Celent Report Identifies Best Practices for Over-The-Counter Derivatives Collateral Management

When any entity, including a hedge fund, trades over-the-counter (OTC) derivatives, it assumes the risk that the counterparty – a bank, financial institution or another hedge fund – will fail to perform.  To mitigate that risk, OTC derivatives documents require each party to post collateral.  The amount of collateral adjusts based on: (1) the value of the derivative; and (2) the value of the collateral.  Both values fluctuate.  This practice, commonly referred to as OTC derivatives collateralization, has grown increasingly popular because of the recent credit crisis.  Celent, a Boston-based financial research and consulting firm, recently issued a report entitled: “OTC Derivatives Collateral Management: A Credit Risk Mitigation Technique Revisited,” regarding the status of and best practices for OTC derivatives collateralization.  The report found that collateralization of OTC derivatives has expanded due to greater hedge fund participation in these transactions.  The report identified the best practices for entities, including hedge funds, who participate in collateralized OTC transactions.  This article summarizes these best practices and the other major findings of the report, as they relate to hedge funds.

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