Meaning and explanation of collateral
Collateral refers to assets or properties which are presented to secure a loan or other credit. Collateral is, however, subject to seizure on default. Investopedia explains collateral as a form of security provided to the lender if the borrower fails to pay back the loan. For instance, if you get a mortgage, your house would be your collateral. In margin trading, on occurrence of a marginal call, the securities in your account perform the function of collateral.
Advantages of Collateral
The main advantages of collateral are listed below:
- Reduced credit risk
Collateralization is helpful in lessening the current as well as prospective future exposure to losses resulting from non-payment by counterparty.
- Capital savings
Collateralizing and netting on counterparty exposures decreases the amount of economic capital obligatory for covering credit risk and protecting the balance sheet. This is also helpful in increased leverage and profit potential of the assets of bank.
- Increased competitiveness
Collateralization features the ability to trade in a wider range of market which includes higher and more predictable profits.
- Improved market liquidity
Collateralization provides increased opportunity to perform more transactions in the markets, through less capital, and reduced time required for credit review and settlement.
- Access to higher risk trades
Use of collateral lessens the risk of illiquid or new-fangled trade types involving higher risk but higher profit margins.
- Higher level of efficient trading between counterparties
The use of collateral formalizes an enduring relationship thus making the transactions and payments smoother with increased opportunity to check evaluations and balance the profits and losses in a standard and repeatable manner.
- Benefits to buy side
Collateralization is beneficial to asset managers and corporate treasury in minimizing collateral amounts through cross-collateralization, collateralize exposures by client, in addition to lessening the collateral movements and give/take collateral on a net basis.
- Benefits to sell side
However, there are wide ranging collaterals which can be used for collateralization of credit exposure with different risk degrees.
Collateralization is helpful for banks, broker dealers, and alike in reducing capital charge to deal out for asset liability management, etc.