Collateral: Meaning and How It Works

What is collateral

Collateral is an asset that a borrower pledges to a lender to secure a debt or other obligation. If the borrower does not pay, the lender can take or sell the asset.

The formal definition: collateral is property over which a creditor holds a security interest, such as a pledge, lien, charge or mortgage. The creditor can enforce that interest if the borrower defaults, meaning the borrower fails to meet the terms. Collateral reduces the creditor's credit risk. It does not remove the risk.

Worked example (hypothetical)

A collateral loan

A borrower pledges gold jewellery to a bank for a loan.

• The bank values the gold. It then lends less than that value. The gap is called a haircut, and it protects the bank if the gold price falls.
• If the gold price drops sharply, the collateral may no longer cover the loan. The bank can then ask for more collateral or for part of the loan to be repaid.
• If the borrower defaults, the bank sells the gold and keeps what it is owed. Any amount left over usually goes back to the borrower, depending on the contract.

Collateral in trading

In a leveraged forex or CFD account, the money set aside when a position opens is called margin. Margin works as collateral against possible losses.

• When the position moves against the trader, the account's equity falls.
• If equity falls far enough, the platform may show a margin call. If it falls further, it reaches the stop-out level, and positions are closed automatically.
• A fast price move can push losses beyond what the trader expected. Leveraged trading can lose money quickly.

To work through real figures, use the margin tools on the calculators page.

Where the term appears

• Trading platforms: MetaTrader and similar terminals show margin, free margin and margin level. These are collateral measures under other names.
• Clearing: a central counterparty collects initial and variation margin from its members. See clearing and settlement.
• Repo and central banks: a repurchase agreement (repo) is a loan backed by securities, often government bonds. Central bank lending facilities are typically collateralised in the same way.
• News: reports on a credit crunch or financial contagion often describe falling collateral values that force lenders to demand more.

Edge cases experienced traders meet

• Mark-to-market: collateral is revalued as prices change. Calls for extra collateral can arrive when markets are under the most stress.
• Wrong-way risk: the collateral's value falls at the same time as the borrower's ability to pay. An example is a company pledging its own shares.
• Rehypothecation: the collateral holder reuses pledged assets for its own funding. This adds a counterparty layer between you and your asset.
• Unsecured vs secured: in a default, secured creditors are paid from the collateral before unsecured creditors. A bail-in usually hits unsecured claims.
• Custody: who holds the asset matters. See custodian.

Related terms

• Exposure
• Credit spread
• Derivatives
• Risk management
• Trading glossary

Frequent questions

What does collateral mean in simple words?

It is something of value you pledge so a lender will trust you with a loan. The lender can claim it if you do not repay.

What is a collateral loan?

It is a secured loan backed by an asset such as gold, property or securities. Because the lender holds that security, the terms often differ from those of an unsecured loan.

Is margin the same as collateral?

In trading, margin is a form of collateral. It is the part of your funds held against open positions.

Can I lose more than my collateral?

It depends on the contract and the provider's rules. Check the specific terms before you trade. Fast markets can cause losses larger than expected.