24 Feb 2021

What is collateral?

In this blog post, we will dive into the concept of collateral. What it is, which types of collateral are used today, and what defines good collateral.
Banking on Bitcoin.png
Before diving into the concept of collateral, we want to introduce the reader to some of bitcoin's unique properties, to keep in mind while reading the rest of this section.
Bitcoin's unique properties
Bitcoin's unique properties make it the perfect collateral asset. A global market, an asset without counterparty or credit risk, available 24/7, 365 days a year. No other asset can match these properties. 
No counterparty risk
Bitcoin is not backed by anything, and the value is inherent in the asset itself, as every individual can store their bitcoin in their own wallets. The network is decentralized and secured by thousands of computers worldwide. There is no third party who can seize the user's bitcoin or censor their transactions. This makes bitcoin free of counterparty risk and leaves the individual in full control.
A global market
Bitcoin is borderless. Without centralized authority, the concept of borders is also removed, making bitcoin global and available for everyone. The world has never seen a type of money that enables instant transfer of value worldwide without relying on trusted intermediaries, such as banks or governments. 
The bitcoin market never closes, which means that the asset is available 24/7, 365 days per year. This is without a doubt unique, as most financial markets are closed during weekends, limiting the hours when assets are available for buying and selling, but also transferring. This makes bitcoin arguably the most liquid asset in existence, as it's always available.
Portable and easy to transfer
The portability of bitcoin is at its essence. Hundreds of millions of dollars can be stored in a small USB drive or even by remembering a password. The latter is not recommended but shows how effortless it is to store and carry bitcoin. You just need to remember a password. The same goes for transferring bitcoin, which is done instantly and almost at no cost.
What is collateral?
Government bonds and U.S. Treasuries dominate as collateral assets today, as they are safe and liquid. However, these present a growing weakness and risk, as rehypothecation creates a systemic risk in the financial system as a whole. Bitcoin can be a solution to this problem but is still in an early stage of developing as collateral.
The concept
Put simply, collateral is defined as the asset a lender requires as security for a loan. Protection for the lender and secures their values in case of default or trouble with interest payments. If the borrower breaches the agreed terms, the lender can seize the collateral and sell it to secure its value.Collateral is a useful tool to minimize risk and has grown to become a significant part of today's financial world. There is a range of collateral assets being used today, and some of the most common assets are bonds and cash-based products alike, equities, real estate, and gold. The type of collateral is often related to the kind of loan in question. Naturally, mortgages are secured by houses and car loans by cars, but there is a range of other loans secured by other assets. Perhaps the most common type of collateralized loans is cash loans, both personal and institutional. The need for liquidity for personal use and business purposes has become an essential part of the world economy.  A commonly used term is "Loan to Value" or LTV. This is the value that the borrower needs to post as collateral in relation to the loan value. For example, if a lender sets an LTV ratio of 0.5 and the borrower wants a loan of $100,000, the collateral value needs to be 100% more than the loan value, which is $200,000. The kind of assets that are used as collateral vary, but the next section will look at the most common ones. 
What kind of assets are used as collateral today?
The most common type of collateral in traditional financial markets is, without a doubt, government bonds and U.S. Treasuries. There is a massive market for overnight loans, the repo market. This enables short-term borrowing of cash in exchange for government securities, often bonds. ICMA estimates that the global repo market may be over EUR 15 trillion in outstanding size, with a turnover of about EUR 3 trillion per day. They also estimate that over 80% of EU-originated repo collateral is in the form of government bonds. Looking at the U.S. market, Treasury securities may account for about two-thirds of the repo market.So what are government bonds or Treasury securities, you may ask? This is, put simply, debt issued by the government and is defined as one of the safest assets to hold since it's backed by the government. These are initially issued to support government spending but are also available in the secondary market. Another type of collateral that perhaps feels more familiar for most readers is real estate. When borrowers apply for a mortgage, the real estate itself is used as collateral for security for the lender. Real estate is also categorized as a very attractive and safe form of collateral, as it historically has been holding its value well.This is another huge market, and the total mortgage debt outstanding in the U.S. amounted to approximately 16 trillion U.S. dollars in 2019, according to StatistaOther related business collaterals are inventory or plant and equipment, where lenders secure their values through company assets. Using securities as collateral is also a common practice to access more liquidity. While this is often used to reinvest in the market and increase one's exposure, it can also be used to access more cash for other purposes. Gold has a long history as a reserve asset, and while the gold standard is not used by any governments today, it has been a common system historically. Gold's role as money and collateral faded over time, but after the financial crisis of the late 2000s, it came back on the radar. In 2011, the European Parliament's Committee on Economic and Monetary Affairs agreed to allow central counterparties to accept gold as collateral. Subsequently, gold has been reclassified to a Tier 1 asset under Basel III and increasingly accepted as collateral over the past ten years. Even as gold has emerged as a global safe-haven asset and become a trillion-dollar market, gold's collateral market is just a fraction of the likes of governments' bonds, equities, and real estate. Greg Muecke of Tradewinds Markets highlights the lack of digital ownership records as the main reason. This makes it challenging to separate the value of gold from its physical location. The logistical challenges of transferring physical gold make it less attractive. Muecke furthermore explains:
"Seven hundred years later, lenders still face the same issue they faced in 14th century England: physically moving metal around the globe is time-consuming and costly."
While gold satisfies many of the desired attributes for good collateral, which will be discussed further in the next section, the challenge of transferability takes us to a new and emerging asset that can be used as collateral: bitcoinAs already mentioned at the beginning of this blog post, bitcoin has several unique properties that make it optimal as collateral. It is the first hard asset without any credit or counterparty risk. It is available in a global and liquid market at all hours of the day. It's even easily transferable at a minimal cost. This sounds like the perfect collateral asset, but let's dive into a more detailed analysis of what defines good collateral. Not even bitcoin is perfect. Yet.  The examples above show us that it is possible to categorize collateral assets. On one side, we have bonds, securities, equities, and cash. These assets have several issues, with counterparty risk being the most problematic. A typical activity in financial markets is the reuse and rehypothecation of collateral. The IMF estimated in 2018 that the same collateral was reused 2.2 times. Meaning that, on average, collateral received in one transaction is reused for more than two new transactions. Institutions typically receive collateral in the repo market or derivatives transactions. If this is eligible for reuse, they may post this as new collateral or use it in short sales. According to the IMF, collateral reuse has become a significant financial market activity and is a common practice.The reuse rate has increased again over the past few years after a substantial setback after the financial crisis in 2008, as a result of counterparty risk aversion. This leaves some regulators and supervisors concerned. For example, the former Vice-President of the ECB, Vítor Constâncio, has stressed that:
 "activities of rehypothecation and reuse of securities amplified the creation of chains of inside liquidity and higher leverage"
The Financial Stability Board (FSAB) has also analyzed this more broadly and found that appropriate monitoring of collateral reuse at the global level will be an important step forward, but that no immediate regulatory actions are needed. The IMF further highlights that collateral reuse significantly increases asset price volatility since more collateral becomes available in the financial market. This allows participants to build up leverage beyond what is feasible in a situation where no reuse of collateral is possible. Another issue is the risk of losing purchasing power. The current monetary experiment with quantitative easing like we've never seen before and the constant cuts in interest rates, puts fiat currencies under extraordinary pressure and risk of devaluation. The money supply increase, yield curve suppression, and debt monetization have historically shown to create a bad environment for the pricing of bonds and cash instruments.On the other side, we find real, hard assets. Real estate, gold, and more recently, bitcoin, fulfill these requirements. There is no counterparty risk in these assets, as the value is inherent in the asset itself.
What defines good types of collateral?
To define which attributes define good collateral, we will rely upon the framework used by the European Central Bank (ECB). This framework has further been simplified by Fulgur Ventures in their brilliant piece on bitcoin as collateral.Fulgur highlights that although more collateral always makes the lender's values more secure,  the ECB argues that collateral transfer to the lender is a costly process. Hence, the optimal loan arrangement concentrates on the use and transfer of collateral in a default situation. In this scenario, the collateral quality is critical, and the ECB defines the quality of the collateral as its liquidity and safety. A liquid asset is then defined as one that:
1. Has high market liquidity
The asset's liquidity is defined by the difference between the bid and the ask price, the spread. In a liquid market, this spread is minimal, and it's possible to sell a large amount of the asset without moving the market price. If a borrower defaults, it is unfortunate for the lender if the collateral is illiquid. This can lead to a situation where the lender has trouble selling the asset to cover the borrower's losses. 
2. Is easy to value
The asset used as collateral must be easy to value for the lender. This is important for risk management if the borrower defaults. A lengthy process of valuing the collateral in a situation where the borrower is defaulting is not desirable and puts an extended risk on the lender.
3. Is easy to transfer
Transferability is naturally important when it comes to collateral assets. Highly portable assets have a lower cost of debt. The importance of fast and uncomplicated transactions where the borrower needs to post additional collateral in a margin call situation is valuable for the lender.
4. Has a low deadweight cost
It is favorable if the collateral transfer from the borrower to the lender creates a minimal loss in its value. A house as collateral is a great example, as the lender will sit with an excess burden if the borrower defaults and the lender is "stuck" with a house. The more fungible an asset is, the lower the deadweight cost.
5. Is easy to verify
To be able to verify the asset used as collateral is understandably significant. If the asset is challenging to verify, this creates extra cost for the lender, which will be passed on to the borrower in the form of a higher interest rate. A lender will mitigate its own risk by increasing the cost of borrowing if the posted collateral comes with uncertainty. Furthermore, the ECB focuses on two important attributes for the safety of the collateral:
6. Low volatility
A stable value of the collateral is essential for the lender. High volatility in the asset value increases the risk of the collateral being insufficient to cover a default. This is not a desirable situation for any lender.
7. Anti-cyclicality
Unlike the other attributes, this point is not related to the asset's characteristics but rather the cyclicality of the asset. The optimal collateral asset would be non-correlated to other assets or the economy in general. Negative shocks in the economy that leads to cascades of defaults would not necessarily impact the collateral value of its anti-cyclical.Take mortgage loans with houses as collateral as an example: If the borrower gets fired because of a struggling economy, this will most likely also affect the borrower's house value and hence the collateral value, as the demand in the housing market goes down because of the struggling economy. These "double effects" create additional risk for the lender, as external factors can impact the collateral value.Fulgur highlights another attribute for the collateral to be deemed safe and attractive.
8. Store of value
This attribute is not included in the ECB framework, but we agree with Fulgur that it indeed is an interesting attribute to discuss when comparing different collateral assets. Both the lender and the borrower are interested in a collateral asset that preserves its value over time. The lender will maintain its purchasing power in case of default. The borrower would also want its collateral to keep its value until it's back in possession after the loan is repaid.
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