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P2.T6.912. The impact of collateral on counterparty risk and funding (Gregory Ch.7)

Nicole Seaman

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Learning objectives: Explain the impact of collateralization on exposure, and assess the risk associated with the remargining period, threshold, and minimum transfer amount. Assess the impact of collateral on counterparty risk and funding, with and without segregation or rehypothecation.

Questions:

912.1. Suppose the current mark-to-market (MTM) value of a portfolio is +$30.0 million and $27.0 million of variation margin is held. Also, $8.0 million of segregated initial margin was posted bilaterally. What are, respectively, the current counterparty risk (CCR) exposure and the funding exposure?

a. CCR Exposure = Zero; and Funding exposure = $11.0 million
b. CCR Exposure = $3.0 million; and Funding exposure = Zero
c. CCR Exposure = $3.0 million; and Funding exposure = $3.0 million
d. CCR Exposure = $11.0 million; and Funding exposure = $19.0 million


912.2. Suppose the mark-to-market (MTM) value of a portfolio is -$36.0 and -$40.0 of variation margin has been posted. Also, $3.0 million of initial margin was posted bilaterally. What are, respectively, the current counterparty risk (CCR) exposure and the funding exposure?

a. CCR Exposure = zero; and Funding exposure = zero
b. CCR Exposure = zero; and Funding exposure = $3.0 million
c: CCR Exposure = $1.0 million; and Funding exposure = $7.0 million
d. CCR Exposure = $3.0 million; and Funding exposure = $33.0 million


912.3. In a certain credit portfolio, Acme Bank holds four large over the counter (OTC) derivative positions, each with a different counterparty. As it happens, the mark-to-market value of each position is significantly positive (i.e., above the threshold) and consequently, Acme Bank holds collateral for each position. However, the type of collateral for each position is different. The collateral types are as follows:

I. Cash that does not need to be segregated​
II. Securities that can be rehypothecated​
III. Cash/securities that must be segregated; i.e., cannot be rehypothecated​
IV. The Counterparty is posting own bonds, and they can be rehypothecated​

Gregory explains the distinction between held collateral that provides a counterparty risk reduction benefit and held collateral that provides a funding benefit. In regard to these four examples (i.e., I., II., III. and IV), which of the following statements is TRUE?

a. All four provide counterparty risk reduction and funding benefits
b. I. and II. provide both counterparty risk reduction and funding benefits; III. provides only counterparty risk reduction benefits; and IV. provides only funding benefit
c. I. provides both counterparty risk reduction and funding benefits; II. and III. provide only funding benefit; and IV. provides only counterparty risk reduction benefit
d. None except I. provide EITHER counterparty risk reduction OR funding benefit

Answers:

912.1. A. True: CCR Exposure = Zero; and Funding exposure = $11.0 million

Given variation margin (VM) and initial margin (IM), the current counterparty risk exposure is given by:
  • Exposure(CCR) = max(value - VM 0- IM, 0) = max(+30 -27 -8, 0) = zero.
  • Exposure(Funding) = MTM - VM + IM = 30 - 27 + 8 = $11.0 million

912.2. C: CCR Exposure = $1.0 million; and Funding exposure = $7.0 million
  • Exposure(CCR) = max(value - VM 0- IM, 0) = max(-36 +40 -3 , 0) = +1.0 million.
  • Exposure(Funding) = MTM - VM + IM = -36 + 40 + 3 = +7.0 million.

912.3. B. True: I. and II. provide both counterparty risk reduction and funding benefits; III. provides only counterparty risk reduction benefits; and IV. provides only funding benefit

Gregory: "7.5.3 Impact of segregation and rehypothecation: Collateral in OTC derivative transactions can be seen to serve two purposes: it has a traditional role in mitigating counterparty risk and it also provides a funding position. Whilst the former role is the traditional use of collateral, the latter has been seen as increasingly important in recent years. Collateral may be complimentary in mitigating both counterparty risk and funding costs. For example, receiving collateral from a counterparty against a positive MTM has a two-fold benefit:
  • Counterparty risk reduction. In the event of the counterparty defaulting, it is possible to hold on to (or take ownership of) the collateral to cover close-out losses.
  • Funding benefit. The collateral can be used for other purposes [footnote 19: As long as it does not need to be segregated and can be rehypothecated, as discussed below]such as being posted as collateral against a negative MTM in another transaction. Indeed, it could be posted against the hedge of the transaction (which by definition will have a negative MTM).
However, as Table 7.4 illustrates, the type of collateral must have certain characteristics to provide benefits against both counterparty risk and funding costs. Firstly, in order to maximise the benefits of counterparty risk mitigation, there must be no adverse correlation between the collateral and the credit quality of the counterparty (wrong-way risk). A second important consideration is that, for collateral to be used for funding purposes, it must be reusable. This means that collateral must not be segregated and non-cash collateral must be reusable (transferred by title transfer or rehypothecation allowed) so that the collateral can be reused. In the case of cash collateral this is trivially the case, but for non-cash collateral rehypothecation must be allowed so that the collateral can be reused or pledged via repo.

Let us consider the counterparty risk mitigation and funding benefit from various types of collateral under certain situations:
  • Cash that does not need to be segregated. As discussed above, this provides both counterparty risk and funding benefits.
  • Explain the impact of collateralization on exposure As above, as long as the haircuts are sufficient to mitigate against any adverse price moves and also the corresponding haircuts associated with reusing the securities (e.g. the repo market or the collateral terms for another transaction).
  • Cash/ securities that must be segregated/cannot be rehypothecated. These provide a counterparty mitigation benefit since they may be monetised in a default scenario but do not provide a funding benefit, since they cannot be reused in a non-default scenario.
  • Counterparty posting own bonds (that can be rehypothecated). These provide a questionable counterparty risk mitigation benefit since they will obviously be in default when needed. 20 However, as long as they can be rehypothecated (and the haircuts are sufficient for this purpose) then they provide a funding benefit."
 
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