Strate Collateral Management Services HandBook

www.strate.co.za

Table of Contents

Introduction 1

Section 1: Collateral Theory 1-7

The Definition of Collateral

What is Collateral Management?

History and Background

Why is Collateral Used?

How Collateral Transfers Risk

Credit Risk vs. Collateral Requirements

The Margin Call

Types of Collateral

Considerations in Valuing Eligible Collateral

Section 2: The AS-IS for Collateral Management: 8-11

Creating a New Collateral Relationship

Collateral Operations

The Typical Client Collateral Team

Daily Collateral Operations Process

Section 3: The South African Market 12-14

Collateral Trading: Rehypothecation of Collateral

The Collateral Crunch - A global priority for South Africa

Strate Collateral Management Services

Strate Collateral Management Services Benefits to the Market:

Glossary 15-17

Introduction

A greater emphasis has been placed on the pursuit of collateral in order to provide stability to

financial systems. Greater regulatory reforms have been put in place in order to enhance

transparency and reduce systemic risk, while simultaneously creating a demand for HQLAs.

Collateral is typically an asset that is used by borrowers to offer lenders security over a loan.

When hedge funds, pension funds and insurers place collateral with large financial

institutions, these banks can re-use the collateral that has been placed with them in the

bank’s name, to generate a return for them. This means that a single source of collateral can

be recycled by a number of parties in the financial market, helping lubricate the financial

system. However, the risk is in that these collateral agreements are bilateral in nature, which

brings with it limitations, such as the incomplete overview of placed and received collateral.

The management of eligible collateral in terms of the bilateral eligibility criteria can be

administratively intensive and often leads to a lack of visibility of the size and location of

collateral placed .

Section 1: Collateral Theory

What is Collateral Management?

“Collateral management is the function responsible for reducing credit risk in unsecured

financial transactions.”

History and Background

Collateral has been used for hundreds of years to provide security against the possibility of

payment default by the opposing party (or parties) in a trade. In our modern banking

industry collateral is used most prevalently as bilateral insurance in over the counter (OTC)

financial transactions. However, collateral management has evolved rapidly in the last 15-20

years with increasing use of new technologies, competitive pressures in the institutional

finance industry, and heightened counterparty risk from the wide use of derivatives,

securitisation of asset pools, and leverage. 1

As a result, collateral management now encompasses multiple complex and interrelated

functions, including repos, tri-party / multilateral collateral, collateral outsourcing,

collateral arbitrage, collateral tax treatment, cross-border collateralization, credit risk,

counterparty credit limits, and enhanced legal protections using ISDA collateral

agreements. Collateral is typically required to wholly or partially secure exposure

transactions between institutional counterparties such as banks, broker-dealers, hedge

funds, and lenders. Collateral is also used in consumer and small business lending (for

example home loans, car loans, etc.),

Why is Collateral Used?

Collateral has multiple uses which fall under the umbrella of collateral management:

• A credit enhancement technique allowing a net borrower to receive better borrowing

rates or haircuts;

• A credit risk mitigation tool for private/OTC transactions - offsets risk that counterparty

will default on deal obligations (in whole or part);

• Applied to secure individual deals or entire portfolios on a net basis;

• A trade facilitation tool which enable parties to trade with one another when they

would otherwise be prohibited from doing so due to credit risk limits or regulations

(for example European pension fund regulations or Islamic banking law);

• A money market investment (lending for short periods to earn interest on available

cash or securities);

• A balance sheet management technique used to optimise bank capital, meet

asset-liability coverage rules, or earn extra income from lending excess assets to other

institutions in need of additional assets;

• An arbitrage opportunity through the use of tri-party collateral transactions; and

• An outsourced tri-party collateral / tri-party repo service for major broker-dealers to

offer to their clients.

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How Collateral Transfers Risk

In OTC trading, counterparties are exposed to the risk that the other counterparty will not

make required payments when they are due. The risk of non-payment is called credit

risk. Credit risk can also arise from effectively any exposure, be it an OTC Derivative, Listed

Derivative, Repo or Securities Lending and Borrowing.

Designed specifically for OTC Derivatives, these types of payments include derivative deal

payments (e.g. interest rate swap payments, CDS premiums or default payments),

dividend payments for stocks, coupon payments for bonds, etc. The amount of credit

risk varies in real time and must be managed on a trade, counterparty, and net portfolio

basis.

The primary purpose for collateralisation is to transfer risk from the lender to the

borrower during the life of a deal. This is done by requiring the losing party to post or

transfer an asset (cash, marketable securities) to the winning party as a form of on-going

security. Generally profit/losses are a zero sum game, whereby one party will always ‘win’

and another will always ‘lose’. The currency value of the collateral represents the

estimated probability of payment default, multiplied by the notional value of the

expected payment(s). This is known as Potential Future Exposure or PFE.

Two simple examples demonstrate this dynamic:

Securities Collateral Example:

1. Net Exposure (single or multiple deals) = $100

2. Collateral posted previously = ($80)

3. Net collateral delivery requirement = $20 = CREDIT RISK

4. Collateral given = $20

5. Net exposure = $0 = NO CREDIT RISK REMAINS

Cash Collateral Example:

1. Net Exposure (single or multiple deals) = $100

2. Cash Collateral Posted = ($80)

3. Overnight interest earned on Cash ($0.10)

4. Net Collateral delivery requirement = $19.90 = CREDIT RISK

5. Collateral given = $15 6) Net exposure = $4.90 = REMAINING CREDIT RISK 3

There is an important difference between over the counter (OTC) deals and

exchange-traded deals/Listed Derivatives. OTC transactions do not normally have clearing

house acting in a credit risk mitigation role between the counterparties which guarantees

and processes deal payments. An exchange clearing house insures that buyers and sellers

on the exchange will make and receive their payments by requiring traders to post daily

margin in the form of cash or marketable securities. Since this form of insurance is not

available to OTC counterparties, they need another form of insurance. Collateral acts as

partial insurance to offset changes in market value.

Credit risk can shift back and forth from one counterparty to the other on a constant basis.

Mark-to-market values on open positions change daily, weekly and monthly. The

counterparty with a net positive gain is exposed to unsecured credit risk in the amount of

open uncollaterised gain. This credit risk can continue to increase until the party has a large

unsecured gain. By demanding additional collateral, this profit is "locked in" or insured up

to the market value of the collateral posted, less the transaction costs associated with

liquidating the collateral. In the event of a missed or delayed payment the Taker of

collateral can keep the collateral posted and sell it in the open market to offset the lost

income.

Margin agreements typically provide a grace period for the counterparties to negotiate

differences in valuation, adjust collateral amounts, substitute one collateral form for

another, etc. This provides some flexibility in the relationship and keeps things running

smoothly in the event that a particular type of collateral are not easily available at a

reasonable price at the time of the margin call, or there is a disagreement on what the

underlying deal value might be (this is common on illiquid OTC structured deals).

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Credit Risk vs. Collateral Requirements

Credit departments of banks, broker-dealers, lenders, and buy side institutions rely on a

variety of techniques to assess credit risk of their counterparties. These include:

• External credit ratings (such as Moody’s)

• Internal credit ratings (perhaps internal to a bank)

• Payment histories (against a specific counterparty)

• Statistical default probabilities per counterparty, industry, or market

• CDS spreads (if the counterparty is an issuer with CDS written on its bonds)

• Equity prices (the counterparty's equity price is considered an accurate

forward-looking gauge of financial health) Collateral requirements can increase or

decrease depending on the factors above. In addition, two additional factors can

influence the amount of collateral required length of the deal: overnight repos have

lower collateral requirements than 30 year swaps as there is far less time in which to

default.

• Quality of collateral: more collateral is required if the securities posted are rated less

than what is considered to be high-quality eligible collateral (typically designated a

rating, such as certain sovereign bonds with the highest ratings of AAA) , or have

volatile prices (e.g. equities).

The Margin Call

Designed specifically for OTC derivative transactions. In some instances a deal is so

unique or illiquid that a third party valuator or appraiser is required to theoretically price a

deal for collateral and PnL purposes. Where this is necessary, the issue becomes cost, the

number of independent valuators used, and how to decide on a final value from multiple

different estimates without proceeding to litigation.

The Margin Call is the primary mechanism which ensures adequate collateral is posted

during the life of a deal. Occasionally counterparties may disagree on whether a margin

call is appropriate, or the amount of collateral requested.

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Margin Call Mechanics

1. All trades are marked to market (daily, weekly, and monthly).

2. All collateral is marked to market.

3. Net collateral requirement is calculated internally by each party

4. Credit risk exposure is compared to a pre-defined acceptable exposure level.

5. A margin call is made to counterparty if exposure limit exceeded.

6. Counterparties net their collateral calculations (if both have posted / received collateral from the other). Otherwise, the party receiving a margin call either accepts the call on its face or analyses it and determines how much needs to be posted by looking at market prices, collateral agreements, etc.

7. The counterparties come to an agreement on how much needs to be posted.

8. The undisputed portion of collateral required (imbalance) is posted by the losing counterparty to the winning counterparty. The disputed portion (if any) may be negotiated.

9. Collateral posting (traditionally) settles T+1 (next normal business day). This may take longer for non-standard collateral or international transactions.

Types of Collateral

According to ISDA, the following types of collateral are most predominant, globally in the OTC Derivatives arena:

• Cash: (73% of USD and EUR trades according to ISDA 2005). Cash is easy to hold, easy to transfer, requires little or no valuation.

• Fixed Income Securities: Predominantly Government Securities (Treasury Bonds, Agency Bonds, etc.), but also includes other types such as MBS, ABS, corporate bonds, sovereign bonds, etc.

• Bank Guarantees

• Equities (stocks): Usually large-cap and highly liquid shares listed on major exchanges.

• Real Estate: Commercial buildings, land, etc. if deemed sufficiently liquid. This collateral is more relevant to structured project financing transactions.

• Convertible Bonds: These must be issued by a credible company with low default risk, and must convert into marketable common stock or premium stock at a significant discount.

• Exchange Traded Funds (ETFs)

• Mutual Fund Shares: This can be very complicated due to interactions between custody, taxes, trading limitations, ownership concentrations, and redemption rights.

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Considerations in Valuing Eligible Collateral

The ability to quickly and accurately value collateral is a critical element of its eligibility, without which the collateral has little use. Collateral provides no security if it cannot be valued or traded for a known value in the event of a default. When deciding whether collateral is eligible, the following factors are important:

Who Values the Collateral?

This is usually governed by either the CSA or trade documents (deal term sheet). The choices are: 1) you, 2) me, 3) both, or 4) third party. Two banks will typically push for either 2) me or 3) both, so that each has a hand in the final determination and can bring their valuation expertise to bear. Smaller hedge funds without dedicated valuation teams and fewer resources usually choose 1) you or 4) third party. This gives valuation control to the prime broker who typically has dedicated valuation personnel and a wider view of market prices.

How Is It Valued?

Depending on the type of trade, the valuation may be done on a mark to market (MTM) or mark to model (theoretical valuation) basis. Where the trade is fairly vanilla and there are plenty of comparative market prices, mark to market is selected. For more exotic or complex transactions where price discovery is a challenge and there is not as much depth of liquidity, mark to model may be necessary, and the determination of a) the model used, and b) who does the valuation, becomes extremely important. These factors should be decided up front before doing a deal, or at least subject to approval by the Collateral or Valuation teams before a deal is completed.

How Often Is It Valued?

Traditional valuation is done on an end of day basis (EOD) after the market closes for fixed income instruments such as government bonds in South Africa for example. However, with the advancement of collateral systems, electronic order networks, and other technology, there is a movement toward periodic intraday (i.e. 30 or 60 minute intervals) or real time valuation – typically in the equities markets. Illiquid trades are still valued on a daily basis and sometimes weekly or monthly for highly structured deals.

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Section 2: The AS-IS for Collateral Management:

Creating a New Collateral Relationship

For OTC transactions, collateral have become the norm rather than the exception. Prior to the widespread use of derivatives, collateral was required by large banks only for smaller or riskier customers (such as hedge funds or niche brokers), under the assumption that other large banks would rarely default on their obligations. With the dramatically increased leverage built into the financial system through derivatives and securitised pools, collaterisation is now mandatory between almost all counterparties. Once a new customer is identified by Sales, the first step is to conduct a basic credit analysis of that customer. This is done by the Credit Analysis team.

The next step is to negotiate and enter into the appropriate legal agreements. In the world's major trading centres, counterparties predominantly use ISDA Credit Support Annex (CSA) standards to ensure clear and effective contracts exist before transactions begin. These agreements cover 90% plus of the information on eligible collateral, margin requirements, independent amounts (haircuts) calculation and payment methods, etc. Negotiation and finalising these agreements can take up the bulk of the time in developing a new relationship, often extending weeks or months. CSAs are typically used for OTC Derivatives, whereas the GMSLA (Global Master Securities Lending Agreement) relates to collateral for the Securities Lending and Borrowing Market and the GMRA (Global Master Repurchase Agreement) for repurchase transactions.

Then the collateral teams at each counterparty implement and automate the collateral relationship. Bank codes, SWIFT codes, custodian and transfer relationships, key contacts and phone numbers, report formats, margin call processes, etc. are all communicated and entered into the collateral systems of both counterparties. This process may be done in a matter of days or take up to several weeks.

If the two parties want to trade right away, they will typically post some initial reciprocal collateral with the other party (either cash or default-free Treasury bonds) to "open the account." This lays the groundwork for new trades, which will only require "topping up" the collateral to meet initial margin requirements.

Once these items are in place, the Front Office Sales and Traders can begin negotiating trades. Once a trade is agreed upon, the Collateral Team is notified of the deal, and the required Initial Margin is posted to enable the trade to occur.

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Collateral Operations

The Typical Client Collateral Team for Current Operations

Collateral Management Team

Does collateral calculations on spread sheets and dedicated software, delivers and receives collateral, runs the collateral operations, maintains customer and securities data, issues and receives margin calls, and liaises with customers, service providers, Legal, Middle Office, and other parties in the collateral chain.

Credit Analysis / Approval Team

Researches, analyses and sets collateral requirements for new and existing counterparties. Typically this entails a preliminary review as well as on-going periodic reviews of the credit risk of each counterparty.

Front Office Sales and Traders

Sales people develop new eligible trading relationships and manage the on boarding process for new accounts, including signing of legal collateral documents, account formation, and on-going sales transactions. Traders may execute trades only with approved counterparties.

Middle Office

Typically responsible for risk and valuation measures, the Middle Office interacts with the Collateral Management team on a daily basis.

Legal Department

Conducts negotiations, drafting and review of agreements. Enforces collateral and margin agreements, including initiation of collections and lawsuits where appropriate. Legal is required to sign off on all written agreements.

Valuation Team

This group focuses on valuing illiquid or exotic collateral often on a mark to model and underlying trade position that must be collaterised. Typically, these types of collateral and deals are thinly traded rather than liquid exchange-traded instruments.

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Accounting & Finance Team

Works with the Middle Office to calculate and account for P&L on collateral posted and received. Also works with Tax and Auditors.

Third Party Service Providers

Software providers, Consultants, Auditors, Tax Specialists, Tri-Party Collateral Managers.

Daily Collateral Operations Process

The Collateral Management team's job is to continually track, value, and give or receive collateral during the life of every trade (whether it’s for OTC Derivatives, Securities Lending and Borrowing or for Repos) in the institution's portfolio. This is a large and complex task requiring sophisticated systems and dedicated personnel. The general tasks on a day-to-day basis include:

Managing Collateral Movements: Tracking the net MTM valuation, making and fielding margin calls, and giving / taking collateral to offset credit risk on a deal and net portfolio basis.

Custody, Clearing and Settlement: Depending on how the legal relationship is structured, one or the other counterparty may act as a custodian for cash and securities, or a third party custodian may be hired. This requires segregated accounts strictly for collateral by customer (and often sub-accounts level). The custodian manages collateral inflows and outflows, counterparty payments (top-ups, etc.), interest calculations, haircuts, dividends, coupon payments, etc. as well as accounting for and reporting all transactions accurately and timely. The custodian role is often outsourced, especially by hedge funds that typically outsource this function to a custodian subsidiary of their prime broker.

Valuations: The Valuation team (often part of the Collateral or Middle Office team) is responsible for valuing all securities and cash positions held or posted as collateral. This duty is affected by the valuation roles defined in the CSA -- for example, many smaller hedge funds delegate valuation to their prime brokers who may have greater access to comparative valuation data, valuation models, and large teams of qualified staff. Traditionally, valuation has been done on an end of day (EOD) basis, but is now moving toward intraday and real time valuation where possible.

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Margin Calls: When the Collateral Team determines that the mark-to-market change of a particular deal or net portfolio position has moved against the counterparty by at least the Minimum Amount, a margin call is issued. Margin calls are made via telephone, fax, email, or SWIFT message, stating the amount of collateral demand and often the type of collateral required, if defined in the relevant CSA. The counterparty is then required to top-up its collateral account by delivering cash or securities, typically by overnight wire transfer. If the counterparty does not meet its margin call, and the amount is large enough, the Collateral team may issue a notice indicating the trading relationship is temporarily or permanently halted until the account is brought to net zero exposure. If the counterparty does not respond the custodian is notified, and the existing collateral may be seized, and the account turned over to the Legal department for enforcement of any outstanding obligations, typically the start of a default process on the specific contract. Typically, the Front Office will offer the counterparty the opportunity to "break" the deal and pay a penalty before full legal action is taken. The above dynamics are reversed if the first party is the net debtor (i.e. receives one or more margin calls).

Substitutions: Often one party would like to substitute one form of collateral for another. For example, cash rather than Treasury Bonds, or Corporate Bonds rather than Treasuries. The Collateral Team will then (usually manually) look to the CSA for guidance on acceptable substitute collateral (if covered) or make a decision based on the perceived value of the substitute collateral. Collateral substitution allows for flexibility in the relationship, and the ability to deliver good collateral at a lower net price (linked to optimisation) determined on cheapest to deliver. Once a substitution is accepted, this must be properly tracked in the Collateral Management system as well as communicated to all relevant parties (custodians, valuation team, etc.), and followed up to ensure the substitution actually occurs.

Processing: Payment and event processing (i.e. on coupons for Bonds or Corporate Actions for equities) is often outsourced to a dedicated third party due to the administrative burden of managing the Corporate Actions. Teams may even elect to substitute collateral out in order to minimise the number of corporate actions which require processing.

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Section 3: The South African Market

Collateral Trading: Rehypothecation of Collateral

The basic function of rehypothecation is to provide counterparties with a broader array of collateral availability to be placed and the ability to enter into a wider breadth of trade types. In certain transactions with credit risk such as credit default swaps, the quality and marketability of collateral is essential to be able to enter into and maintain a deal over its life. A trader who is able to access different types of collateral from other transactions has a greater ability to negotiate trades where collateral is required, and to obtain and post additional collateral as needed by leveraging other profitable deals. The trader may also earn an interest rate spread between the haircut charged and the haircut paid to two different counterparties.

Rehypothecation has been traditionally used in bi-lateral trading relationships and is a valuable tool used to lubricate the market. However, to rehypothecate collateral efficiently and on a larger scale is very complex and requires dedicated staff, inventory and accounting systems, and legal support unavailable to many smaller institutions such as hedge funds. Without the proper systems and procedures, there is a risk of double-committing collateral or not being able to obtain the collateral back when needed. These factors have led to the rapid growth of the tri-party collateral business, where reuse of collateral is centrally tracked.

Reuse of collateral has also become key in most developed markets such as the US or Europe and is an accepted ‘norm’. In the South African Market reuse also happens, albeit currently predominantly with cash due to the complexity and the administrative burden associated mentioned above.

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The Collateral Crunch - A Global Priority for South Africa

The pending regulations envisaged from Basel III and Solvency II requires systemic changes for many financial institutions. Risk management is now the regulators' first priority and this is having a major impact on the way financial institutions securitise their exposures. As a result, the global market will need to mobilise trillions of US Dollars more in collateral to cover their financial and regulatory obligations. Since the events of 2008, the emphasis on risk mitigation and asset safety has significantly increased for all players in the financial markets.

As local and international financial institutions have had to reassess the use of quality collateral to mitigate credit and settlement risk, pending new regulatory requirements will place greater emphasis on the retention of cash on the balance sheets of banks. Basel III requires higher capital adequacy and thus greater liquid assets ratios for banks. In addition the proposed amendments to Solvency II also requires greater capital adequacy for long-term life assurers. These represent some of the pressures the market is expected to face from a shortage of high-quality eligible collateral. Consequently, more efficient and optimum use of available collateral becomes an imperative, as does the eradication of silos of collateral both internal and external to financial institutions that have caused the fragmentation of available collateral.

External silos of collateral exist due the very nature of the current bilateral arrangements in place today. Counterparties are unaware of the relationships their counterparties have with other counterparties, which may be common to both. This makes optimisation of collateral impossible without a centralised solution. Currently in South Africa, collateral agreements are bilateral in nature and predominantly cash-based, exposing parties to counterparty risk in the case of default and settlement risk in the instance where margin calls cannot be met.

As a member of The Group of Twenty Finance Ministers and Central Bank Governors (G-20), South Africa also has to meet the G-20's requirements to have standardised non-cleared over-the-counter derivatives traded on an exchange or an electronic platform and reported to a trade repository, which is expected to create a growing need to collateralise transactions.

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Key Drivers for Collateral South African Financial Market

Fragmentation and uncertainty of the size, location and the timing of the collateral delivery increases the costs associated with funding and credit risk this ultimately impacts the bottom line associated with collateralised transactions. Tracing collateral placed and changing eligibility criteria as activity increases, while managing multifaceted portfolios, various margin calls, substitutions of collateral - especially where elective entitlements to corporate events are concerned for example - provide an indication of the administrative burden and complexities that are associated with collateral management.

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Glossary

Collateral Management Glossary of Key Terms

The following key terms will be useful as you read through this Guide.

Add-On: An additional currency amount added on to the mark to market value of an underlying trade or security to offset the risk of non-payment. This represents the credit spread above the default-free rate which one counterparty charge the other based on its internal calculations (often negotiated beforehand and memorialized in a CSA).

Call Amount: The currency amount of collateral being requested by the Taker.

Collateral Support Document (CSD): A legal agreement which sets forth the terms and conditions that collaterisation will occur under in a bi-lateral or tri-lateral / multilateral relationship.

Credit Support Annex (CSA): A legal agreement which sets forth the terms and conditions of the credit arrangements between the counterparties. The trades are normally executed under an ISDA Master Agreement then the credit terms are formalized separately in a CSA (SEE ALSO Collateral Support Document).

Give: To transfer collateral to a counterparty to meet a collateral or margin demand. The counterparty with negative mark-to-market (a loss) is usually the collateral Giver. (SEE ALSO Pledge).

GMRA: Global Master Repurchase Agreement

GMSLA: Global Master Securities Lending Agreement

Independent Amount: An additional amount which is paid above the mark-to-market value of the trade or portfolio. The Independent Amount is required to offset the potential future exposure or credit risk between margin call calculation periods. If daily calculations are used, the Independent Amount offsets the overnight credit risk.

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If weekly calculations are done, the Independent Amount will usually be higher to offset a large amount of potential mark-to-market movement that can occur in a week versus a day. Many counterparties set the Independent Amount at zero then substitute the Minimum Transfer Amount (MTA) as the Independent Amount on a counterparty-by-counterparty basis.

ISLA: International Securities and Lending Association

Margin Call: A request typically made by the party with a net positive gain to the party with a net negative gain to post additional collateral to offset credit risk due to changes in deal value.

Margin: Initial margin is the amount of collateral (in currency value) that must be posted up front to enter into a deal on day 1. Variation margin (a.k.a. maintenance margin) is the amount of collateral that must be posted by either party to offset changes in the value of the underlying deal. Initial margin is generally, but not always, higher than variation margin.

Mark to Market (MTM): Currency valuation of a trade, security, or portfolio based on available comparative trade prices in the open market within a stated time frame. MTM does not take into account any price slippage or liquidity effect that might occur from exiting the deal in the open market, but uses the same or similar transaction prices as indicators of value.

Mark to Model: Currency valuation of a trade or security based on the output of a theoretical pricing model (e.g. Black Scholes).

Minimum Transfer Amount (MTA): The smallest amount of currency value that is allowable for transfer as collateral. This is a lower threshold beneath which the transfer is more costly than the benefits provided by collaterisation. For large banks, the MTA is usually in the USD 100,000 range, but can be lower.

Netting: The process of aggregating all open trades with a counterparty together to reach a net mark-to-market portfolio value and exposure estimate. Netting facilitates operational efficiency and reduced capital requirements by taking advantage of reduced risk exposures due to correlation effects of portfolio diversification versus valuing all trades independently. However, netting relies upon efficient and accurate pricing at a portfolio level to be effective.

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Pledge: To give collateral to your counterparty. (SEE ALSO Give).

Potential Future Exposure (PFE): The estimated likelihood of loss due to non-payment or other risk, in this case the likelihood of default on a counterparty's obligations.

Rehypothecation: The secondary trading of collateral. Rehypothecation is the cornerstone of tri-party collateral management.

Substitution: Replacing one form of collateral (e.g. corporate bond) with another form of collateral (e.g. Treasury bond) during the life of a particular deal or trading relationship.

Take: To receive collateral from a counterparty to meet a collateral or margin demand. The counterparty with positive mark-to-market is usually the collateral Taker.

Threshold Amount: The amount of unsecured credit risk that two counterparties are willing to accept before a collateral demand will be made. The counterparties typically agree to a Threshold Amount prior to dealing, but this is a source of on-going friction between OTC counterparties and their brokers.

Top-up: To give additional collateral to your counterparty to meet a margin call.

Valuation Percentage: A percentage applied to the mark-to-market value of collateral which reduces its value for collaterisation purposes. Also known as a "haircut", the Valuation Percentage protects the collateral Taker from drops in the collateral's MTM value between margin call periods. For example, if the MTM value of the collateral is $100 and the Valuation Percentage = 98.5% then 1.5% is being charged to offset period-to-period valuation risk and the collateral amount counted is only $98.50. The Valuation Percentage offered by different counterparties and brokers may vary in the market, so buy side participants often "haircut shop" for the best rate.

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1st Floor, 9 Fricker Road, Illovo Boulevard, Illovo, Sandton, 2196, South AfricaT + 27 (0) 11 759 5300. F + 27 (0) 11 759 5500info@strate.co.za • www.strate.co.za

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