The Rise of Collateral and the Urgent Need for Collateral Risk Management

The downturn has clearly pushed Collateralization to the fore of OTC derivatives, repos and securities financing. What was often viewed as a luxury, is now seen as a necessity as counterparty risk is not confined to low rated entities (sic. Lehmans!). But the rise of collateralization does not destroy the problem faced by counterparties. Collateral may increase some business opportunities but it also converts counterparty credit risk into operational and legal risks and into residual market and residual credit risk. This new bundle of risks is certainly different from what was held before and arguably is more complex. Consider Operational Risk is implied in everything from reconciliation to posting collateral with a custodian, from collateral valuation to settlement. Legal Risk is endemic to the OTC derivatives space and is of course the rationale for the various master ageements (ISDA, GMRA etc) and associated credit annexes, many of which remain to be tested in emerging markets legal jurisdictions. Residual Risk always remains, whether it be from market risk - the changing value of the collateral, or the changing risk sensitive margins, or even reinvestment risk; or from credit risk - wrong way risk - the possibility of correlations between counterparty default and collateral values. In short, collateralization is a good thing, one to encourage, provided one realizes that risk is not removed, merely converted into another form. And these new risks must be managed if collateral is not to give a false sense of security in these turbulent times.