Market risk arises in the sense that it is likely that there will be a market movement that will occur after the last reservation of guarantees. For example, collateral may irreversibly lose value, so any haircut will not compensate for the total loss. Although market risk does not translate into an actual loss, it does expose the guarantee holder to a significant loss in the event of default. Counterparties regularly mark their marketing positions and calculate net worth. Subsequently, the party presenting a negative risk may be required to deposit guarantees against its position in accordance with the dictates of the treaty. In most cases, the reservation of guarantees is made in blocks on specific dates during the term of the contract. Compare the «Outright Transfer», which is offered under English Law Credit Support Annex, with «Security Interest» under New York Law Credit Support Annex. The New York Law Credit Support Annex and the English Credit Support Annex are used to create security interests on the collateral to be deposited, the differences are operational and can be essential in the event of bankruptcy of the other party. Simply put, security right refers to an asset that bears a risk in a legally enforceable manner.
Why are guarantees needed? At any point in the term of a derivative contract, one party has positive exposure (the party will «win»), while the other party has a deposit (the party will «lose»). The winning party needs a sign giving the counterparty the obligation to provide/make available the profits in accordance with the provisions of the contract. Therefore, the party with a negative exposure will deposit collateral in the form of cash or marketable securities with the party with a positive exposure. An institution that carries out secured transactions faces liquidity risk as it may not be able to meet frequent security requirements in accordance with contractual agreements. Most institutions generally do not have large cash reserves or liquid securities that can be quickly cancelled and reserved as collateral. Segregation, if any, continues to perse an institution`s funding opportunities, as it cannot require security already held. A discount of 2% means, for example, that for every unit issued as collateral for that security, only 98% of the credit («valuation percentage») is granted. . . .