How Does Posting Collateral Work?

Reader Dennis Mangan emails asking how and where firms post collateral in the CDS market. It’s a good question, and the answer can get as complicated as you like. But here’s a short(ish) answer.

Most of the time, collateral requirements are governed by the standard ISDA master agreement, which covers the majority of CDS contracts: we’ll assume that you’re not buying your credit protection from a triple-A-rated insurer, or anything like that. Instead, let’s keep it simple, and assume you’ve just bought credit protection on IBM from Goldman Sachs.

Every day, the value of that CDS contract is marked to market. If it’s worth more than you paid for it, you’re in the money. And for every dollar that you’re in the money, Goldman Sachs deposits one dollar, in cash or Treasuries, in a bank account in your name. If the value of the CDS contract falls, Goldman can withdraw money from the same account.

Note that it’s always the seller of credit protection who has to post collateral: if you bought protection, you have a fixed obligation to pay Goldman Sachs a certain amount every six months, and that doesn’t ever change. But if you have been both buying and selling protection on various credits with Goldman Sachs, it’s entirely kosher to net things out. If Goldman needs to put up $10 million of collateral to you, and you need to put up $9 million of collateral to Goldman, then that works out with Goldman just putting up $1 million of collateral to you, and you putting nothing into Goldman’s account. These bilateral netting processes are not to be confused with the multilateral compression processes, which can end up changing your counterparties, just not your net exposures.

What are you allowed to do with the money in your bank account? Can you use it as collateral with other counterparties, in a process known as rehypothecation? Normally, no — but there are exceptions, as hedge funds doing business with Lehman Brothers Europe found out. The collateral might be in your account, but it’s not there for spending: it’s there to protect you against your counterparty going bust. If that happens, the CDS contract is closed out, and you get to keep the collateral.

Thanks to Nishul Saperia of Markit for helping me out with all this — any errors are entirely mine and not his. Do be sure to read the comments, too; I’m sure they’ll explain where I’ve gone wrong.