Risk mitigation

Objective: adequate collateralisation

The Eurosystem's collateral framework is aimed at translating the statutory requirement of adequate collateralisation into concrete tools and procedures that guarantee sufficient mitigation of the financial risks in a reverse transaction. To achieve this goal, the collateral accepted in such a transaction must be of a quality and quantity such that, in the event of a counterparty default and a subsequent realisation of the collateral in the market, it is highly probable that the Eurosystem would be able to recover the full amount of its claim.

Three kinds of risks

In order to successfully mitigate the counterparty risk in a reverse transaction, the collateral framework must adequately limit three kinds of risk, all of which arise only if the counterparty defaults:

1. the credit risk associated with the collateral accepted;
2. the market risk of an adverse movement in the price of an asset accepted as collateral due to exogenous factors occurring between the last collateral valuation and collateral realisation;
3. the liquidity risk of an adverse movement in the price of an asset caused by an attempt on the part of the Eurosystem to liquidate a potentially large position in that asset.

Three elements

Risk mitigation in the framework of the Eurosystem's liquidity-providing reverse operations is based on three elements:

• The Eurosystem uses assets of a high credit quality to collateralise its operations. For this purpose, it uses market sources and applies best practices to assess the credit quality of the heterogeneous set of eligible assets. The section on the Eurosystem credit assessment framework (ECAF) informs on the procedures, rules and techniques which ensure that the Eurosystem requirement of high credit standards for all eligible assets is met.
• Collateral needs to be valued accurately and on a daily basis to ensure that the Eurosystem is appropriately covered against credit risk. The section on the Eurosystem valuation framework (Valuation) summarises the key elements of the Eurosystem valuation framework.
• To address market and liquidity risk, risk control measures are applied to the properly valued collateral. While protecting the Eurosystem from financial risks in its operations, these measures aim to avoid penalising counterparties and to allow them to use eligible assets efficiently. The section on the Eurosystem risk control framework (Risk control) gives an overview of the risk control measures available to the Eurosystem.

For details, seeFinancial Risk Management of Eurosystem Monetary Policy Operations, July 2015