1) Collateral management has become increasingly important for financial institutions due to market developments like increased collateral circulation and new regulations requiring more collateral. It is no longer a back office function but a major challenge. should build or buy systems that can integrate with existing 2) Key features of collateral management include bi-party agreements between two parties, tri-party agreements involving a third party custodian, collateral trading and re-hypothecation, and repurchase (repo) agreements. infrastructure and provide a centralized view of collateral across 3) Best practices for financial institutions include regularly revaluing collateral, maintaining relationships with key clients, performing regular portfolio reconciliations, considering outsourcing collateral

1. www.niit-tech.com
Collateral Management
Nidhi Lall
NIIT Technologies White Paper

2. CONTENTS
Executive Summary
3
Collateral Management and Market Developments
3
Collateral Management – Features
4
1. Bi-Party Collateral Agreement
2. Tri-Party Collateral Agreement
3. Collateral Trading and Re-hypothecation
4. Repos and Repos Market
Collateralized Relationship Structuring
3
1. Credit considerations
2. Determine eligible collateral for the counterparty
Implementing the Collateralized Relationship
6
Best Practices
7
1. Revalue Collaterals
2. Maintaining Critical Buy Side Relationships
3. Regular and Frequent Portfolio Reconciliation
4. Outsource Collateral Management
5. Build and Buy Systems
Role of Technology in Collateral Management Systems
8
Conclusion
8

3. INVESTMENT
FINANCE
CAPITAL
BANKING
INVESTMENT
WEALTH
FINAANCE
MARKET
INVESTMENT FINANCE
CARGO CAPITAL
ECONOMICS
FINANCE
REVENUE
REVENUE
MATKET
INVESTMENT CAPITAL
CAPITAL ECONOMICS
MARKET
FINANCE
Executive Summary
Financial institutions need accurate and sophisticated enterprise wide
Collateral use in the market has increased. According to ISDA survey
approach to keep their collateral inventory optimized while generating
in 2013, the $3.7 trillion estimate of total collateral in circulation is
revenue and reducing costs. This paper provides an insight into
based on total reported collateral amount of $2.67 trillion. With the
Collateral Management, in the current economic scenario. The paper
increase in collateral circulation it is important for firms to implement
provides a broader view on how technology bridges the gap and also
robust, automated collateral management solutions to support
enumerates the best practices that financial institutions must follow to
evolving market and regulatory needs.
improve collateral management process.
Growth in value of reported and estimated collateral (USD billion)
OTC Contracts Cleared on CCP
4500
4000
3957
3500
3151
3652
2934
2649
3000
2150
2500
2000
2459
3700
2666
Collateral Management and
Market Developments
Collateral is any asset that is used to secure a borrowing. It is a
1984
guarantee that the cash borrowed by the counterparty would be
1500
returned back at the predefined time. When two parties engage in
1000
Collateral Agreement, the lender reduces Credit risk while lending
500
cash and the borrower gains favorable conditions for financing.
0
2009
2010
2011
2012
2013
Year
Estimated
Collateral Management assists organizations to mitigate Credit
risk, by accepting a similar valued asset in return for the loan/cash
Reported
lent. Collateral Management reduces risk between the lender and
Banks and Financial institutions are under immense pressure in
every area of their business with the introduction of new rules and
market changes from the Global regulators. With ~90% of firms
reeling under pressure from aggressive regulatory changes and
the borrower and is effective when it constantly rebalances
exposure as per changes in prices and regulations. Collateral
Management has developed as a strong Business practice that
forms the core aspect of the organization.
over 35% facing compliance, administrative and reporting burdens
(Celent, 2013), collateral management has become the top priority
for the banking and capital markets industry. It is no longer
recognized as a back office function but has evolved as a major
challenge for both banks and financial institutions to convert
outmoded spreadsheet based systems to an automated and
advanced collateral management system.
Collateral Management has undergone a major transformation after
the collapse of Lehman Brothers and the onset of the financial crisis.
The credit crisis of 2008-09, along with freezing of credit markets
and increased volatility resulted in the introduction of new regulations
(BASEL III, CRD IV, EMIR and Dodd Frank Act) and high volumes of
collateralized loans. In Europe, banks had a shortfall of €374.1 billion
(Quantitative impact study by Basel Committee, Sep 2012) to
75% Dodd-Frank
65% EMIR
comply with additional liquidity requirements of Basel III.
Exerts biggest impact
on the economics of
trading derivatives
3

4. After millions of dollars were lost when the financial institution
Once the market became stable, capital market industry started
Lehman Brothers collapsed, industry demanded better collateral
considering collateral management as a core function fully
management.
Industry initiatives required firms to consider
integrated in the management of financial institutions and closely
smarter ways of using the limited collateral available. Financial
linked to treasury, trading, risk management, operations, finance
institutions were forced to focus on counterparty credit risk and
and capital management.
the wide use of derivates and the entire collateral management
process. Regulatory changes also called for additional collateral
and margin requirements for large and complex derivatives. The
Collateral Management – Features
implementation of global regulations such as Dodd Frank Act,
Collateral Management has evolved for hundred of years, from a
EMIR and other capital regulations emphasized to automate the
single, ancillary function of an organization to cover a
collateral management systems in order to manage them with
comprehensive list of functions and features. Some of them are:
ease. Automating collateral management systems mitigated
systemic risk and increase transparency in Over-the-Counter
(OTC) trades, and pre- and post-trade financial transactions.
However, to prepare for the changes firms needed investment in
technology. Technology helped firms in looking at the collateral
holistically and facilitated clearing. According to a survey by a
research firm Celent in 2012, an estimated 40-50% of OTC
Bi-Party
Collateral
Agreement
Tri-Party
Collateral
Agreement
contracts are expected to be cleared by the end of 2013, leaving
a $2.5 trillion to $6 trillion collateral hole to fill.
Centrally Cleared OTC Contracts Will Leave a $2.5 Trillion to
$6 Trillion Collateral Hole to Fill
OTC Contracts Cleared on CCP
90%
80%
Repos and
Repos Market
80%
70%
70%
60%
60%
50%
40%
Collateral
Trading and
Rehypothecation
40%
50%
30%
20%
10%
0%
2012
2013
2014
2015
2016
Bi-Party Collateral Agreement
Bi-Party agreements are collateral agreements where two
Source: Morgan Stanley, Oliver Wyman, Celent
parties interact among themselves and form a collateral
The enterprise collateral management challenges from the
agreement without any interference from a third party or a
inefficiency of collateral silos also resulted in the implementation of
centralized bank. The Bi-Party Collateral Agreements are over
new processes and procedures to manage current and future
the counter agreements customized according to the needs. It
collateral management needs. There was an immediate need to
is a two-legged transaction – Initiation of the Agreement and
link collaterals to credits. After the financial crisis, the amount of
Termination of Agreement.
uncollateralized
credit
available
between
transacting
counterparties has sharply fallen down. Decrease in the
uncollateralized credit increased the demand for collateralized
credit, which in turn generated interest in the mechanisms
available to support collateralized solutions.
4

5. Tri-Party Collateral Agreement
Tri-party Collateral Agreement involves third parties during the
transaction. Third party is an intermediary during the entire
process and usually the Custodian Bank of the firms. The
Custodian bank is the safe-keeper of the Collateral for the Lender,
Collateralized Relationship
Structuring
1. Credit considerations
Structuring of collateral relationship involves credit considerations
to be followed. These considerations are:
and assists in transferring funds from the Lender to the Borrower.
1.1 Is collateral a suitable credit enhancement tool?
Triparty Collateral Management
To determine whether collateralization is appropriate, financial
The Collateral Management Outsourcing Solution
Bi-lateral Contract
Triparty Service Agreement
Collateral
Giver
institutions must analyze the counterparty’s financial position. It is
important for firms to note that collateral does not turn a bad
Operating Procedures
Terms and Conditions
Eligbility profile
Concentration profile
Margin percentages
Neutral Agent
Collateral
Taker
counterparty into a good counterparty without eliminating credit risk.
A collateral arrangement provides assets of value during
Eligibility Set 1
• Eligible: AAA - A
• No concentration
• x % haircut
Eligibility Set 2
• Eligible: AAA - BBB
• only y % of BBB
• z % haircut
counterparty’s default or bankruptcy/insolvency. A financial
institution loses funds only under a fully collateralized arrangement.
If the direct counterparty defaults during the default period (prior to
liquidation of the collateral), there is a significant increase in MTM
exposure or decrease in collateral value held after taking into
account independent amounts (initial margin) and haircuts on the
Collateral Trading and Re-hypothecation
value of the collateral securities.
Collateral Trading is done to free resources for working capital
requirements by the bank. It traditionally involves few market
participants and represents a very small proportion of total trading.
Re-hypothecation, on the other hand, is the process where the
secured lender extends the collateral posted, by either lending or
posting it as collateral to another party. It is also done to free up
collateralized capital.
1.2 Determine the Credit Type of the Counterparty
It is always helpful to determine the counterparty’s ability to
• Deliver collateral on a timely basis or hold collateral
• Measure collateral requirements on a daily, weekly or monthly basis.
1.3 Determining the Appropriateness of Collateral
Upon successful completion of credit analysis and gathering of
Repos and Repos Market
Repo is an agreement in which one party sells securities or assets
to counterparty and simultaneously commits to repurchase the
same at an agreed time. The repurchase price is equal to the
general counterparty information, the credit officer must determine
whether the collateral is an appropriate credit enhancement tool.
He must identify appropriate credit support terms to negotiate. In
some instances, other provisions, such as guarantees or an option
to terminate the transaction may be helpful.
original sale price plus interest on the repurchase price.
5

6. they should be valid enough to provide deemed ratings for
2. Determine eligible collateral for the
collateral. However, revealing credit ratings may have confidentiality
counterparty
2.1Considerations for Selecting Appropriate Collateral
Appropriately selected collateral gives financial institutions
implications. Therefore, confidentiality of the use of internal credit
ratings must be agreed upon between counterparties before they
are shared with the outside world.
protection against counterparty risks and may reduce capital
costs. Poorly selected collateral gives rise to unacceptable levels of
price risk, liquidity risk, operational risk and legal uncertainty. The
following criterion has been used as a basis for determining
collateral eligibility.
as the S&P500, the FTSE100, DAX30, CAC40 or Nikkei 225) is
2.1.4 Instrument Tenor (Time Remaining to Mature)
Firms should consider credit rating, currency, issue size and the
frequency of price updates to understand the liquidity of the
collateral. If the price for a particular item of collateral is not
available, the firm must interpret it as a significant downturn in the
liquidity of that asset. It is advisable to establish a liquidity threshold
below which an item of collateral is valued as zero.
Collateral is group of tenor buckets with tenors measured as
residual maturity rather than original maturity. Existing collateral
agreements refer to original maturity but measure residual maturity
suggesting a need to amend the agreement. However, in this
dispute of original maturity vs. residual maturity oral arrangement
may not be enforceable.
2.1.2 Volatility
volatile
on the major exchanges and especially in the prime indices (such
generally viewed as indicating greater liquidity of the collateral.
2.1.1 Liquidity
Highly
Collateral quality is difficult to gauge for equities. However, listing
2.1.5 Avoid Strong Correlation to Exposure
instruments
should
be
subject
to
lower
concentration limits and higher haircut rates in order to be
accepted. The haircut computation methodology ensures that the
price volatility is factored into the haircut. When establishing initial
margin levels or haircuts, it is important for the firms to understand
that operational risk is generated by the delay between the time at
Collaterals with strong correlation to underlying exposure are not
appropriate as their value always decreases when the exposure
increases. These collaterals are always unacceptable even if they
qualify under all acceptability criteria. In certain circumstances, the
collateral chosen may specifically offset the liability because of its
strong correlation to the liability, creating a covered trade.
which a margin call is made and the time at which the collateral is
delivered. During periods of extreme market volatility, if the
2.1.6 Avoid Positive Correlation to Collateral Giver
collateral call is made on day T while delivery of the collateral will
Any collateral whose value correlates directly and positively to the
not take place until T plus one day, a lag of one day will create
collateral giver’s credit standing is usually not acceptable.
operational risk. It is, thus, inadvisable to accept collateral subject
Securities or any related equity issued by the collateral giver is
to long settlement periods. Initial margin levels and haircuts should
normally not accepted as collateral.
be established at all levels to take account of this risk.
2.1.3 Collateral Quality (Credit Rating)
a bond is not rated by an agreed rating agency (e.g. S&P or Moody’s),
Implementing the Collateralized
Relationship
the bond should undergo a deemed rating process. In deemed rating
Collateral management complicates the handling of relationships
process, firms must review ratings accorded by an agreed rating
between two parties under one agreement for one line of business.
agency to senior unsecured issues by the same issuer, and accord a
A firm may be doing business with the same counterparty out of
similar deemed rating if the issue in question is not subordinated. If the
multiple entities in different jurisdictions for tax, accounting,
issue being assessed is subordinated, the deemed rating is two to
regulatory or other reasons.
A minimum acceptable credit rating is often stipulated for all bonds. If
three modifiers lower than the rated issue.
Due to volatile market and jurisdictions, collateral management has
An alternative source is credit department of a financial institution.
to resolve the following issues that may arise:
If
• Counterparty initiates multiple calls for collateral to secure
credit
decisions
are
based
on
internal
risk
ratings,
various exposures;
6

7. • A call for collateral may be initiated by one entity while another
• Type of collateral – Security collateral or cash collateral Security
entity is returning collateral to the same counterparty. At this
collateral including accrued interest should be revalued while
time, both the parties run the risk of over collateralizing on a net
cash collaterals exclude accrued interest while revaluation
basis; and
• Market conditions - Time, Market volatility, Finance availability,
• Relations with counterparty may be governed by multiple
Economic environment, Lack of maintenance etc.
agreements with different terms covering different products that
may overlap.
Maintaining Critical Buy Side Relationships
Relationships for the buy-side are extremely critical for
Monitoring collateral positions and tracking collateral movements
requires both parties to have systems that can handle collateral.
Firms need to automate the entire collateral management process.
With automation, additional administrative burdens come in the
understanding collateral demands in both bilateral and central
counterparty world. Hedge funds, asset managers and insurance
companies still look at primary service providers to offer best deals
across multiple products on a holistic basis.
form of monitoring or tracking the securities that are subject of a
collateral agreement, performing daily MTM calculations and
handling margin calls.
Regular and Frequent Portfolio Reconciliation
Detailed portfolio reconciliation should be performed regularly or
prior to the first margin call. If it is not done regularly/frequently, the
collateral that flows back and forth is based on the estimate of the
Best Practices
exposure;
which
is
not
considered
a
sound
basis
of
collateralization.
Revalue Collaterals
Regular portfolio reconciliation reduces the frequency of
collateral disputes. In order to resolve collateral disputes, the
Maintain Critical Buy Side Relationships
most effective way is to extract trade files from the collateral
system on a regular basis.
Regular and Frequent Portfolio Reconciliation
Outsource Collateral Management
Outsource Collateral Management
Fewer than 50% have outsourced collateral management, 25%
Build and Buy Systems
have deployed vendor collateral management solutions internally,
with the remainder reliant on bespoke applications and
spreadsheets
(ISDA,
2012).
In
an
outsourced
collateral
management system, it is easy to retain bilateral relationships with
Revalue Collaterals
Financial institutions must revalue and monitor collaterals against
outstanding debt on a regular basis. The frequency of revaluation
will depend on the following two factors:
preferred counterparties. The outsourced solution will also enable
counterparties and investment manager to focus on making
strategies rather than worrying about the operational, regulatory
reporting and transaction requirements.
7

8. Build and Buy Systems
Financial institutions struggling hard in collateral management and
OTC derivatives must invest in plug and play type of systems. They
can purchase or lease systems locally or via a hosted solution from
a dedicated or a bundled service provider. The systems developed
• Scalability and economies of scale to handle increased volume
of collateral
• Capability to efficiently calculate Mark to Market calculations
• Risk management and alert mechanism with audit features to
handle market volatility
by service providers can be customized to meet the collateral
management services needs. Build and Buy systems strategy is
the most popular technology strategy with core functionality
integrated into existing systems.
• Reporting capabilities to handle legal and documentation
requirements
• Capability to manage disparate systems, data capture from
several sources, margin call calculations etc.
Role of Technology in Collateral
Management Systems
Technology plays a critical role in Collateral Management Systems.
Collateral management requires compatibility and seamless
integration with third party platforms and applications like Order
and Trade Management, Trading Platforms, Risk Management
Systems and External data feeds for running the business in a
seamless manner. A centralized system can process and manage
Conclusion
The changing regulatory and trading environment has necessitated
the need to revisit the existing collateral management processes
that involves integration with third party institutions, platforms and
applications. It involves precision, accuracy and timely flow of data
to margin management and calculation systems. Any discrepancy
in data can result in financial institution insolvency.
collateral requirements and at the same time handle increased
volumes and agreements.
In the current market scenario, technology
• Improves the efficiency of information and allows market data to
move swiftly
• Makes the system efficient and capable of handling mark to
market calculations
• Achieves cross product netting, collateral optimization and
management of new regulation requirements.
Collateral management is not a perfunctory back office function
but considered a core function. NIIT Technologies with 15000 +
person years of experience in capital market domain have
in-depth expertise in regulatory and change management
functions. We evaluate the existing systems and identify the
shortfalls. NIIT Technologies provide services in the area of
collateral management, third party feeds and data provider
integration, enterprise data management, order and trade
management, risk management, fund accounting, margining
and netting, and reporting.
The collateral management systems should evolve in technology
with changing times and should always reflect the true picture of
A solution that mitigates risk, processes collateral information
the market. It should integrate all functions like business
consistently across clearing methods and asset classes, and
operations, legal documentation etc. to ensure that the system has
meets new regulation and industry best practices can
core functional capabilities.
dramatically change the dynamics of the collateral management
market. NIIT Technologies has the know-how and solution to
A typical collateral management system should provide
develop and automate the collateral management process with
• Integration with market data feed providers
proven industry knowledge. These strengths have led to a large
• Integration with all third party platforms and applications
ecosystem with a large number of partners utilizing our
• Integration with third party institutions involved in collateral
collateral management systems.
agreements
8

9. About NIIT Technologies
NIIT Technologies is a leading IT solutions organization, servicing customers in North America,
Europe, Asia and Australia. It offers services in Application Development and Maintenance,
Enterprise Solutions including Managed Services and Business Process Outsourcing to
organisations in the Financial Services, Travel & Transportation, Manufacturing/Distribution, and
Government sectors. With employees over 8,000 professionals, NIIT Technologies follows global
standards of software development processes.
Over the years the Company has forged extremely rewarding relationships with global majors, a
testimony to mutual commitment and its ability to retain marquee clients, drawing repeat
business from them. NIIT Technologies has been able to scale its interactions with marquee
clients in the BFSI sector, the Travel Transport & Logistics and Manufacturing & Distribution, into
extremely meaningful, multi-year "collaborations.
NIIT Technologies follows global standards of development, which include ISO 9001:2000
Certification, assessment at Level 5 for SEI-CMMi version 1.2 and ISO 27001 information
security management certification. Its data centre operations are assessed at the international
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ISO 20000 IT management standards.
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