What are the main challenges of collateral substitution in collateral management?

1 Eligibility criteria

One of the key challenges of collateral substitution is to ensure that the new collateral meets the eligibility criteria agreed by both parties. Eligibility criteria can include factors such as asset class, credit rating, currency, maturity, haircut, and concentration limits. If the new collateral does not satisfy these criteria, the substitution request may be rejected or incur additional fees or penalties. To avoid this, you need to have a clear and updated understanding of the eligibility criteria for each collateral agreement, and communicate effectively with your counterparties before initiating a substitution request.

3 Market risk

A third challenge of collateral substitution is to manage the market risk associated with the change in collateral. Market risk refers to the potential loss or gain due to changes in the market value or liquidity of the collateral. When you substitute one type of collateral with another, you may expose yourself to different market risks, such as interest rate risk, currency risk, credit risk, or liquidity risk. For example, if you replace a fixed-rate bond with a floating-rate bond, you may benefit from a rise in interest rates, but also suffer from a fall. To mitigate this, you need to monitor and measure the market risk of your collateral portfolio, and adjust your hedging strategies accordingly.

4 Legal risk

A fourth challenge of collateral substitution is to deal with the legal risk associated with the change in collateral. Legal risk refers to the potential loss or gain due to changes in the legal rights or obligations of the collateral. When you substitute one type of collateral with another, you may affect the enforceability, priority, or security of your collateral claim, especially in cross-border or cross-jurisdiction transactions. For example, if you replace a domestic bond with a foreign bond, you may face different legal frameworks, tax regimes, or regulatory requirements. To address this, you need to review and update your collateral documentation, and consult with legal experts before initiating a substitution request.

5 Counterparty risk

A fifth challenge of collateral substitution is to cope with the counterparty risk associated with the change in collateral. Counterparty risk refers to the potential loss or gain due to changes in the creditworthiness or behavior of your counterparty. When you substitute one type of collateral with another, you may alter the risk profile or incentives of your counterparty, and affect the trust and cooperation between you. For example, if you replace a high-quality collateral with a low-quality collateral, you may increase the default or settlement risk of your counterparty, or reduce their willingness to accept further substitutions. To manage this, you need to assess and monitor the creditworthiness and reputation of your counterparty, and negotiate fair and transparent terms for collateral substitution.

6 Liquidity risk

A sixth challenge of collateral substitution is to handle the liquidity risk associated with the change in collateral. Liquidity risk refers to the potential loss or gain due to changes in the availability or cost of funding or collateral. When you substitute one type of collateral with another, you may affect the liquidity of your collateral portfolio, and impact your cash flow and balance sheet. For example, if you replace a liquid collateral with an illiquid collateral, you may reduce your ability to raise funds or meet margin calls, or increase your funding costs or haircuts. To control this, you need to analyze and forecast the liquidity of your collateral portfolio, and diversify your sources and uses of collateral.

7 Here’s what else to consider

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