The pleas of fund managers and broker-dealers for the Financial Industry Regulatory Authority (FINRA) to change proposed rules requiring the collateralization of agency mortgage-backed securities and other transactions are falling on deaf ears and time is running out.
The SEC is requiring that final comments on FINRA’s new proposal published last month be submitted by February 11. For the most part, the reproposal reflects only minor tweaks to a previous FINRA proposal, published in the Federal Register in October 14, 2015 with comments due by November 10.
Chances are that if FINRA has not made any substantive accommodations for industry players by now, it won’t. Based on comment letters submitted last year, fund managers and broker-dealers warn they will have too many operational difficulties implementing the new rules. As a self-regulatory agency for broker-dealers, FINRA must submit all proposed rules to the SEC for approval.
Although FINRA has direct oversight only over broker-dealers, its proposed Rule 4210 would also impact fund managers. Fund managers are sometimes counterparties to trades in TBA trades that are processed outside of a clearinghouse. Short for “to-be-announced” the TBA category includes adjustable rate mortgage, specified pool and collateralized mortgage obligations. These trades often settle up to 30 days after they are executed.
At the core of FINRA’s new Rule 4210 is for its broker-dealer members to require that fund managers post initial, otherwise known as maintenance, and variation margin when they enter into transactions in the TBA market. The impact on smaller firms is expected to be disproportionately large. “Smaller to mid-sized fund managers and broker-dealers will have to make adjustments to their technology, operating procedures and legal agreements,” explains Stephen Mellert, executive director of Matrix Applications, a New York technology firm offering margin applications for TBA trades for banks and broker-dealers.
FINRA’s proposed Rule 4210 codifies recommendations for margin made by the Treasury Market Practice Group (TMPG) of the Federal Reserve Bank of New York in 2012, in response to concerns that the long settlement cycle of TBAs introduced the potential for a systemic financial disaster if one of the counterparties went bust or defaulted on its obligations.
The TMPG’s recommendations and FINRA’s rules do not apply to TBA trades which are processed through a clearinghouse such as the Mortgage-Backed Securities Division (MBSD) of the Fixed Income Securities Clearing Corporation, a subsidiary of US market infrastructure Depository Trust & Clearing Corporation (DTCC). The majority of TBA trades are cleared through the MBSD, which has its own collateral rules and has membership of 80 banks and broker-dealers. At the time the TMPG issued its recommendations, it estimated that bilateral trades accounted for US$750 billion to US$1.5 trillion of the US$5 trillion TBA market.
Making Life Harder
Even those fund managers and broker-dealers which have been following the recommendations for margin made by the TMPG will find FINRA’s rules to be far more onerous. The TPMG did not recommend that fund managers be required to post maintenance margin, but it did say that both broker-dealers and fund managers should post variation margin. Ignoring the vigorous objections of some fund managers and broker-dealers, FINRA in its latest proposed iteration of Rule 4210 continued to insist that broker-dealers collect from fund managers maintenance or initial margin equal to two percent of the value of the trade.
FINRA gave lip service to the requests of fund managers and broker-dealers to allow two-way variation margin, suggesting it might consider the idea at a later date. “Creating a mismatch between FINRA margin standards and the TMPG best practice recommendations will lead to conflicting requirements, unnecessary compliance, build-out costs, confusion in the marketplace as well as economic differences between trading with a member and a non-member,” warned Timothy Cameron, managing director and Mathew Nevins, general counsel of the Asset Managers Forum (AMF) of the Securities Industry and Financial Markets Association (SIFMA) in a November 10. 2015 letter to the SEC. “One-way margin would disincentivize market players from entering into covered agency transactions because of lowering their risk-adjusted expected returns.”
Fund managers who think they can simply ask their broker-dealer counterparties to put up variation margin voluntarily had better think again, according to David Blass, general counsel of the Investment Company Institute, a Washington, D.C. based mutual fund group. “Broker-dealers possess significant market and bargaining power. This is especially true relative to smaller registered funds,” he said in his November 9 letter to the SEC. “Without a requirement for broker-dealers to post margin to their counterparties, registered funds will find negotiating for bilateral margining difficult and costly.”
In its latest proposal FINRA did retain its previously cited exceptions to margin requirements for what it calls “cash accounts or “small accounts.” Broker-dealers, says FINRA, won’t have to collect variation margin for transactions from cash accounts — a designation FINRA defines as being either accounts settled in the month the trade was executed or the following month regularly in cash, or accounts in which the fund manager counterparty has not engaged in dollar rolls, round robin trades or other financing transactions. FINRA is also reiterated that there would be a “small account” exemption for both maintenance and variation margin for fund management firms, which it defined as gross open positions of less than US$2.5 million if the settlement takes place in the month the trade was executed or the following month in cash or if the account isn’t related to dollar rolls, round robin trades or other financing techniques.
While broker-dealers and fund managers may have appreciated the exemptions, SIFMA insists that they are far too difficult to implement. “It is not always possible to identify whether a particular trade or group of trades is intended to constitute a dollar roll because, for example, the trades may not occur at the same time or even on the same day,” commented Mary Kay Scucci and Christopher Killian, managing directors of SIFMA in a November 10 letter to FINRA. They added that the term “regularly” is too subjective.
On a positive note, Daniel Budofsky, a partner with the law firm of Morgan, Lewis & Bockius in New York, tells FinOps Report that FINRA clarified that broker-dealers could be liberal in how they counted the number of robin-roll or other transactions which might eliminate the exemption for fund managers to post margin. One trade in those category could be overlooked. However, compliance directors at some fund management shops counter that the leeway makes them nervous. “We are left at the mercy of the broker-dealer to interpret the number and we would have preferred much more specificity,” griped the compliance manager of a US East Coast fund management firm.
FINRA did exempt from its maintenance margin requirements counterparties that fall under the category of federal banking agency, central bank, multilateral development bank or Bank for International Settlements. However, the self-regulatory agency ignored the requests of fund managers and broker-dealers to exempt sovereign wealth funds from that group as well as government-sponsored entities and US federal home loan banks from that category. FINRA also did not clarify whether collective investment trusts would be exempt.
When it came to increasing the threshold under which variation margin which must be collected by the broker-dealer, FINRA would not budge from its previously cited US$250,000 figure. Fund managers and broker-dealers had hoped broker-dealers could avoid needing to collect variation margin for any amount under US$500,000. “We do not believe amounts below US$500,000 would create excessive risk or result in significant build-up of current exposure,” said the ICI’s Blass. “Moreover, a minimum transfer amount that is set too low would result in more frequent transfer of collateral and increase the potential for operational risk. Frequent transfers of collateral also would increase transaction costs.”
Even worse for fund managers and broker-dealers: FINRA did not agree to their requests to extend the timetable for liquidation of positions by broker-dealers, if they don’t receive enough variation margin to cover a “deficiency” or potential financial loss. The five-day timetable FINRA wants is far too short, counter the AMF and SIFMA.
Ideally, the timing of liquidation should be left to the two counterparties to work out, say fund managers and broker-dealers. If FINRA insists on dictating the timetable it should be 15 days after the margin call is made as the TPMG recommended. There could be legitimate reasons a fund management firm can’t post variation margin quickly such as an administrative error or dispute over the amount which could easily take more than five days to resolve.
When does FINRA’s five-day clock kick in? Broker-dealers will typically send out a call notice for more margin as soon as it determines that the initial margin is “deficient.” If they don’t get it fulfilled on that day, they will likely have to take a net capital charge and if fund managers don’t meet that margin call on the day they receive it, the five-day clock starts ticking. SIFMA and the AMF said the timetable was not feasible and asked for a three-day window before the countdown to the possible liquidation of positions begins.
“Many market participants are just not operationally equipped to comply with same-day margining, even for standard domestic transactions,” cautioned the AMF’s Cameron and Nevins, noting the multitude of steps involved. “Requiring same-day margin is likely to result in an increase in processing errors, more disputes between parties and a greater likelihood of defaults by counterparties, without a commensurate corresponding benefit.” The potential for errors will be even greater for transactions with non-US accounts, said Cameron and Nevins, because of time-zone differences when converting foreign currency to US dollars and communicating with foreign custodians.
In their letter to the SEC, SIFMA’s Scucci and Killian also called “impractical” FINRA’s proposed timing for the net capital charge, noting that it differs from the SEC’s current rules that a capital charge is not required for uncollected margin until five business days after a call for margin. “Member firms and their counterparties have extensive operational and legal arrangements that are set up to work with the margin and capital requirements for securities transactions as a whole,” they said. “Modifying these requirements so that they operate on a product-specific basis would be a tremendous [operational] task.”
Shaking Up Contracts
If industry talk that the SEC will let FINRA adopt the rules it wants proves accurate, fund management firms and smaller broker-dealers had better get their compliance, operations and technology staff lined up for some mega changes. “For starters,” Budofsky tells FinOps, “fund managers and broker-dealers need to determine whether they are exempt from any of the margin rules and whether they need to change any contractual agreements to allow for collateral to be posted for TBA accounts.” Many industry players rely on “Master Securities Forward Transaction Agreements” which provide some guidance as to the legal language they can use.
Custodial agreements may also need to established or altered if a custodian bank is required to hold the collateral, as is the case with collateral for investment funds registered under the Investment Company Act of 1940. New account control agreements typically dictate where the collateral is to be located and how it would be transferred if necessary.
Even if only one of their accounts will need to post collateral, fund managers must establish operating procedures and technology within their middle office for verifying broker-dealer calculations of margin requirements and ensuring delivery within the timetable required by FINRA. The assumption that fund managers and broker-dealers already collateralizing swap deals could just automatically handle TBA trades is faulty, operations experts tell FInOps. Not all collateral management platforms can accommodate the operational requirements for TBAs.
“Fund managers must verify with the collateral management software providers that they can handle TBA and other transactions,” explains Mellert to FinOps. Otherwise, they will be forced to do a “workaround” — which likely means handling the tasks manually. Some collateral management experts advocate that fund management firms attempt to tweak their existing collateral management systems while others, such as Mellert, recommends using a dedicated platform. DTCC subsidiary Omgeo does offer a collateral management platform called ProtoColl which allows clients the ability to support the collateralization of TBA trades, but it could not be determined at press time just how many fund managers are using that application.