Overview
Collateral is an asset that one party to a credit transaction (involving credit risk) gives to the other party in order to guarantee their performance of the contract. If the borrowing party fails to fulfill the contract in question, the lending party has the legal right to sell the collateral in order to be made whole.
When collateral is transferred, the borrower retains the legal right to the collateral. Legal ownership only changes hand in the event of non-fulfillment of the contract. When the collateral makes a payment (interest or dividend), it is generally the case that the holder of the collateral is required to pay the owner an equivalent amount.
In order for collateral to be useful, it needs to be both valuable and liquid. In addition, the collateral should not fluctuate in value too much, which makes cash and/or high quality bonds the best type of collateral.
Risky collateral is generally subject to a haircut, that is, the value of the collateral needs to be higher to cover the risk. If the value of the collateral drops too much over the course of the transaction, the lender may have the right to request additional collateral.