A contractual clause that is included in derivatives contracts in order to mitigate credit risk. According to a standard collateralization agreement, the contracts are valued periodically. It specifies a threshold level to which the total value of the contracts of a given firm is compared. If the value is above that level, the agreement requires the cumulative collateral posted by the firm to equal the difference between the value of the contracts to the firm and the threshold level. For instance, if the threshold is set at $5 million, and the value of the contracts totals $7 million, then the cumulative collateral will need to be:

Cumulative collateral = total value of contracts – threshold

Cumulative collateral = $ 7 million – $5 million = $ 2 million

After having posted the collateral, if the value of the contracts moves in favor of the firm in a way that the cumulative collateral decreases below the total margin already put up, the firm can reclaim redundant margin. In the event of default, the dealer can seize the collateral as a compensation. The dealer can close out the outstanding contracts if the firm doesn’t put up collateral as required.