With less than 100 days left before new Rule 4210 of the Financial Industry Regulatory Authority becomes effective, broker-dealers aren’t the only ones that should be preparing for new margin requirements for to-be-announced (TBAs) transactions and other forward settling fixed-income trades. Even if indirectly, investment management firms will also be in the regulatory crosshairs.
Time is running out for compliance, operations and technology managers at investment management firms to be ready, and the workload is significant. The terms of their legal contracts need t0 be reviewed, as well as their collateral management procedures and applications. Managers will likely have to change their standard master securities forward trade agreements (MSFTAs) developed by the Securities Industry and Financial Markets Association. Ultimately, portfolio and trading managers will have to decide whether to keep their executing brokers or find new ones.
Effective on June 25, FINRA’s Rule 4210 applies directly only to broker-dealer members. However, buy-side firms are still responsible for posting the correct initial and variation margin with their broker-dealer counterparties. That is unless they meet FINRA’s criteria for exemption from either both types of margin or only variation margin.
Initial margin, also called maintenance margin, refers to the collateral posted before the trade is executed based on two percent of the contract value of the trade. Variation margin — often called mark-to-market margin — is additional margin based on the day-to-day changes in the value of the TBA transaction, which may be required.
For many fund managers, FINRA’s new rule represents a significant change from their current margin practice. They may have been using MSTFAs, which are based on the less stringent recommendations of the Federal Reserve Bank of New York’s Treasury Market Practice Group released in 2012. Those called for the use of two-way variation margin only.
Now FINRA wants broker-dealers to collect both initial and variation margin from their counterparties, when dealing with trades processed outside of the Mortgage-Backed Securities Division of the Fixed Income Clearing Corp., a subsidiary of the Depository Trust & Clearing Corp. (DTCC). When entering into TBA transactions with each other, broker-dealers that are members of the MBSD already collateralize those trade based on the MBSD’s requirements.
FINRA’s Rule 4210 allows just five days for broker-dealers to receive variation margin from investment manager counterparties before they have to make a call — or request– to unwind or liquidate the trade. However, the broker-dealer can ask for an extension to the five-day timetable, if it cannot quickly agree with its fund manager counterparty on on the amount of the variation margin .
Relief from FINRA’s margin requirements won’t always be easy for investment managers to win. It will depend on either the fund’s legal classification or its financial circumstances. “FINRA will expect broker-dealers to ask their investment manager clients for the correct paperwork to substantiate their status for an exemption from variation and/or maintenance margin requirements,” says Nihal Patel, an attorney with the law firm of Cadawalder, Wickersham & Taft in New York. “A few types of counterparties — such as sovereign funds and small accounts — will be excused from posting margin altogether. However, most funds will likely still need to post variation margin.”
FINRA will allow any counterpary, including a fund, to be exempt from having to post margin to a broker-dealer if the value of its open position with the broker-dealer is less than US$10 million and the TBA trades are “regularly settling” on the same month or the month after the trade is executed. The small account exemption does not apply to accounts that use dollar roll and/or robin trades.
FINRA offers a laundry list of factors that the broker-dealer can take under consideration to avoid collecting variation margin. Those include proving the underlying fund client has a net worth of US$45 million and financial assets of at least US$40 million. To show that is the case, the investment manager must give the broker information on the underlying fund’s ownership, business operations and financial conditions including current audited statements and income statements.
“Investment managers and broker-dealers will be wrangling over what type of documentation the manager must provide on behalf of their client,” predicts Andrew Cross, a partner with the law firm of Perkins Coie in Washington DC who specializes in registered investment managers. “Broker-dealers might insist on more paperwork to be satisfied it has met FINRA’s due-diligence requirements.”
Investment managers, believes Cross, may have a harder time asking for audited financial statements from institutional separate accounts — such as corporate accounts — if there are a large number of clients or if a client does not provide the manager with enough due-diligence information. In the end, the negotiation of what documentation to provide could come down to how eager the manager is to do business with a particular broker-dealer and how much the broker-dealer is willing to budge.
In addition to obtaining an exemption based on regulatory or financial status, investment managers can also avoid sending the broker-dealer variation margin if the variation margin falls at less than US$250,000. However, FINRA gives broker-dealers some leeway to reduce the threshold for requiring variation margin. Some broker-dealer operations managers tell FinOps Report that the figure will likely be closer to US$100,000 for higher-risk clients.
Determining whether or not to send variation margin based on the US$250,000 threshold is not necessarily as easy as it sounds. The margin is not based on an individual transaction, but an entire portfolio of trades. Net forward exposure is the determining factor, and there could be a difference in interpreting what that means.
“The investment manager and broker-dealer will need to work out whether the figure will be calculated to include trades that settle on the day the variation margin is calculated,” say Cross. Some broker-dealers will want to exclude trades which settle on the day the calculation is made, while others want to collateralize variation margin to include settled trades. The reason, brokerage operations managers tell FinOps, is that some of their systems can’t calculate variation margin to include settled trades.
Of course, fund managers must always verify that the variation margin calculated by the broker-dealer matches its own calculation. “It comes down to compute, control and comply,” says Tom Miller, managing director of Matrix Applications, a New York firm offering margin applications for TBAs. “The fund manager has to compute the variation margin, and control the workflow to comply with its contractual requirements.”
Fund managers face a technology decision for margin calculations. They may decide to build a platform in house, tweak a current platform to accommodate TBAs, use a dedicated third-party platform or outsource the collateral management process to a third-party, namely a custodian bank. Miller predicts that, even if a fund manager outsources to its custodian bank the process of transferring collateral to broker-dealers, it will likely want to do all of the margin calculations in-house.
Simply posting collateral at the right time to meet contractual obligations with broker-dealers is just the tip of the iceberg in what fund managers will need to do. Ensuring that right type of collateral is available will be an even bigger challenge.
“Fund managers will need to incorporate the collateral requirements of TBAs into their broader collateral management programs to ensure that they can optimize their use of collateral over a broader range of products,” says Mike Airey, vice president of strategic solutions at operations outsourcing giant Broadridge Financial in New York. The firm has incorporated the new margin requirements for TBAs into its securities finance and collateral management platform.
Collateral optimization requires knowing how much collateral is available, when it is available and where it should be delivered. It also requires the fund management firm’s back office and IT department to electronically translate the terms of contracts with broker-dealers into a rules-based workflow that takes into account any exemptions allowed by FINRA, the inventory of available collateral and the cost of using the each type of collateral.
Large fund managers may take a holistic approach to margin requirements through a single centralized process which takes into account all of the margin requirements for all collateralized transactions. By contrast, smaller ones might still be relying on a siloed process based on business line, or even using spreadsheets.
Whatever collateral management system is used for TBAs, testing is a good idea before the rule comes into effect. The goal is to reduce the potential for errors — either missing a margin call or over-collateralizing a transaction.
“It’s time for fund managers to set up a firedrill if they haven’t done so already,” recommends Mary Kopczynski, founder of 8of9, a New York-based regulatory technology solutions firm. “Take your last month of TBA trades and figure out which ones have triggered the need to collect collateral. Then calculate the margin call for each scenario and make certain your figures match those of the broker-dealer.”
Of course, setting up a firedrill presumes that fund managers have already completed testing the functionality of their collateral management system. If they don’t have one, they will need to set up a back-up plan — likely manual processing.
Legal and operational work aside, investment managers trading TBAs will have some client handholding to do. “Not every fund has been paying attention to FINRA Rule 4210. Some might feel upset or blindsighted when a margin call is made,” explains Kopczynski.
“Client management teams must be prepared to explain Rule 4210,” she adds, “and arm each fund with a basic understanding of how margin will be calculated and what will happen if a request must be made for an extension to the five-day deadline.”
Compliance and risk specialists also caution that investment managers will need to be aware of the ramifications of FINRA Rule 4210 far beyond meeting margin requirements. Best execution obligations will also be affected.
“Because TBA transactions will now have to be collateralized, fund managers will need to incorporate the cost of the collateral requirements into their decision-making process as to whether to retain or eliminate a brokerage relationship,” says Joanna Fields, principal at Aplomb Strategies, a New York-based consultancy specializing in regulatory compliance. “If they decide to reduce the number of brokerage relationships, they will have to document why they are concentrating their transactions with fewer brokers.
Such a change, cautions Fields, could also impact calculations of counterparty risk and liquidity risk. “Risk managers and portfolio managers will need to create new models for risk metrics to incorporate the collateralization of TBAs,” says Fields.
The obvious easy solution– adding more executing brokers– could reduce the need to post either initial or variation margin. However, doing so isn’t always practical. Investment managers would have far more administrative work to do to keeping track of of TBA transactions with more broker-dealers.
Yet another solution that some investment managers are already considering: transferring their TBA execution business to a non-FINRA member broker-dealer, such as a bank. “Fund managers will have an easy time convincing their client funds that they can switch to trading with a non-FINRA counterparty,” says George Bollenbacher, a partner at Capital Markets Advisors Group, a New York based firm specializing in risk management and regulatory compliance.
“The fund manager will not only avoid having to address FINRA’s margin requirements, but might also end up with better execution pricing than the FINRA-member firm,” he says.
Why? It is virtually impossible to close out a position in a marginable transaction with anyone but the firm an investment manager has opened an account with. A FINRA member-firm dealer can take advantage of the fact it has a captive client when calculating the sell price.