Restating the Role of Collateral

Abstract

This chapter documents the practice of collateral posting in derivative markets, introduced at the onset to provide protection against the potential default of a counterparty, and which has evolved into an art: selecting instruments—cash or securities—eligible as collateral, settling disputes, and minimizing costs. The liquidity risk stemming from the obligation to post collateral, or Margin Call Risk, has contributed to the collapse of several large firms (the case of Metallgesellschaft is reviewed). Post-2008 regulation significantly tightens collateral posting rules in order to remove all shortcomings existing in the protection against default risk. The Chapter documents how regulation leaves flexibility in the practice of collateral re-use (or re-hypothecation) so as to help collateral “circulate” and remain available, and to help participants minimize its cost.