Fund Managers Tell Off US FINRA on TBA Margin Rules

Fund managers are up in arms about new rules proposed by the US Financial Industry Regulatory Authority (FINRA) requiring the collateralization of many US-forward- settling agency mortgage-backed securities transactions, or those of similar asset classes, and their potential quick liquidation trades in a worse case scenario.

While FINRA has direct oversight only over US broker-dealers, when it comes to the TBA market, the regulatory agency’s rules will still have a direct impact on fund managers because of the role they can play. Most business in the TBA market takes place between a handful of large broker-dealers and banks and trades are processed through a clearinghouse, but in some cases asset managers may be the counterparties.

FINRA has added more specifics to the voluntary guidelines established by the Treasury Market Practices Group (TMPG) of the Federal Reserve Bank of New York in late 2012 and set to be implemented as of January 2014. However voluntary they may be called, many broker-dealers — outside the realm of primary dealers — and their fund manager counterparties  saw them as competitively unavoidable, as noted in an article published on FinOps Report on February 18, before FINRA released its proposed new rules. 

Compared to the TMPG guidelines, FINRA appears to be far more rigorous in dictating how much margin should be used, when it will be required, and when trades need to be liquidated. That has fund management firms and trade groups representing them — such as the Investment Company Institute (ICI) and Asset Management Group of the broker-dealer organization Securities Industry and Financial Markets Association (SIFMA) — concerned about whether they will be able to continue trading in the products given the operational cost of changing from the status quo. So are broker-dealers.

Until now, bilateral trades — those conducted between fund managers and broker-dealers in so-called TBA trades outside the confines of a clearinghouse — didn’t have to be collateralized. If they were, the counterparties negotiated between themselves just how the margining would take place along with other terms for what would occur in the event of a default on a payment. Trades between broker-dealers and banks must be collateralized if they are processed through the Mortgage-Backed Securities Division (MBSD) of the Fixed Income Clearing Corp. (FICC), which acts as a central counterparty or middleman, so FINRA has opted to exempt them from its new proposed rules. The FICC is a subsidiary of US market infrastructure Depository Trust & Clearing Corp.

In the case of so-called bilateral, or uncleared trades, the New York Fed’s operations-focused TMPG is concerned about the potential of a trading partner going bust or defaulting on its obligations between the time the details of a TBA or similar trade are ironed out and the time of settlement. Many of these agency mortgage-backed transactions are settled on extended timetables as long as thirty days after they are executed, thus the designation of “to be announced” or TBA.  This long settlement time leaves plenty of room for a potential financial disaster which FINRA fears could ultimately spread from just one or two to hundreds of other unrelated market players.

Here are the five most significant changes fund managers want FINRA to make to its proposed rules, as expressed in their comment letters. FINRA extended the deadline for feedback from February 26 to March 28. (As of the initial date only a Morgan Stanley employee had responded and that letter no longer appears on FINRA’s website).

Collateralize Fewer TBA Trades

Instead of requiring collateralization of all TBA trades with a settlement cycle of more than one day, FINRA should only require those settling on a timetable of more than three days to be impacted, according to the Washington, DC- based ICI, which represents the mutual fund market. The reason: the additional risk isn’t great enough to justify the extra expense and headache involved in modifying middle and back office systems. “Systems and resources must be prepared to communicate and respond to margin calls, reconcile possible disputes, and manage collateral flows and settlement,” explains the ICI in its letter to FINRA.

Likewise, Newport Beach, CA-headquartered fund manager Pacific Investment Management Company (PIMCO) says that FINRA shouldn’t rely on different minimum settlement cycles — over T+1 for TBAs, specified pool and adjustable rate mortgage transactions and over T+3 for collateralized mortgage obligations — to determine when trades should be collateralized. “A number of market participants are likely to be driven out of this investment or incentivized to transact with banks that are not FINRA members, thereby causing the market to become more consolidated among fewer players in reducing the liquidity of the TBA market,” says PIMCO in its letter to FINRA. PIMCO’s solution: either the settlement cycles that include the covered agency securities need to match the settlement cycles on the spot market for these securities (from greater than T+1 to greater than T+3) or the settlement cycles of the spot markets should be moved to match the settlement cycles that include covered agency securities.

Morristown, NJ-based Metropolitan Life Insurance Company (MetLife) recommends yet another barometer for determining which trades should be collateralized: only those with settlement dates that extend beyond the first standard settlement date set by SIFMA following the trade date for the transaction.

Change Margin Requirements

Fund managers shouldn’t be the only ones posting variation margin. TBA transactions involve two-sided exposures the same way future, options, swaps, repurchase and securities lending transactions do. What’s more, if variation margining is so important to reducing systemic risk, as FINRA claims, then FINRA should also consider protecting counterparties such as registered funds and mitigate their credit exposure to broker-dealers, says the ICI in its letter to FINRA.

In agreeing with the ICI’s stance, the Geneva office of alternative fund manager Brevan Howard Investment Products also cites the unintended effect of not requiring two-way variation margining: introducing liquidity risk by introducing “asymmetry” in the manner in which the trades are margined. “If TBAs are not subject to full two-way margining, a decline in interest rates could cause mark-to-market losses on interest rate swaps or futures, triggering variation margin payment requirements on those positions. At the same time, although the market participate has offsetting mark to market gains on the TBAs it would not receive variation margin with which to offset its variation payment obligations,” says the firm in its letter to FINRA.

The SIFMA’s AMG also wants FINRA to scrap its requirement for non-exempt fund managers — those which must meet its requirements — to post initial or maintenance margin on the grounds it would hurt smaller fund managers and managers of separately managed accounts (SMAs) by keeping them out of the market. The reason: asset managers might not be able to meet FINRA’s requirement for exemption because they can’t provide broker-dealer counterparties with all the financial information they need to grant them the exemption.

“TBA market participants should be able to liquidate and replace defaulted positions early and quickly with minimal risk of exposure to changes in the marked-to-market value of the securities that are the subject of the transaction,” says the AMG in its letter to FINRA. The regulatory agency wants its broker-dealer members to collect variation margin for all fund manager counterparties. However, non-exempt fund managers would also have to fork over maintenance margin to the tune of 2 percent of the market value of the securities subject to the transaction. If sufficient margin isn’t collected, the broker-dealer could quickly deduct the uncollected amount from its net capital.

Change Acceptable Exposure Level

Requiring a minimum amount of counterparty exposure before variation margin must be posted is a good idea. But setting the amount US$250,000 isn’t. “We don’t believe amounts below US$500,000 would result in significant build-up of current exposure,” says the ICI, noting the extra operational costs involved. Requiring broker-dealers to take a net capital charge with respect to customer exposure up to the minimum transfer amount also wouldn’t be practically feasible. Broker-dealers could decide to accept small amounts of variation margin, instead of suffering a hit to capital, the ICI reasons.

No Mandatory Close-Out

Broker-dealers shouldn’t be forced to liquidate a trade immediately if the fund manager counterparty doesn’t pay variation margin within five days of a margin call. Taking a charge to net capital would give broker-dealers enough incentive to collect variation margin from fund managers, says the ICI, which also cites fairness as a rationale for its stance. “Imposing a close out obligation only on broker-dealers fails to recognize the bilateral exposure inherent in covered agency securities,” says the trade group in its letter to FINRA. “Counterparties are exposed to the broker-dealer at all times, yet FINRA does not propose to impose a similar punitive action for accounts for which a broker-dealer has failed to post variation margin.”

SIFMA’s AMG also calls into question whether FINRA has any business telling broker-dealers when they should liquidate a TBA trade. “Whether to liquidate trading positions in the face of a counterparty failure to post margin is a business decision and should not be mandated by rulemaking,” says the organization in its letter to FINRA. “Depending on the nature of the relationship with the counterparty, the reason for the default, the likelihood of curing the default, the market for the collateral and the size of the position, there may be reasons for the non-defaulting party to refrain from or delay liquidating positions.”

Extend Compliance Timetable 

Requiring fund managers and broker-dealers to meet the new rules within six months after they are effective isn’t practical. Investment funds registered with the Securities and Exchange Commission will need a year to renegotiate triparty custodial agreements with their custodians and broker-dealers about the terms for holding and transferring collateral. Registered funds which are not authorized to post collateral will also need to win shareholder approval. Therefore, a six-month timetable will put fund managers in a precarious negotiating position with broker-dealers. “A short time period will result in dealers pressuring registered funds to sign agreements with unfavorable terms to complete the process before the compliance deadline,” says the ICI. SIFMA’s AMG is calling for an 18-month implementation timetable.

While all of the fund management firms responding to FINRA’s request for comment were clearly eager to ensure that fund managers are financially protected when doing business with broker-dealers for uncleared trades — those not processed through a clearinghouse — Brevan Howard wants the protection extended,  as well, to trades which are cleared through FICC’s MBSD unit.

“The status quo leaves customers at significant risk,” says Brevan Howard in its letter to FINRA. “Customer margin held at its clearing broker is unprotected, customer assets passed through MBSD are unsegregated and exposed to risk of the clearing broker’s losses. Customers receive no variation margin to protect against the clearing broker’s default and one-way margining creates the potential for liquidity stress unrelated to the health of the underlying portfolio.”

Here is the adjustment that the fund management firm proposes FINRA implement for trades cleared through MBSD: require FINRA members to maintain all excess customer margin in a triparty custody account and not hold this margin on their own books, require customer margin passed through the MBSD to be segregated, require FINRA members to provide their customers with variation margin when necessary.

A full view of all comments posted on FINRA’s website regarding proposed rules for TBAs can be found here.