Updated: Oct 1, 2025
The Basel III rules create new capital requirements for banks on derivative transactions, which are particularly costly in the absence of a collateral agreement (“Annexe de Remise en Garantie” under an FBF contract or “Credit Support Annex” under an ISDA contract). These requirements are all the more costly when the transaction is long-term and its valuation volatile.
As a result, banks incorporate a significant additional cost and may even refuse to process certain OTC derivatives without the signing of a collateral agreement.
For companies, signing such agreements appears beneficial as it immediately reduces the cost of hedging transactions and provides them with better access to the market. However, caution is required and it is important to fully understand all the associated risks.
The principle of collateral agreements
The signing of a bilateral collateral agreement between a bank and its client consists of a mutual commitment to deposit cash (or securities) with the counterparty whenever the market value of all transactions governed by the same master agreement indicates a credit risk. Collateral is a guarantee wich is physically transferred to the counterparty and periodically adjusted according to changes in the valuation of the contracts.
Thus, broadly speaking, assuming that a company has entered into a swap agreement with its counterparty whereby it receives a fixed rate and pays a variable rate, the company pays cash to its counterparty if rates rise, and receives cash from its counterparty if rates fall. In the case of a derivatives portfolio, it is the total value of the portfolio vis-à-vis the counterparty that determines whether the company must deposit or receive cash as collateral.
As a general rule, the cash deposited is remunerated at the EONIA rate.
The implementation of a collateral agreement enables counterparties to significantly improve their prices on market transactions, as it allows them to execute transactions while greatly limiting their credit risk vis-à-vis the counterparty and without consuming significant capital. The new Basel III rules have significantly strengthened these capital requirements.
Collateral and liquidity management
For the company, implementing such an agreement therefore reduces the cost of new transactions. However, it has several immediate consequences:
The agreement generally applies not only to new transactions but also to existing transactions: depending on the valuation of the existing portfolio, the agreement therefore requires the company either to immediately deposit an amount equal to this valuation in cash (or securities) with its counterparty, or to receive this amount, which has a direct impact on the company's cash flow.
Depending on market fluctuations, the valuation of the derivatives portfolio varies, leading to unpredictable cash outflows or inflows.
Let's take the example of a European industrial company which, in order to broaden its investor base and benefit from attractive financing conditions, occasionally raises funds on the dollar-denominated bond market. With the assistance of its banking partners, it issues dollar-denominated bonds with a maturity of seven years. At the same time, it enters into a currency swap with one or more banks, enabling it to hedge its currency risk very precisely, so that regardless of fluctuations in the EUR/USD exchange rate, its financial expenses in euros are known and its financial position remains stable.
Under Basel III and in the absence of a collateral agreement, the capital charge for banks on such swap transactions is very high. When banks calculate their capital using the advanced approach, capital consumption depends on implied interest rate and currency volatility, CDS spread levels, and their historical variability over a one- to four-year horizon. Given the state of the markets since 2008, capital consumption is all the more significant.
The implementation of the collateral agreement requires the company to commit to providing the bank with cash collateral in the event that the market value of the swap changes, for example due to a shift in the EUR/USD exchange rate. Without a collateral agreement, a 30% change in the EUR/USD exchange rate would have no impact on the company's cash flow and balance sheet due to its perfect hedging of currency risk. After the collateral agreement was put in place, the fall in the dollar has a considerable impact on the company's liquidity, as it has to deposit 30% of the nominal value of its loan in cash with the bank, thereby significantly reducing the portion of the borrowed amount available for planned investments. This sum will be remunerated at EONIA, which is well below the company's long-term financing cost.
Furthermore, the implementation of a collateral agreement may have accounting implications insofar as auditors may consider it appropriate to value derivatives under collateral agreements by discounting future cash flows using the swap curve against EONIA, but that the underlying debts should continue to be valued based on a curve against Euribor, thus leading to inefficiencies in the hedge.
Understanding and negotiating your collateral agreement
When hedging currency positions is a strategic issue, companies sometimes have no choice but to agree on signing such agreements. However, it is still necessary to negotiate them carefully and then implement appropriate risk management measures.
It is therefore not always necessary to sign collateral agreements with each of your banking partners. You need to carefully examine the existing stock of derivatives with each partner, the variability of their valuation, and the immediate impact of the contract on the company's cash flow. The company will also need to estimate the cost of remunerating the collateral at EONIA by stress testing the assumptions on the future amount of margin calls and the future cost of financing or replacing the cash consumed through the collateralization agreement.
The direct benefits that the bank will derive from the implementation of this agreement due to the associated reduction in its regulatory capital must also be taken into account and weighed in the negotiations. Finally, the bank is all the more motivated to sign a collateral agreement as it gives it a decisive competitive advantage over its competitors.
Furethermore, note that the day-to-day operational costs of such agreements for the company should not be overlooked. Continuous validation of the valuations provided by the bank is important, as it has a direct impact on the company's cash flow. Day-to-day contract management therefore requires new resources within the company.
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