Margin Standards for TBAs May Edge Funds Out of the Market

Despite a six-month reprieve from collateralizing their US forward-settling agency mortgage-backed securities trades, many fund managers may be dismally unprepared for new margining standands, and shut out of the market.

The answer won’t come easy or cheap: either upgrading or installing collateral management systems will be required. Then comes the cumbersome process of redrafting contracts or writing new ones from scratch.    

At a recent conference about bilateral collateralization of so-called TBA trades, hosted by the US broker-dealer trade group Securities Industry And Financial Markets Association (SIFMA) , panelists acknowledged that compliance with new guidelines remains spotty at best. “The margining process in this space is new to many of our counterparties, and it is expected we will encounter some teething pains,” says Michael Rogozinski, executive director of fixed-income operations at Nomura Securities, who spoke at the SIFMA event.

The source of the fund managers’ dilemma is guidance issued in late 2012 by the the Treasury Market Practices Group (TMPG) of the Federal Reserve Bank of New York. The committee of operations experts at some of the world’s largest financial institutions recommended that as of June 2013, buyers and sellers of US forward settling agency mortgage-backed securities, otherwise called “to be announced” or TBA trades, collateralize their transactions and sign documentation outlining how each counterparty will be made whole in the event of a default or bankruptcy of the other. The timetable for “substantial” completion of the necessary readiness for compliance was later postponed to December 31, as buy- and sell-side firms alike clamored they needed more time to prepare legally and operationally.

But even such a delay might not be enough. “What [preparations] the Fed says should take twelve months to complete could take fund managers at least two or three years to do,” warns Joseph Kohanik, chief executive of Alpha Financial Software, a Boston-based software firm specializing in clearing and settling TBAs.

“At issue for fund managers is how to change dozens of agreements with broker-dealers and implement the correct collateral management workflow,” explains Ted Leveroni, executive director of derivatives strategy for post-trade communications shop Omgeo, which last year upgraded its ProtoColl collateral management system to accommodate margining for TBAs. “Larger fund managers tell us they are already compliant, while smaller ones are still hard at work.”

No one can clarify just what the TMPG meant by “substantial” completion, nor can anyone quantify what percentage of fund managers are still not up to snuff, but it is clear that broker-dealers have some tough decisions to make on whether or not they want to cut off non-compliant buy-side firms. In making its recommendations, the TMPG never discussed just how broker-dealers should handle fund manager counterparties who cannot follow the guidelines.

Pressure Mounts

Although the guidelines are not legally binding, practically speaking, fund managers wanting to do business with the Fed’s primary dealers will need to comply. “We don’t have any alternatives and are being pressured by our broker-dealers to renegotiate our contracts and automate our collateral management procedures for TBAs or they will cut us off,” bemoans an operations manager at a New York fund management shop.

His stance was shared by five other fund managers contacted by FinOps Report as well as Kohanik. “For many smaller firms it could mean they are cut out of the market, until they can get broker-dealers to renegotiate their contracts,” he warns.

Nomura’s Rogozinski would not specify his firm’s policy, but acknowledges decisions will be made on a firm-by-firm basis through some tough talks with the legal, compliance and credit risk departments. “Primary dealers will need to attest to the New York Fed they are following the TPMG’s recommendations and will need to be comfortable with that stance, should they decide not to accept collateral from some fund managers,” he says. That certification requires primary dealers, such as Nomura, to have policies and procedures to comply with the TPMG’s recommendation and to test those policies and procedures.

Making the potential for being shut out of the TBA market a likely scenario for fund managers is the prospect that the Financial Industry Regulatory Authority (FINRA), the self-regulatory agency for broker-dealers, may well require broker-dealers under its oversight to comply with new rules for the margining of TBA trades. Panelists at the SIFMA event couldn’t specify the timetable for the new rules, but insist they will likely be far more detailed than the TMPG’s recommendations in requiring a specific threshold of counterparty risk to trigger margin calls and minimum values of collateral which must be transferred between counterparties should margin calls be required.

“A good chunk of the broker-dealer market falls under FINRA’s rules, so they will be affected,” says Caroline Monroe-Koatz, managing director and associate general counsel for JP Morgan Securities, who spoke at the SIFMA event. Such rules will likely require broker-dealers to amend their agreements with fund managers twice — once to accommodate the TPMG’s recommendations and yet another to address FINRA’s rules.

Just what effect potentially reduced participation from fund managers will have on the TBA market remains to be seen. Panelists at the SIFMA event acknowledged there had been a small reduction in liquidity, but were hesitant to attribute that to non-compliance with the TPMG’s recommendations. Instead, they speculated it could well have come from the recently enacted requirement for reporting of mortgage-backed securities on the FINRA-operated TRACE system or the reduction in mortgage origination.

Many trades in US agency mortgage-backed securities are not settled in the usual few days, but take at least one month after the deals are struck between counterparties, hence the nomenclature TBAs. Such a lengthy timetable increases the prospect for financial loss should one of the two partners go bust. Counterparty risk could be mitigated, if not eliminated, for the two parties and others in the market should adequate margin be used, said the TPMG, warning that anywhere from US$750 billion to US$1.5 trillion of the US$5 trillion mortgage backed market is represented in TBA bilateral trades. Those are “over the counter” trades conducted outside the processing requirements of the Mortgage-Backed Securities Division (MBSD) of the US Fixed Income Clearing Corp, where margin must be posted.

Hence, the 86 bank and broker-dealer members of the MBSD will have already met the TMPG’s recommendations. Not so for fund managers which represent the bulk of bilateral trade volume. Fund managers cannot become direct members of the MBSD; only individual investment funds can and so far only four have been able to meet the stringent risk management requirements.

Panelists at the SIFMA event said that the MBSD had considered setting up a separate default fund to service fund managers in the TBA market handle their counterparty risk, but that scenario fell short of assuming counterparty risk and was abandoned after failing to win sufficient industry support.

Legal Quagmires

In lieu of participating in the MBSD, fund managers wanting to comply with the TMPG’s requirements must adjust — or in many cases implement for the first time — legal agreements related to collateralizing the transactions.  They can make use of the initial Master Securities Forward Transaction Agreement (MSFTA), published by SIFMA in 1996 . But that agreement is pretty flexible in allowing for either one-way, bilateral or even no margining whatsoever, so there is plenty of room for wrangling. “Fund managers might not agree on the type of collateral the broker-dealer wants or how it is to be valued,” explains Omgeo’s Leveroni. “Broker-dealers might favor cash, but fund managers will likely prefer other types of cheaper collateral.”

Rearranging contracts with broker-dealers is just one of three potential hurdles. Yet another one is that fund managers which are registered with the Securities and Exchange Commission under the rules of the Investment Company Act of 1940 are not allowed to post margin with broker-dealers. They can only do so through their custodian banks, which in turn will set up such margin accounts under the name of the individual fund for the benefit of the broker-dealer, otherwise known as the secured party or “pledgee.” Therefore, fund managers must set up so-called account control agreements (ACAs) with their broker-dealers and custodians dictating the conditions under which their custodians can move collateral to broker-dealers on their behalf. Broker-dealers attending the SIFMA gathering told FinOps Report they were having plenty of difficulty in signing up 1940 Act-funds for ACAs to collateralize TBA transactions. “Fund managers are often resistant to providing details of where the collateral was located and exactly how it would be transferred when necessary, but we think that’s a minimum requirement for us to sign such ACAs because the collateral is posted away from us, ” said one fixed-income operations specialist at a large New York brokerage.

Last but not least, fund managers must rework private client agreements. “Each underlying fund managed by a fund manager has specific requirements for managing assets and most mandates say that all monies be put to work at all times or fully invested,” says Kohanik. “If cash needs to be readily available to use in the event of a margin call, the manager will need to sell securities quickly, which could impact portfolio performance. The alternative: Until fund managers work out details of their mandates with each of their clients, they might want to limit their investment in mortgage-backed securities transactions to those with standard settlement cycles, warns Kohanik.

Deciding which collateral to use and when involves workflow management that is far too complicated to be handled through Excel spreadsheets. “Fund managers will need to decide whether they will want to rely on a more comprehensive generalist platform, which can be upgraded to accommodate TBAs, or whether they will want to depend on a TBA specialist system,” says Leveroni. “Yet another alternative, outsourcing the TBA margining process to a custodian bank.” Among those custodians working on such initiatives, say industry sources, are BNY Mellon; JP Morgan and State Street.

TBA technology specialists, such as Kohanik, naturally advocate relying on a dedicated platform which can add functionality. For any firm that has an existing mortgage-backed securities clearance and settlement software tool, it won’t be much of a stretch to add additional functionality rather than implement a heavy-duty collateral management system for a single asset class. Alpha Financial  is upgrading its TBA Mortgage Master application to allow firms to margin their TBAs daily and address margin calls. “Many firms have margining systems and only need to mark-to-market data to provide an end-to-end solution,” says Kohanik.

Leveroni counters that fund managers will do better relying on a more comprehensive collateral management system. “We have more experience in helping firms managing their broader collateral requirements and breaking down silos of collateral management and fostering more efficient centralized risk management,” he says. “Specialist providers want to keep those silos intact.”

Broadridge Financial Solutions says that it is providing broker-dealer customers with reports on their TBAs through its fixed-income back-office system IMPACT, but the firm is clearly aware of the opportunity to expand its reach into the buyside.  “It’s an area we are evaluating,” says Michael Hopkins, president of securities processing solutions for fixed-income and risk at the New York-headquartered operations outsourcing giant.

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