrower.

Interpreting Incremental Collateral

Interpreting incremental collateral involves understanding its implications for both the collateral poster (borrower) and the collateral receiver (lender). For the poster, a demand for incremental collateral signifies an increase in their financial obligation, often due to adverse market movements that have increased their unsecured loan equivalent exposure or decreased the value of their posted assets. It can signal rising market volatility or a shift in the counterparty's risk assessment. The ability to meet these demands is critical for maintaining liquidity and avoiding default.

From the receiver's perspective, demanding incremental collateral is a proactive risk management measure. It indicates that the existing security is no longer sufficient to cover the potential loss if the counterparty defaults. The receipt of incremental collateral reduces their credit risk exposure, bringing the collateralization level back to an acceptable threshold. The frequency and magnitude of incremental collateral demands can serve as an indicator of underlying market stress or the financial health of the counterparty.

Hypothetical Example

Consider two financial institutions, Bank A and Bank B, engaged in an OTC derivatives trade with a notional value of $100 million. They have a collateral agreement in place, requiring a 10% initial margin on the exposure and daily marking-to-market with variation margin exchanges.

• Day 1: Bank A's exposure to Bank B is $10 million. Bank B posts $1 million in collateral (10% of initial margin) to Bank A.
• Day 2: Due to unfavorable market movements, Bank B's exposure to Bank A increases from $10 million to $12 million. The existing collateral of $1 million is now insufficient.
• Calculation:
  • Required collateral (variation margin for the increase in exposure): $12 million (new exposure) - $10 million (old exposure) = $2 million.
  • Total required collateral (assuming no threshold for simplicity, just covering the current exposure): $12 million.
  • Current collateral held: $1 million.
  • Incremental collateral needed: $12 million - $1 million = $11 million.

Bank A would issue a margin call to Bank B for $11 million. Upon receiving this incremental collateral, Bank A's exposure would again be adequately covered, reflecting the updated market value of the trade.

Practical Applications

Incremental collateral is fundamental across various segments of the financial markets:

• Derivatives Trading: In both centrally cleared and OTC derivative markets, the daily exchange of variation margin and the posting of initial margin are direct applications of incremental collateral. Regulations such as EMIR in Europe and the Dodd-Frank Act in the U.S. mandate robust collateralization practices for non-centrally cleared derivatives to mitigate systemic risk.⁶,⁵
• Repurchase Agreements (Repos): In repurchase agreements, entities borrow cash by selling securities with an agreement to repurchase them later. The market value of the securities typically exceeds the cash received (haircut), and if the value of the securities falls, the borrower may be asked to provide incremental collateral to maintain the agreed-upon overcollateralization. The Federal Reserve Bank of New York actively participates in the repo market to manage liquidity in the financial system.⁴
• Securities Lending: Similar to repos, securities lending involves lending securities against collateral, usually cash or other securities. If the value of the collateral declines, the borrower must post incremental collateral.
• Lending and Credit Facilities: While less dynamic than daily margin calls, some commercial secured loans or credit lines may include provisions for incremental collateral if the borrower's financial health deteriorates or the value of the underlying collateral falls significantly. This helps protect the lender's interest and ensures adequate coverage on their balance sheet.

Limitations and Criticisms

While vital for risk management, incremental collateral mechanisms are not without limitations and criticisms. A significant concern is procyclicality, where the demand for incremental collateral can intensify during periods of market volatility and economic downturns. As asset prices fall, the value of collateral decreases, triggering more margin calls, which can force market participants to sell assets to raise cash, further depressing prices and creating a negative feedback loop. This "collateral crunch" can exacerbate financial instability and liquidity issues within the financial system.³ Central banks and regulators actively study and work to mitigate the procyclical impact of collateral requirements.²

Another criticism emerged from the 2008 financial crisis, particularly with the collapse of Lehman Brothers. The firm famously used "Repo 105" transactions, a form of repurchase agreement where they temporarily sold assets with a commitment to repurchase them, to reduce their reported balance sheet leverage. By overcollateralizing these transactions (pledging $105 of securities for every $100 borrowed cash), they accounted for them as sales rather than financing, effectively hiding liabilities and the true extent of their leverage.¹ This practice demonstrated how certain accounting treatments, even when involving collateral, could be exploited to misrepresent financial health, leading to calls for stricter accounting standards and greater transparency.

Incremental Collateral vs. Margin Call

While closely related and often used interchangeably in practice, "incremental collateral" and "margin call" represent distinct but sequential concepts.

Incremental collateral refers to the amount of additional collateral that needs to be posted to meet a deficiency or increased requirement. It is the quantitative value of the assets that the collateral poster must deliver. The need for incremental collateral arises when the existing security falls short of covering the risk exposure, typically due to adverse price movements of the underlying asset or the posted collateral itself.

A margin call, on the other hand, is the demand or notification issued by a lender or central counterparty (CCP) to a borrower, requesting that this incremental collateral be posted. It is the operational trigger that prompts the delivery of the additional assets. A margin call is the action, while incremental collateral is the substance of that action. Therefore, a margin call is issued for incremental collateral.

FAQs

Q1: Why is incremental collateral required in financial markets?

A1: Incremental collateral is required to mitigate credit risk and counterparty risk for lenders. It ensures that the value of the collateral held remains sufficient to cover potential losses from a borrower's default, especially in volatile markets where underlying asset values or existing collateral values can change rapidly.

Q2: What kind of assets can be used as incremental collateral?

A2: Typically, highly liquid assets are preferred for incremental collateral, such as cash, government bonds (e.g., U.S. Treasuries), high-quality corporate bonds, or highly liquid equities. The specific types of acceptable collateral are usually outlined in the collateral management agreement between the parties.

Q3: How often is incremental collateral calculated and exchanged?

A3: In many markets, particularly derivatives and repurchase agreements, incremental collateral is calculated and exchanged daily, based on the marking-to-market of exposures. In highly volatile conditions, this can even happen intraday to ensure continuous risk coverage.

Q4: What happens if a party cannot provide incremental collateral when requested?

A4: Failure to provide incremental collateral on time constitutes an event of default under most collateral agreements. This can allow the non-defaulting party to seize the existing collateral, close out the outstanding positions, and potentially pursue legal action to recover any remaining losses. It can also lead to a loss of market access and severe reputational damage for the defaulting party.