Meaning
Legal documents governing the provision of collateral for over the counter derivatives transactions function as risk management tools. The credit support annex is typically a part of the ISDA Master Agreement and defines how much cash or securities a party must post. It reduces the exposure one party has to the default of the other.
Collateral Mechanism
Parties agree on a threshold below which no collateral is required. If the market value of the trade moves past this point, the losing party must transfer assets to the winner. This transfer happens daily in many sophisticated agreements to keep pace with market volatility.
The type of assets accepted, such as government bonds or cash, is specified in the text. Valuation haircuts are applied to non cash assets to account for potential price drops in the collateral itself.
Credit Mitigation
Exposure limits are set based on the creditworthiness of the counterparties involved. A reduction in credit rating often triggers a requirement for more collateral to be posted immediately. This protection prevents a sudden failure from cascading through the financial system.
Margin Requirement
Minimum transfer amounts ensure that small fluctuations do not trigger a constant back and forth of minor sums. This efficiency reduces the administrative burden on the middle office teams. Interest is usually paid on the cash held as collateral.
