Collateral transformation is a key part of central banks' liquidity insurance role in financial markets.
Collateral transformation allows participating banks to temporarily exchange less liquid forms of collateral, for collateral which is more liquid.
For example, a participant might exchange corporate bonds, which are less liquid, for high-quality and highly liquid sovereign securities (gilts).
Examples of collateral transformation facilities include the Bank of England's:
- Discount Window Facility (DWF).
- Contingent Term Repo Facility (CTRF).
Collateral transformation is one type of 'liquidity upgrade'.
The purpose is normally to enable a participating bank which uses the facility to go on to borrow in the private market, against the improved security of the temporarily 'upgraded' collateral.
The fees and other terms attached to the central bank's facilities are set at levels designed to ensure that participants use them as a back-stop to private market liquidity management, rather than using the central bank's facilities routinely.