Collateralization or margining is used to reduce credit exposure or credit risk after using netting and other methods. In a break clause, single payment of collateral happens at the beginning of the trade and at the time of cancellation or termination while for reset feature collateral is paid periodically to reduce credit risk exposure due to fluctuations of prices.
The collateral related terms and conditions including form of collateral (Cash or securities) are finalized before the trading and updated based on requirement.
⦁ Party A and Party B got into a trading transaction where Party A makes mark-to-market profit while Party B makes mark-to-market loss. In this case, Party B will pay more collateral to Party A to compensate the credit exposure arising from more loss. The collateral can be in the form of either Cash or Securities.
⦁ Party C wants to get into a swap contract but its credit rating is very low and no Investment bank is ready to trade. Party C decides to deposit security as collateral which reduces its credit risk significantly which helps it to find a suitable party for the swap derivatives transaction. Here collateral helps it to complete the transaction.
Benefits of Collateralization:
⦁ Helps in reducing credit exposure or credit risk which leads to more business and transactions
⦁ Enables parties to trade with counterparties with low credit rating because of collateral
⦁ Counterparty risk Pricing can be competitive due to collateralization
⦁ In case of default, the collateral can be liquidated easily (if in security form) unlike case of secured creditors. For secured creditors can claim of asset of the defaulted counterparty but the entire bankruptcy process makes it very much complicated