Collateral Operations

At a financial institution that trades derivatives under agreements to exchange collateral, calculating and exchanging collateral as market values move is a daily task for the collateral operations staff.

Why collateral operations are needed

Exchanging collateral reduces counterparty credit risk but does not eliminate it¹. With enough collateral, the credit risk moves from the counterparty to the issuer of the bonds posted as collateral. In exchange, legal, operational, and liquidity risks increase. Using collateral means monitoring the collateral agreements, tracking the collateral exchanged and revaluing it at market value, and keeping the collateral safe. The 1999 examination manual of the US Federal Reserve Board said that this requires a large investment in systems and in the back office (operations and settlement), and that relying more heavily on collateral management systems also increases operational risk¹.

For OTC derivatives subject to Japan's margin rules, an institution must calculate every day, for each counterparty, the total market value of the trades and the market value of the collateral, and exchange variation margin². A financial institution with many collateralized trades repeats this calculation and exchange every day, once for each counterparty. How much collateral reduces exposure to a counterparty's default is covered in Risk Reduction through Netting and Collateral.

Terms of the collateral agreement

In bilateral OTC derivatives, collateral is generally exchanged under a credit support annex (CSA) attached to the master agreement³. Because the terms are set in each agreement with a counterparty, they differ from counterparty to counterparty even within the same institution, and the daily calculation uses the terms of each counterparty.

Around 2017, thresholds of 0 had become common in trades between financial institutions, and the margin rules also require a threshold of 0 for variation margin. The minimum transfer amount reduces the operational burden of moving collateral every time the market value changes slightly³. In practice around 2010, the interest on cash collateral was usually paid at the overnight rate of the currency, and the detailed terms varied from trade to trade⁴.

For trades subject to the rules, the assets that can be used as collateral are cash and assets set by the Commissioner of the Financial Services Agency. An asset other than cash is valued at its market value minus the market value multiplied by a percentage set by the Commissioner. If the collateral is in a currency different from the one agreed by the parties, a further percentage for the currency is deducted⁵. The Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc. list two points of focus for a financial instruments business operator's internal control. One is concluding agreements such as the ISDA Master Agreement and a CSA with counterparties. The other is diversifying the assets used as collateral, for example by keeping illiquid securities below a certain level⁶.

Calculating the daily collateral requirement

For trades subject to the margin rules, the collateral operations staff make the following calculations every day, in this order².

1. Taking in the market values of the trades: find the total market value of the trades with each counterparty.
2. Valuing the collateral: revalue the collateral received and the collateral posted at market value. Collateral other than cash is valued after deducting the haircut⁵.
3. Calculating the requirement and the shortfall or excess: subtract the value of the collateral already held from the part of the market value above the threshold to find the amount to transfer.
4. Comparing with the minimum transfer amount: for an agreement that sets a minimum transfer amount, ask the counterparty to post or return collateral only when the amount to transfer exceeds it. For an agreement that does not set one, ask for the amount to transfer as it is.

Let $V$ be the total market value of the trades from the financial institution's point of view, $T_C$ the counterparty's threshold, $T_B$ the institution's own threshold, and $X$ the value of the collateral the institution holds (negative when it has posted collateral). The new amount of collateral to transfer, $\Delta$, is given by the following formula⁷.

$$\Delta = \max(V - T_C, 0) - \max(-V - T_B, 0) - X$$

If $\Delta$ is positive, the counterparty posts collateral to the institution. If it is negative, the institution returns collateral to the counterparty or posts collateral to it. For an agreement that sets a minimum transfer amount, call it $M$; collateral is then transferred only when the size of $\Delta$ exceeds $M$. For an agreement that does not set one, $\Delta$ is transferred as it is⁷.

Figure description

The figure is the decision for an agreement that sets a minimum transfer amount. For an agreement that does not set one, skip the first question; the full $\Delta$ is transferred, and the second question only decides the direction. The first question asks whether the size of the new amount of collateral to transfer, $\Delta$, exceeds the minimum transfer amount $M$. If the answer is no, nothing is transferred that day. If yes, go on to the second question. The second asks whether $\Delta$ is positive. If yes, the counterparty posts collateral to the institution; if it is negative, the institution returns collateral to the counterparty or posts collateral to it.

For collateral other than cash, with market value $P$ and haircut $h$, the collateral value is as follows⁵.

$$\text{Collateral value} = P - P \times h$$

Consider a hypothetical example in which a financial institution has a CSA with Bank J. The threshold is 0 for both parties, and the minimum transfer amount is 100 million yen. Bank J may post cash or government bonds as collateral, and the haircut on government bonds is 2% (2% is deducted from the market value). At the start, the institution holds 500 million yen in cash and government bonds with a market value of 2 billion yen, received from Bank J. The collateral Bank J posts on day 2 is cash. In the table, a positive amount to transfer goes from Bank J to the institution, and a negative amount goes from the institution to Bank J.

On day 1, the bonds are valued at 1.96 billion yen, which is 2 billion yen minus 2%, so the collateral value is 2.46 billion yen. The difference of 40 million yen does not exceed the minimum transfer amount, so nothing is transferred. On day 2, the market value rises to 2.7 billion yen and the difference grows to 240 million yen, so Bank J posts 240 million yen in cash.

Applied to the figure, day 1 ends at the first question, day 2 follows the path where the counterparty posts collateral, and day 3 follows the path where the institution returns collateral.

On day 3, the market value falls to 2.2 billion yen, and the market value of the bonds also falls to 1.9 billion yen (a collateral value of 1.862 billion yen). The collateral value of 2.602 billion yen is 402 million yen more than the market value of the trades, so the institution returns collateral to Bank J. Here, the institution returns 402 million yen of the 740 million yen in cash it holds. On days when the market value moves in the institution's favor, Bank J provides collateral; on days when it moves against the institution, the institution returns collateral. When the price of the collateral falls, the collateral can become insufficient even if the market value of the trades stays the same.

The steps from calling the calculated amount, through agreeing it with the counterparty's own calculation, to the transfer are covered in Handling Margin Calls. The same article covers how to resolve amounts that do not match, and what happens when margin called by a central counterparty (CCP) cannot be paid by the deadline.

Managing collateral and paying interest

The collateral operations staff record the collateral received and the collateral posted by security and revalue it every day. In December 2024, the Financial Stability Board (FSB) issued a report on margin and collateral calls. Its examples of recommendations for non-bank market participants include being able to track the status and location of collateral that is not pledged elsewhere and of collateral that has been posted⁸⁹. The same examples also include making sure that assets intended for use as non-cash collateral are clearly identified in the collateral management system as not pledged elsewhere, and are held in custody accounts from which they can be delivered to the counterparty within the required time¹⁰.

Under Japan's margin rules, variation margin received is not prohibited from being pledged or lent for other trades¹¹. A financial institution with the right to repledge collateral to a third party (rehypothecation rights) is exposed to the risk that the third party fails to return the collateral or returns a different type of collateral (the 1999 examination manual)¹².

Cash collateral earns interest. Under a collateral agreement, the party for which the market value is positive receives collateral from the counterparty, and it pays the counterparty that posted the collateral an amount equal to the balance of collateral received multiplied by the interest rate on collateral⁴. Consider a hypothetical example in which a financial institution holds 1 billion yen in cash collateral. The agreement sets an interest rate of 0.5% a year, calculated daily on the basis of a 365-day year. One day's interest is 1 billion yen × 0.5% ÷ 365, or about 13,699 yen. If the balance stays the same for 30 days, the interest is about 410,959 yen, which the institution pays to the counterparty¹³.

Segregating initial margin

Initial margin subject to Japan's margin rules is held by the receiving party separately from its own assets. The receiving party manages it by setting up a trust or by a similar method, so that the margin can be used without delay if the counterparty fails to perform its obligations, and is returned to the counterparty if a close-out netting event occurs for the receiving party¹⁴. Initial margin received is not pledged or lent for other trades. The only exception is that cash initial margin may be invested in a safe way as part of its management through a trust or similar arrangement¹⁴.

In December 2015, the Financial Services Agency (FSA) answered public comments on the draft Cabinet Office Order for the margin rules. It gave the use of a custodian as an example of "a similar method" (translated from the Japanese). It also said that initial margin posted should preferably be held bankruptcy-remote from the parties to the trade¹⁵. A custodian is an institution that holds securities and other assets in safekeeping on behalf of others. The Principles for Financial Market Infrastructures (PFMI) call the risk of losing assets held with a custodian through the custodian's insolvency, negligence, or poor recordkeeping custody risk¹⁶. Initial margin is posted in full by each of the two parties, without netting one against the other¹⁵. The collateral operations staff therefore manage both where the initial margin received from the counterparty is held and where the initial margin the institution posts is held.

The FSA's supervisory guidelines for financial instruments business operators list, as points of focus for managing initial margin, concluding agreements for its management, such as setting up a trust, and ensuring safety when cash initial margin is invested⁶. The amount of initial margin is calculated with a quantitative calculation model notified to the Commissioner of the Financial Services Agency or with the standardized schedule in the FSA notice¹⁷.

Exchanging margin with a central counterparty

With a central counterparty, it is the central counterparty that calculates the amounts, and the collateral operations staff of the clearing participant pay or receive the notified amounts. Take the interest rate swaps of Japan Securities Clearing Corporation (JSCC) as an example. Between JSCC and its clearing participants, initial margin, intraday margin, and the clearing fund are deposited and returned, and variation margin and other amounts are paid and received. Under the definitions in JSCC's business rules, intraday margin is a type of initial margin. The clearing fund is cash or securities that a clearing participant deposits with JSCC to secure its obligations to JSCC¹⁸. Every business day, JSCC calculates the required amounts of initial margin, intraday margin, and the clearing fund, and the market value of substitute securities (securities such as government bonds deposited in place of cash)¹⁹. JSCC sets the value of substitute securities (the substitute price), and it may change the price on a temporary basis, for example when market prices move sharply²⁰.

If the required amounts and the collateral values show a shortfall, the clearing participant deposits the shortfall by the relevant deadline. The deadlines are 11:00 a.m. for initial margin and for paying variation margin, 3:30 p.m. for intraday margin, and 2:00 p.m. for the clearing fund¹⁹. A shortfall in initial margin is deposited by 11:00 a.m. on the business day after the day the shortfall arises²¹. The deadline for applying for the return of excess initial margin or clearing fund is 11:00 a.m¹⁹. Deposits and returns of margin and payments of variation margin and other amounts are netted and settled as a single transfer¹⁹.

JSCC and its clearing participants also pay and receive interest on variation margin every business day, in cash in the currency of the trade. The rate is a reference rate set by JSCC, and a clearing participant that owes interest pays it to JSCC by 11:00 a.m. on the business day after the calculation date²².

Common problems and how to prevent them

If assets you intend to use as collateral have already been pledged elsewhere, or are in an account from which they cannot be delivered quickly, you cannot meet a call by the deadline. The FSB's recommendations for non-bank market participants call for testing that assets not pledged elsewhere can be used within the required time, including for intraday calls²³. The examples in the recommendations also include negotiating in advance with counterparties the right to post a different type of collateral than usual, in case operational delays leave the collateral short¹⁰.

Financial institutions that use collateral were expected, under the 1999 examination manual, to do the following²⁴. An institution that accepts a large amount of collateral reviews its haircuts at least once a year to reflect price volatility and liquidity. Its collateral policies and procedures set out how collateral is revalued, how often calls are made, how valuation disputes are resolved, who holds the collateral, how much time is allowed for transfers, how rehypothecation is handled, and the procedure for approving exceptions in which collateral is not required²⁴.

Notes

1. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual", Section 2020.1 (September 1999), the paragraph on collateral, page 6 (page 62 of the PDF). ↩ ↩²

2. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 1, item 21-10 (a) (calculating daily, for each counterparty, the total market value of the trades and the total market value of the variation margin). ↩ ↩²

3. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), "イ．信用極度額" (a. threshold), "ロ．最低受渡担保額" (b. minimum transfer amount), "ハ．評価頻度" (c. valuation frequency), and "ニ．適格担保" (d. eligible collateral) in Section 3 (1), pages 117–118 (in Japanese). The paper calls the threshold "信用極度額" and the minimum transfer amount "最低受渡担保額." ↩ ↩²

4. Masaaki Fujii, Yasufumi Shimada, Akihiko Takahashi, "A Note on Construction of Multiple Swap Curves with and without Collateral" (first version June 2009, revised January 2010), Section 3.1, page 9. ↩ ↩²

5. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 10 (assets used as margin) and paragraph 11 (substitute price; item 1 covers cash, item 2 assets in the same currency, and item 3 assets in a different currency). Paragraph 1, item 21-10 (a) and item 21-11 (a) use the substitute price under paragraph 11 as the market value of collateral other than cash. ↩ ↩² ↩³

6. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-2-4(4)①イ (agreements for variation margin), ②イ (agreements for initial margin and for its management), ②ロ (safety of investing cash initial margin), and ③イ (diversification of assets used as margin), pages 124–125 (in Japanese). ↩ ↩²

7. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), equation (3) (page 118) and equation (4) (page 119) in Section 3 (2) (in Japanese). This page writes the paper's $V(t_k)$, $X(t_{k-1})$, $T_C$, $T_B$, and $MTA$ as $V$, $X$, $T_C$, $T_B$, and $M$. Using the collateral value after the haircut follows the substitute price in Article 123, paragraph 11 of the Cabinet Office Order. ↩ ↩² ↩³

8. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 1 (page 3; page 7 of the PDF). ↩

9. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), examples for Recommendation 6 in Annex 3 (page 30; page 34 of the PDF). ↩

10. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), examples for Recommendation 7 in Annex 3 (pages 30–31; pages 34–35 of the PDF). ↩ ↩²

11. Financial Services Agency, "コメントの概要及びコメントに対する金融庁の考え方" (Summary of public comments and the FSA's views; December 11, 2015), No. 105, page 15 (in Japanese). ↩

12. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual", Section 2020.1 (September 1999), the paragraph on rehypothecation, page 7 (page 63 of the PDF). ↩

13. One day's interest is 13,698.63 yen and 30 days' interest is 410,958.90 yen; the text rounds to the nearest yen. ↩

14. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 1, item 21-11 (d) (management by setting up a trust or a similar method) and (e) (not pledging or lending the margin, except for investing cash initial margin in a safe way as part of its management). ↩ ↩²

15. Financial Services Agency, "コメントの概要及びコメントに対する金融庁の考え方" (Summary of public comments and the FSA's views; December 11, 2015), No. 101 (initial margin is posted by each party on a gross basis) and No. 109 (a custodian as an example of "a similar method"), pages 15–16 (in Japanese). Item 21-6 in the draft at the time corresponds to the current item 21-11. ↩ ↩²

16. Committee on Payment and Settlement Systems of the BIS and Technical Committee of the International Organization of Securities Commissions, "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.16.1 (custody risk), page 128 (in Japanese). The English original is CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), which uses the same paragraph numbers. ↩

17. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 1, item 21-11 (a), and Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-2-4(4)②ハ a (use of a quantitative calculation model or the standardized schedule), page 125 (in Japanese). ↩

18. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules for the interest rate swap clearing business, in Japanese), Article 2, item (11) (interest rate swap clearing fund, page 3) and item (54) (intraday margin, page 9), and Article 17, paragraph 1 (deposit of the clearing fund, page 18); and Japan Securities Clearing Corporation, "金利スワップ担保・決済" (Interest rate swap collateral and settlement, in Japanese), the first paragraph of "当初証拠金、日中証拠金及び清算基金の差入れ及び返戻並びに変動証拠金の決済方法" (Methods for depositing and returning initial margin, intraday margin, and the clearing fund, and for settling variation margin). ↩

19. Japan Securities Clearing Corporation, "金利スワップ担保・決済" (Interest rate swap collateral and settlement, in Japanese), "当初証拠金、日中証拠金及び清算基金の差入れ及び返戻並びに変動証拠金の決済方法" (Methods for depositing and returning initial margin, intraday margin, and the clearing fund, and for settling variation margin). ↩ ↩² ↩³ ↩⁴

20. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules for the interest rate swap clearing business, in Japanese), Article 7 (substitute securities), page 13. ↩

21. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules for the interest rate swap clearing business, in Japanese), Article 66, paragraph 1 (deadline for depositing initial margin), page 61. For clearing clients, an exception allows a deadline of 11:00 a.m. two business days after the shortfall arises when this has been agreed in advance (paragraph 2 of the same article). ↩

22. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules for the interest rate swap clearing business, in Japanese), Article 83 (treatment of interest on variation margin), page 68. For foreign currency trades, interest is paid and received on days that are both JSCC business days and business days in the home country of the currency. ↩

23. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 3.3, Recommendation 6 (page 18; page 22 of the PDF). ↩

24. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual", Section 2020.1 (September 1999), the paragraph on collateral policies, page 7 (page 63 of the PDF). ↩ ↩²