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Understanding Collateral

A lender will receive collateral from the borrower, generally in the form of cash or other securities. This protects the lender from the risk of potential loss in the event that the borrower is unable to return the securities. The value of the collateral provided by the borrower is normally greater than the value of the borrowed securities, providing additional protection for the lender (this is known as a margin or haircut).

The exchange of collateral is an important means of risk reduction in the securities lending transaction, and therefore the level of over-collateralisation will reflect the characteristics of the trade. To protect both parties from market fluctuations during the life of the transaction, securities and collateral on loan are revalued on a daily basis and adjusted if needed. 

In return for lending their securities, the lender receives a payment. This can be in the form of a simple fee in respect of non-cash collateral transactions, or through an implied fee for cash collateralised loans.

Non-Cash Collateral 

The borrower and lender will agree what are deemed to be eligible securities for each transaction or basket of transactions. Non-cash collateral such as government bonds or equities are delivered at the (prior to) beginning of the transaction, adjusted daily to market prices, then returned when the transaction is closed out. A tri-party agent is often responsible for the safekeeping of these collateral assets, monitoring and rebalancing non-cash collateral on a lender’s behalf. The tri-party agent will also run allocation algorithms seeking to achieve the most optimal use of a firms’ assets as collateral.

Cash Collateral

In a cash collateral transaction, a borrower delivers cash when the transaction is initiated. The lender may invest the cash in approved financial vehicles which may produce additional revenues. A proportion of the cash reinvestment revenue earned is ‘rebated’ back to the borrower. In this case, the cost of the transaction is referred to as the rebate rate.

Whether based on cash or non-cash collateral, adjustments in the borrowing rate can occur based on the ebb and flow of demand for the particular security borrowed. This re-rating can occur at the behest of either the borrower or lender and is typically initiated by the party in whose favour the market has moved. Billing statements and fees are normally produced, accrued and paid on a monthly basis.

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