Collateral

Collateral is an asset that a borrower pledges to a lender as security for a loan or another obligation. If the borrower does not pay, the lender has the right to take the asset and sell it to recover what it is owed. Houses secure mortgages, cars secure car loans, and in financial markets cash and government bonds secure trades worth trillions of dollars every day.

A loan backed by collateral is called secured, and one without it is unsecured; the wiki covers both as collateralized loans and uncollateralized loans. Collateral is related to, but not the same as, a lien, which is the legal claim that gives the lender its rights over the asset, and a guarantee, which is a promise by another person to pay rather than a pledge of property.

Lending someone money always carries a worry: what if they do not pay it back? Collateral answers that worry by putting something of value on the table. It works like a deposit you leave when you borrow a neighbour's ladder. If you bring the ladder back, you get your deposit back. If you never return it, your neighbour keeps the deposit and is not left out of pocket.

Because the lender has something to fall back on, it can lend more cheaply and with less fuss. That is why a mortgage usually costs less than a credit card. The catch is that the deposit has to be worth enough, and has to keep its value. A lender will not accept a deposit that might lose half its worth overnight without asking for more.

A secured lending arrangement usually sets out four things: what asset is pledged, how it is valued, how much can be borrowed against it, and what happens on default. In consumer and business lending the asset is often physical, such as property, vehicles, stock or equipment. In wholesale markets it is usually cash or securities, and the main arrangements are:

• Repurchase agreements. In a repo, one party sells securities and agrees to buy them back, so the securities act as collateral for a short-term cash loan.
• Derivatives margin. Counterparties post initial margin against possible future losses and variation margin to cover daily price moves, often through a central counterparty.
• Central bank lending. Banks borrow from a central bank, including in its role as lender of last resort, by pledging eligible assets.
• Crypto lending. Platforms and DeFi protocols require loans to be over-collateralized, often through a collateralized debt position.

Lenders rarely lend the full market value of an asset. They apply a haircut, a percentage cut that protects them if the asset falls in price before it can be sold. The amount that can be borrowed is:

Here market value is the current price of the pledged asset and $h$ is the haircut written as a decimal. Safe, liquid assets such as Treasury bills attract small haircuts, while shares, corporate bonds and crypto assets attract larger ones.

Suppose a fund pledges corporate bonds worth $10 million and the lender applies a 15\% haircut. The fund can borrow $10{,}000{,}000 \times (1 - 0.15) = 8{,}500{,}000$ dollars. If the bonds fall to $9 million, the lending value drops to $7.65 million, and the lender will issue a margin call asking for about $850,000 in cash or extra collateral to close the gap.

In many markets the lender may re-use collateral it receives, for example by pledging a client's securities to borrow money itself. This is called rehypothecation. It makes collateral go further, because the same bond can support several transactions in a chain, but it also means a client may become an unsecured creditor if the firm holding its assets fails.

The rules differ by jurisdiction. In the United States, SEC Rule 15c3-3 limits how much of a customer's securities a broker-dealer may re-use, generally to 140 percent of the customer's debit balance. In the United Kingdom, clients can agree to looser terms, and the 2008 collapse of Lehman Brothers International (Europe) in London left many hedge funds struggling to recover assets that had been re-pledged. These chains are a central feature of shadow banking, where repo and securitization turn collateral into funding.

Collateral only protects a lender if the law will enforce its claim, particularly in insolvency. In the United States, security interests in personal property are governed by Article 9 of the Uniform Commercial Code, which sets out how a lender "perfects" its claim, usually by filing a public notice or taking control of the asset. Mortgages over land follow state real estate law. In the European Union, the Financial Collateral Directive (2002/47/EC) makes it easier to create and enforce cash and securities collateral between financial firms, including close-out netting. Basel bank capital rules also give lower risk weights to exposures backed by eligible collateral.

Collateral reduces credit risk but does not remove it. Its value can fall exactly when the borrower is in trouble, a problem known as wrong-way risk, and forced sales in a falling market can push prices down further. During the 2008 financial crisis, rising haircuts on mortgage-linked securities forced borrowers to sell assets, which deepened losses across the system.

• Directive 2002/47/EC on financial collateral arrangements, EUR-Lex
• SEC Rule 15c3-3 (Customer protection), eCFR