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The video explains the concept of collateral security using an example of a company, XYZ, seeking a loan of 50 lakhs. To secure the loan, XYZ pledges its machinery as collateral. Additionally, the company issues debentures worth 60 lakhs to the bank, which serves as extra security. These debentures function as collateral security and will only be utilized if XYZ defaults on the loan. The bank retains these debentures, but they are not the primary security for the loan, which is backed by the company's machinery.