Late last year, the Federal Reserve Bank of New York’s Treasury Market Practices Group (TMPG) put forward a recommendation to introduce margin requirements for all forward-settling agency mortgage-backed securities – typically transacted as To Be Announced trades (TBAs).
The TMPG best practice recommendation isa significant development for the industry. And its significance is compounded by a relatively aggressive implementation timeline. Market participants are expected to show “significant progress” toward a margining solution by June and have their margining process “substantially complete” by the end of the year.
Compliance with the new guidance will be challenging as new and existing TBA market participants will need to implement or update systems and processes to manage the new collateralization requirements of these products.
The sheer size of the mortgage-backed securities (MBS) market alone – approximately $270 billion in value traded daily, the majority of which are TBA trades – means that almost everyone will be impacted. Up to now, no margin has been required for these types of trades, so firms will need to introduce a robust, flexible and sophisticated collateral management process under an extremely tight and challenging timetable.
The TMPG recommendation
According to the TMPG’s official recommendation, “the forward-settling nature of most agency MBS transactions exposes trading parties to counterparty credit risk between trade and settlement.” In order to mitigate this risk, the TMPG recommends that participating counterparties enter into a master collateral agreement that defines the margining aspects of relationships such as the frequency of collateral calls, the timing of these calls and collateral eligibility, as well as more sophisticated terms such as thresholds, valuations – of both exposure and collateral – and liquidation terms. The TMPG understands that, in order to comply with these recommendations, some firms will need to adopt new collateral solutions that take time to implement and can be complex when integrated across existing systems and processes. As a result, the TMPG initially gave the industry approximately seven months to makes these changes, and then extended the deadline through to the end of 2013.
It should be noted that while the TMPG uses the word “recommendation”, it is important to understand that this does not mean “optional”, and that there will likely be consequences for non-compliance even though no specific penalties were stated in the recommendation. Ultimately, it is understood that the TPMG’s recommendations will foster an environment where almost every institution will be required to collateralize these transactions.
The rationale behind the recommendation
It has become widely accepted that swaps, futures, and listed options should typically be collateralized, given the significant inherent counterparty credit risk in these instruments. However, a significant proportion of the $5 trillion MBS agency market remains forward-settling and bilateral, and not collateralized. It is this reality that lead to the TMPG’s actions, highlighting approximately $750 billion – $1.5 trillion in gross, unsettled, unmargined MBS trade exposure existing today.
This is no small amount, especially when considering that the TBA market is essential for the proper functioning of the retail mortgage market. In fact, it could be argued that should a major counterparty default occur in this market, it could have a disproportional impact on the general public. Locking in mortgage rates and securing a finance commitment when one is buying or refinancing a home is essential and TBAs allow lenders to provide that service.
Despite the importance of a liquid and fully functioning TBA market as well as its significant size, very few investment managers and banks collateralize their bilateral TBAs today. When one looks at the settlement process of a TBA it is evident that parties are open to counterparty default risk for the period between execution and settlement. According to FINRA estimates, the average timebetween execution and settlement today is about 25 days, but can last as long as long as three months.
As we have seen in other markets, a lot can happen in just a few short days, turning what appears to be a creditworthy institution into a non-performing defaulting party. In times of market stress that often accompany or cause entities to default, it is common to see large swings in the yield curve and significant price volatility in fixed income instruments including TBAs. If a TBA counterparty defaults during a period of market volatility, the non-defaulting party may get a less favourable price for their “replacement” TBA and thereby suffer a loss. It is the mitigation of that potential loss that the new TPMG recommendation is looking to address.
As noted earlier, the impact of the TMPG recommendation will be felt by almost all TBA market participants, to varying degrees. Those firms that already collateralize their TBAs will be unaffected.
However, for firms that do not collateralize these transactions, compliance could be challenging when considering the specific capabilities of these firms and their current business relationships.
While there will be many challenges, a few of the primary issues include legal set-up, relationship formalization, and operational/technology preparation.
I. Legal set-up
Under the recommendation, it is stated that collateralization be performed under a formalized collateral agreement. The industry standard for such a collateral agreement between parties trading in forward-settling mortgage-backed securities is the Master Securities Forward Transaction Agreement (MSFTA). Fortunately the Securities Industry and Financial Markets Association (SIFMA) recently revised their standard recommended template for the MSFTA which can be used as a starting point for negotiations between counterparties. However, it is only a starting point, and the detailed terms must be negotiated and agreed between the trading parties. This can take months, but it is an essential component of compliance with the recommendation.
II. Relationship formalization
While some buy-side firms are able to deliver collateral directly to their counterparties, others, such as US 40 Act mutual funds and offshore Undertakings for Collective Investment in Transferable Securities (UCITS), are not legally permitted to physically deliver collateral. Those entities will need to formalize a tri-party control relationship between their organization, their custodian, and their counterparty. Setting up such a tri-party account, which includes agreeing on countless legal and operational aspects, can take months.
III. Operational/technical preparation
Many firms trading or that will begin trading TBAs do not have operational or technical expertise in collateral operations, nor do they have the systems to properly support collateral processes. For those, building an in-house solution or leveraging existing licensed technology is not an option. They will need to find a suitable collateral management solution that can process and manage collateral under an MSFTA. In either case, firms must consider the impact on their operations – people, processes and systems – when selecting a solution to address these new requirements.
For firms that already have collateral management departments that leverage sophisticated and flexible collateral management technology across other asset classes, it will be important that they review their processes and technology to ensure that they can handle all forward-settling MBS margining.
At Omgeo, we believe that market risk reduction is a goal everyone should work toward, and we fully support the TMPG principles in both spirit and in action. We also see the development as one that will promote safety in the TBA market. We have worked to ensure that our collateral management system, Omgeo ProtoColl, is ready to provide a fully automated solution for the collateralization of all forward-settling mortgage-backed securities, including TBAs, well ahead of the end-of-year deadline.
Ted Leveroni is Executive Director for Derivatives Strategy at Omgeo.
Omgeo are operations specialists, automating trade life-cycle events between investment managers, broker/dealers and custodian banks, and working with 6,500 clients and 80 technology partners in 52 countries. Formed in 2001, Omgeo is jointly owned by the DTCC and Thomson Reuters.