Collateral is assets provided to secure an obligation. Traditionally, banks might require corporate borrowers to commit company assets as security for loans. Today, this practice is called secured lending or asset-based lending. Collateral can take many forms: property, inventory, equipment, receivables, oil reserves, etc.
A more recent development is collateralization arrangements used to secure repo, securities lending and derivatives transactions. Under such arrangement, a party who owes an obligation to another party posts collateral—typically consisting of cash or securities—to secure the obligation. In the event that the party defaults on the obligation, the secured party may seize the collateral. In this context, collateral is sometimes called margin.
An arrangement can be unilateral with just one party posting collateral. With two-sided obligations, such as a swap or foreign exchange forward, bilateral collateralization may be used. In that situation, both parties may post collateral for the value of their total obligation to the other. Alternatively, the net obligation may be collateralized—at any point in time, the party who is the net obligator posts collateral for the value of the net obligation.
In a typical collateral arrangement, the secured obligation is periodically marked-to-market, and the collateral is adjusted to reflect changes in value. The securing party posts additional collateral when the market value has risen, or removes collateral when it has fallen. The collateral agreement should specify:
Acceptable collateral: A secured party will usually prefer to receive highly rated collateral such as Treasuries or agencies. Collateral whose market value is volatile or negatively correlated with the value of the secured obligation is generally undesirable.
Frequency of margin calls: Because the value of an obligation and the value of posted collateral can change, a secured party typically wants to mark-to-market frequently, issuing a margin call to the securing party for additional collateral when needed.
Haircuts: In determining the amount of collateral that must be posted, haircuts are applied to the market value of various types of collateral. For example, if a 1% haircut is applied to Treasuries, then Treasuries are valued at 99% of their market value. A 5% haircut might be applied to certain corporate bonds, etc.
Threshold level: Only the value of an obligation above a certain threshold level may be collateralized. For example, if a USD 1MM threshold applies to a USD 5MM obligation, only USD 4MM of the obligation will actually be collateralized.
Close-out and termination clauses: The parties must agree under what circumstances the obligation will be terminated. The form of a final settlement in the event of such termination—and the role of the collateral in such settlement—is specified.
Valuation: A methodology for marking both the obligation and the collateral to market must be agreed upon.
Rehypothecation rights: The secured party may wish to have use of posted collateral—possibly lending it to another party or posting it as collateral for its own obligations to another party. Rehypothecation is not permitted in many jurisdictions.
Legal treatment of collateral varies from one jurisdiction to another. In some jurisdictions, the secured party takes legal possession of collateral, but is legally bound by how the collateral may be used and the conditions upon which it must be returned. Such transfer of title provides the secured party a high degree of assurance that it may seize the collateral in the event of a default. Transfer of title, however, may be treated as a taxable event in some jurisdictions. In other jurisdictions, the securing party retains ownership of collateral, but the secured party acquires a perfected interest in it.