Collateral arrangements can be unilateral or bilateral. Unilateral agreements require one counterparty to deliver collateral on trades in which it has a negative mark-to-market value. The other counterparty in the transaction is not required to post collateral. Unilateral collateral arrangements generally are used when one of the counterparties is less creditworthy. Bilateral collateral arrangements require two-way movement of collateral whereby the counterparty with the negative mark-to-market value collateralizes the exposure to the other party.

If netting applies and is enforceable, the collateral generally is based on the net negative mark-to-market value. If netting does not apply, the collateral arrangement is often on a gross basis. The most common form of collateral is cash and Government securities. The security interest on the collateral typically is required to be perfected with delivery mechanics and further assurances as demanded by the secured party.

Recommendation 14: Credit Enhancement

Dealers and end-users should assess both the benefits and costs of credit enhancement and related risk-reduction arrangements. Where it is proposed that credit downgrades would trigger early termination or collateral requirements, participants should carefully consider their own capacity and that of their counterparties to meet the potentially substantial funding needs that might result.

Collateral arrangements are negotiated by the counterparties to address the concerns of both parties. As such, collateral arrangements differ according to the conditions under which collateral must be provided, the amount of up-front collateral required (if any), and the frequency with which collateral calculations are made. Specifically, some collateral arrangements are structured so that the obligation of a counterparty to post collateral is triggered by an event such as a credit downgrade or material adverse change in financial condition whereby the other party has "reasonable grounds for insecurity," or a specified threshold level of exposure has been reached. It should be noted that trigger provisions based on credit downgrade or other adverse changes have the potential to create sudden and sizeable liquidity requirements. Derivatives dealers and end-users should carefully consider their capacity and the capacity of their counterparty to meet such potential liquidity requirements when they negotiate such provisions.

To enhance the enforceability of collateral agreements, a security agreement addendum may be attached to the customer master agreement. The agreements generally are customized. If all trades made between the two counterparties within a particular product group--that is, all cities, branches, subsidiaries, or affiliates--are netted, then the collateral agreement would reflect this and thus avoid sending collateral to one location while receiving collateral from another. Similarly, cross-product netting agreements may be considered in the collateral agreement.

An alternative to collateral arrangements is periodic cash settlement of the underlying positions. In this structure, two counterparties agree to periodically send cash to cover any negative mark-to-market position that exists. The counterparty with the positive mark-to-market position takes actual ownership of the cash and the terms of the transaction are reset at market rates to have a zero mark-to-market value. These arrangements also often permit the early termination of the derivatives contract on a predetermined cash settlement date if either party so desires.

The Survey indicates that the most common forms of credit enhancement accepted by dealers are cash, government securities, and third party guarantees or letters of credit. Most dealers report collateral arrangements whereby the amount of collateral is adjusted up or down over the life of the derivative according to the level of current exposure. While most dealers will accept the credit enhancement arrangement discussed above from end-users, 48% of dealers surveyed do not provide credit enhancement of any form to counterparties.

Collateral arrangements represent a small portion of gross credit exposure. Most dealers report that less than 5% of their gross credit exposure to counterparties is collateralized; similarly, less than 5% of their counterparties´ gross exposure to the dealers is reported to be collateralized.

With respect to end-users, the Survey reported that 42% of end-users accept third party guarantees, 22% accept cash collateral, and 22% accept government securities as collateral. In the future, end-users plan to increase their acceptance of cash and securities collateral. Thirty-nine percent of respondents do not accept any forms of credit enhancement, presumably preferring to deal with relatively strong counterparties. End-users that accept credit enhancement tend to require it from counterparties on a case-by-case basis rather than refer to a minimum acceptable credit rating.

The majority (60%) of end-users surveyed are not prepared to provide any form of credit enhancement in derivatives transactions. About 20% of respondents provide cash as collateral and 20% provide securities as collateral. The responses to this question are remarkably uniform across countries and types of end-user.