US broker-dealers and their fund manager customers that deal in forward-settling agency mortgage-backed securities or similar asset classes better prepare for even more legal and operational stress.
The Financial Industry Regulatory Authority (FINRA) has just come up a set of far more rigid and comprehensive rules than guidelines from a committee of the Federal Reserve Bank of New York, which were supposed to be effective last month.
The Treasury Market Practices Group (TMPG) says there are too many “bilateral” trades conducted in the TBA and similar asset-class market. Because they are not processed through a central clearinghouse, there is far too much counterparty risk floating around, which could be reduced, if not eliminated entirely by requiring those transactions be backed by collateral.
FINRA agrees. But if the TMPG’s recommendations were difficult enough to follow, then FINRA’s proposed rules are even harder to stomach, according to what C-level operations and internal counsel at five of the US’ largest broker-dealers tell FinOps Report. They spoke on condition of anonymity as they have yet to file their comment letters with FINRA, which has extended the deadline from February 26 to March 28.
The self-regulatory organization overseeing the entire US broker-dealer community is requesting feedback for its stricter set of practices for how TBA (to-be-announced) and other asset-backed transactions with a “long” settlement cycle — either more than one day or over three days — must be collateralized. That’s just about every trade based on the standard monthly settlement cycle of TBAs.
The common beef: “FINRA has really limited our flexibility in negotiating with fund managers,” one general counsel at a large New York brokerage tells FinOps. “While it might sound ideal to come up with rules, we can no longer negotiate with our counterparties as much as we would like to.”
What it means in practical terms is that not only would broker-dealers have to negotiate collateral requirements for new trades in a hurry, but they must also go back to their fund manager clients and renegotiate their existing margin contracts. For the largest broker-dealers that could mean reviewing several hundred documents they just completed in time to fulfill the deadline for meeting the previous high-level guidelines set by the New York Fed’s committee.
What that means in financial terms is that broker-dealers might lose valuable customers. Having enough wiggle room to make exceptions on how much risk they absorbed, when to collect margin, and from which customers certainly went a long way to ensuring far happier fund manager counterparties.
What’s more, not all broker-dealers had to follow the TMPG’s guidelines. As noted in a previous article, its guidelines were only mandatory for primary dealers who had to attest to the New York Fed they would follow them. Naturally, fund manager clients of those primary dealers are keen to follow them as they don’t want to be shut out of the market by broker-dealers who refuse to do business with them. By contrast, FINRA’s new proposed rules, when effective, would apply to all broker-dealers under its jurisdiction. So it stands to reason, a lot more fund managers would also be affected.
Broker dealers are already worried that fund managers will abandon the TBA and similar asset-backed deals in favor of other financial transactions with far less rigid margining guidelines. That’s even though the TMPG was pretty lenient in not imposing any specific guidelines beyond recommending that trades be margined. Not so with FINRA’s far more detailed changes to its current Rule 4210.
Here are just five key new restrictions FINRA wants to impose which broker-dealers dread the most.
US$250,000 Threshold for Counterparty Exposure: If a broker-dealer’s exposure to a fund manager or any counterparty for an individual deal comes to more than $250,000 it must collect variation margin.
Sounds like a reasonable figure — and is a defacto industry standard for many US broker-dealers when it comes to other asset classes besides TBA and collateralized mortgage obligation deals. But broker-dealers say they sometimes make exceptions — particularly for their largest most lucrative fund manager and other counterparties.
“Our exposure to some of our biggest clients exceeds that figure so we would have to go back and tell them we will require margin,” says one operations manager at a New York brokerage firm. “They are not going to be happy.”
Likewise, broker-dealers might want to impose a threshold of under US$250,000 for some high risk-customers. “The previous flexibility in threshold went both ways. So now we have to penalize our safe low-risk customers and reward our unsafe high-risk customers,” says the general counsel for the same New York brokerage. “You gotta be kidding me.”
Five Days to Liquidate: Broker-dealers dealing with fund managers who fall under the category of “exempt” parties don’t have to worry about maintenance margin. But the broker-dealers will be required to mark-to-market the trade each day and collect variation margin if necessary. If a broker-dealer doesn’t receive the necessary variation margin from an exempt fund manager counterparty within five days from the date a mark-to-market loss was calculated, the broker-dealer will have to immediately liquidate the trade.
Broker-dealers dealing with non-exempt fund managers must collect maintenance margin equal to two-percent of the market value of the securities affected. They must also collect variation margin within five business days from when they calculated a potential market loss. If their fund manager counterparty doesn’t meet that timetable, the broker-dealer must likewise immediately liquidate the trade.
Anyone faced with unwinding a trade, knows it takes an army of compliance, legal, operations, credit and risk management experts to do so. Broker-dealers who spoke with FinOps did say they have unwound these trades — but over a fifteen day timetable, not five days.
FINRA will allow broker-dealers to seek extensions to the liquidation period, but broker-dealers tell FinOps it’s not worth the effort. “Have you ever gone to FINRA to ask for an extension on anything?” says one general counsel at a New York brokerage. “Fuggetaboutit.”
One day to collect: FINRA says broker-dealers have just one day to collect on a margin call or they must take a charge to their net capital. One day sounds like enough time, right? Not exactly, when dealing foreign customer with their own holiday schedules.
Like many Asian nations, the Japanese have a host of holidays that don’t match the Western markets. An example is Golden Week — which will cause US broker-dealers plenty of angst. In 2014 Golden Week is celebrated on April 29, May 3, May 4, May 5 and May 6. With the exception of May 3 a Sunday, the rest of the days are weekdays.
So what’s a US broker dealer to do? Quipped one operations manager at a brokerage firm, “Trying to do business with Tokyo [during Golden Week] will be like trying to reach someone on a US space shuttle. Good luck.”
Rules for Exemptions: FINRA does allow for exceptions to its proposed rule that maintenance margin must be collected for TBA and other asset-backed deals. But broker-dealers can’t grant a fund manager an exemption just because they want to. In a footnote to its new proposal, FINRA says that broadly speaking exempt accounts include FINRA members, non-member registered broker-dealers, designated accounts and persons meeting certain specified net worth requirements and other conditions. The designation of exempt will depend on the underlying beneficial ownership of the assets. Subaccounts managed by a fund manager won’t count as single owner. Each subaccount will be treated individually.
While the criteria sound like what FINRA already imposes for exemptions to margining for other asset-classes, broker-dealers are still peeved. To prove they exempt the right fund managers, broker-dealers will have to go back to their fund manager customers and ask for the documentation all over again. “It’s going to be a pain in the neck,” says one legal expert at a New York brokerage firm, “and a lot of extra work for the fund managers.”
Flexible collateral types: Apparently the one category in which FINRA did grant flexibility isn’t the one broker-dealers would have chosen. FINRA said that fund managers could use other types of assets to collateralize their “covered agency” trades besides cash and US Treasuries. Broker-dealers can no longer demand the most liquid collateral. FINRA doesn’t demand broker-dealers accept other types of collateral: they “may accept” is the exact wording in the proposal. But fund managers will likely interpret the leeway to their advantage.
“That makes our collateral management process a lot harder,” says one fixed-income operations manager at a New York brokerage firm. “There are different haircuts we must recode into our systems.”
Just what do fund managers think of FINRA’s new proposal? They are still absorbing the TMPG’s recommendations, they tell FinOps. They haven’t even begun to digest FINRA’s proposal which directly affects only broker-dealers.
The one thing fund managers know for sure: They will be negotiating brand new collateral contracts with broker-dealers. FINRA estimates that about 30 broker-dealers who don’t currently clear their TBA and other affected asset-backed deals through Mortgage Backed Securities Division of Depository Trust & Clearing Corp.’s subsidiary Fixed Income Clearing Corporation will be affected the most by the new proposed rules.
“It’s just a big headache for everyone,” says one vice president of operations at a US fund management shop. “Everything works just fine now.”
Ditto, says the sole respondent to meet FINRA’s initial deadline for feedback for its proposed margining rules.”I have been working with these types of institutions [banks, credit unions and savings banks] for over thirty years and have never had a client fail to take deliver of either an MBS [mortgage-backed security] or CMO [collateralized mortgage obligation] for regular delivery whether TBA or specified pool or tranche that they are committed to,” writes Peter Badger, an executive director at Morgan Stanley’s fixed-income unit in Houston in his heated comment letter to FINRA, dated February 7.
Badger added that the self-regulatory authority shouldn’t penalize active buyers of lower-risk tranches involved in the MBS or CMO deals just to protect the market from “unregulated” buyers and sellers. So let’s forget about requiring margin for those market players even if their trades settle in thirty days. They don’t need it.
FINRA’s request for comment on the proposed change to Rule 4210 included a list of topics on which it wants feedback – including the potential damage to liquidity and possible loss of business for regulated broker-dealers.Based on what FinOps heard from broker-dealers active in the TBA market, FINRA can expect an earful.
There are some solutions out there for small and mid-sized firms, but I agree that many of them lack the infrastructure to deal with the margin process. But in our experience with our clients, they are managing.
I have been an MBS/CMO portfolio manager for 25 years. In that time, I have never experienced or seen a counterparty problem.
I cannot imagine that the regional and mid-sized firms will have the infrastructure to accommodate the credit, legal, and operational issues and expenses implied by the TMPG and FINRA requirements. Beyond that, I don’t think clients will react well to the aggravation of the legal and documentary issues. What I fear is that clients will just forego the mortgage sector, and allocate those assets elsewhere. And that will result in smaller firms just closing down their MBS desks.
From my perspective, this is a case of larger money managers along with the big primary dealers seeking a universal solution to a problem that affects no one but them, with the not-coincidental benefit of squeezing the smaller guys out of the business.