A bilateral collateral agreement is a contract between two parties that governs the exchange of collateral to secure the obligations they owe each other under financial transactions. It states what triggers a transfer, what assets may be delivered, how they are valued and what happens if one party defaults. It is used chiefly for over-the-counter derivatives, and also for repurchase agreements and securities lending.
"Bilateral" distinguishes the arrangement from central clearing, in which a central counterparty (CCP) stands between the parties and sets margin under its own rules. In a bilateral relationship, the terms are negotiated directly and each party bears the other's counterparty risk. The best-known form is the credit support annex (CSA) published by the International Swaps and Derivatives Association, which forms part of the parties' master agreement.
What the agreement covers
The agreement turns a general promise to collateralise into precise operating rules. Its main terms are:
- Exposure calculation. The net market value of all covered transactions is calculated, usually daily, by a designated valuation agent. Collateral moved to cover changes in this value is variation margin.
- Initial margin. An additional amount, the initial margin or independent amount, may be required to cover potential losses in the period after a default.
- Threshold. This is an amount of unsecured exposure a party will tolerate before any collateral is due. Many modern agreements set it at zero.
- Minimum transfer amount. Calls below this size are not made, to avoid frequent small movements.
- Eligible assets and haircuts. The list of eligible collateral, typically cash in major currencies and high-quality government bonds, is set out with the collateral haircut applied to each.
- Timing. The agreement states when a margin call must be made and by when the transfer must settle.
- Interest and substitution. It sets the rate paid on cash collateral and the right to swap one asset for another.
- Disputes. A procedure applies when the parties disagree on a valuation; see collateral dispute.
Legal forms
Collateral can be provided in two legal ways. Under a title transfer arrangement, the party delivering collateral passes full ownership to the other, which owes back equivalent assets when exposure falls. The English law credit support annex of 1995 works this way, as do the standard agreements for repo and securities lending. Under a security interest arrangement, the provider keeps ownership and grants a pledge or charge; the New York law annex of 1994 and the English law credit support deed take this form.
The difference affects what the receiver may do with the assets. A title transfer receiver owns them outright. A secured party may use them only if the agreement grants a right of reuse, known as rehypothecation. In either case the agreement relies on close-out netting: on default, all transactions are terminated, valued and reduced to a single net sum, against which the collateral is applied. Parties obtain legal opinions confirming that netting and the collateral arrangement are enforceable in each relevant jurisdiction.
Regulatory margin rules
Before the financial crisis of 2007 to 2009, collateral terms were a matter of commercial negotiation, and many relationships had high thresholds or no agreement at all. The losses caused by under-collateralised derivatives exposures led the G20 to require central clearing of standardised contracts and margin for the rest.
The Basel Committee and the International Organization of Securities Commissions published a framework for margin on non-centrally cleared derivatives, implemented in the European Union through technical standards under EMIR and by regulators in the United States, Japan and other markets. It requires financial firms and large non-financial users to exchange variation margin daily with a zero threshold, and requires the larger participants to exchange initial margin in both directions. Initial margin must be held so that it is protected if the collecting party fails, usually with a third-party custodian in a segregated account, and it cannot be reused. The initial margin rules were phased in between 2016 and 2022 according to the size of each group's derivatives portfolio.
To meet these rules, the industry produced new standard documents, including variation margin annexes in 2016 and separate initial margin documentation that works with custodians and tri-party collateral management services.
Operation in practice
Each business day, the parties value their portfolio, compare the result with collateral already held, and issue or receive calls. Agreed amounts are settled by cash payment or securities delivery, and positions are reconciled regularly to prevent valuation differences. This daily cycle is the core of collateral management.
Firms with many counterparties hold hundreds or thousands of agreements with differing terms. The terms affect pricing: the interest rate on cash collateral and the range of deliverable assets determine how future cash flows should be discounted, so two trades with identical economics can have different values under different agreements. Many dealers have therefore renegotiated older agreements towards simpler, cash-only terms in a single currency.
Limitations
A collateral agreement reduces credit exposure but does not remove it. Exposure can grow between the last successful call and close-out, collateral can fall in value, and disputes can delay transfers. Margin calls are also procyclical: in volatile markets they rise sharply, forcing parties to find liquid assets at short notice, as several episodes of market stress since 2020 have shown.