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20. How do repo parties ensure they have enough collateral?
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The first step is collateral selection. Collateral that is high quality and liquid will be inherently stable in value. In addition, collateral issued by a party whose credit risk is uncorrelated with that of the repo counterparty will diversify exposure and avoid so-called wrong-way risk, which is the danger of the collateral value falling as the creditworthiness of the counterparty deteriorates.

Whatever collateral is accepted, buyers then need to value that collateral as accurately as possible. They also need to anticipate potential problems in liquidating less liquid collateral in the event of a default, by applying a risk adjustment to its market value in the form of a haircut or initial margin.

Once the terms of a repo have been agreed, both parties should revalue the collateral frequently (at least daily) and as accurately as possible. When the value of collateral in a repurchase agreement falls, the buyer should promptly call for margin from the seller to top up the collateral and ensure the urgent delivery of that margin. Guidance on efficient margining is set out in the Guide to Best Practice in the European Repo Market published by the European Repo and Collateral Council (ERCC) of the ICMA. In the case of sell/buy-backs, an alternative mechanism is employed that achieves the same result as margining (see question 8).

In order to minimise the problems that may occur in the aftermath of a default, it is important to have a robust written legal agreement such as the ICMA’s Global Master Repurchase Agreement (GMRA). This protects the rights of the buyer to sell collateral in any circumstance and to net his exposures to the defaulter swiftly as well as flexibly in terms of the timing and method of valuation to accommodate less liquid collateral and difficult market conditions.

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