A collateral concentration limit is a rule that restricts how much of a collateral pool can consist of a single security, a single issuer, a single asset class, a single currency or a single type of issuer, such as one country's government bonds. Central counterparties, central banks, payment systems and banks lending against securities use these limits so that, if a borrower or participant defaults, the collateral can be liquidated quickly without crashing its price.
Concentration limits work alongside eligibility criteria, which decide which assets are accepted at all, and haircuts, which reduce the value credited for each asset. They are a separate control from limits on a counterparty's overall credit exposure, such as a counterparty credit limit. A pool can be fully eligible and properly haircut and still be dangerous if it is all in one illiquid bond.
Collateral concentration limits in plain terms
A pawnbroker who accepts guitars as security for loans is happy to hold a few. But if one customer offers fifty identical guitars, the pawnbroker knows that selling them all at once, if the customer never comes back, would flood the local market and the price would collapse.
A concentration limit is the pawnbroker's rule: "no more than five guitars from any one customer, and no more than a third of my shelf in guitars". It keeps the security varied enough that it can actually be turned back into cash at a fair price when it is needed.
Why concentration limits exist
Collateral protects a lender only if it can be sold for close to its marked value within the time needed to cover a default, often the margin period of risk. Large holdings of a single asset make that harder in several ways:
- Liquidation risk. Selling a large block can move the market price, so the realised value falls well below the marked value.
- Issuer risk. If one issuer accounts for much of the pool, its downgrade or default wipes out a large share of the protection at once.
- Wrong-way risk. Collateral issued by the provider itself, or by firms closely linked to it, is likely to lose value exactly when the provider defaults. Many frameworks ban or tightly cap such collateral.
- Correlation risk. Assets from the same country, sector or currency can fall together in a crisis, adding to concentration risk across the pool.
How limits are set
Limits are usually expressed as a percentage of the total collateral a provider has posted, an absolute amount, or a share of the outstanding issue or average daily trading volume of the asset. A CCP might, for example, allow unlimited cash and top-rated government bonds, cap lower-rated sovereign debt at a set percentage, and cap any single corporate issuer more tightly still. Some frameworks apply higher haircuts once a holding passes a threshold instead of refusing excess collateral outright.
Collateral takers review limits regularly and monitor them daily as prices change. A provider that breaches a limit is typically asked to substitute other assets, using the collateral substitution process, or to post additional collateral.
Regulatory expectations
The Principles for Financial Market Infrastructures say that financial market infrastructures should accept collateral with low credit risk, liquidity risk and market risk, set stable and conservative haircuts, and avoid concentrated holdings of particular assets where this would significantly impair the ability to liquidate them quickly without significant price effects. In the European Union, EMIR rules for CCPs include detailed requirements on collateral concentration. Central banks apply similar rules in their monetary policy and intraday credit frameworks, for example limits on unsecured bank bonds from a single issuer or group.
In practice
For a bank posting margin, concentration limits shape which assets it can use and can force it to hold a wider inventory of collateral than it otherwise would. Collateral optimisation tools and a collateral management service help firms allocate assets across many counterparties while respecting each one's limits. For the collateral taker, the limits are one of the main tools for making sure that its default management process will work under stress.
Concentration limits have costs. Tight limits increase demand for the most liquid assets, which can become scarce in a crisis, and they may push smaller firms with narrow portfolios towards more expensive funding. Collateral takers try to balance safety against these effects and to avoid sudden limit changes that could be procyclical, tightening conditions just as markets come under strain.