Asset managers and broker-dealers will have to revamp some of their relationship terms, as well as those with the underlying investors, to meet the pending margin requirements for to-be-announced (TBA) transactions and other forward-settling fixed-income transactions.
Panelists and attendees at a recent afternoon conference held by the Securities Industry and Financial Market Association about the Financial Industry Regulatory Authority’s new Rule 4210, bemoaned the legal and operational challenges facing buy- and sell-side firms. They will have to agree on whether maintenance and mark-to-market margin must be posted and how much. If fund managers don’t meet a margin call — seeking more collateral– quickly enough, they risk having the trade liquidated by the broker-dealers. Maintenance margin refers to initial margin at the time the deal is struck, which comes to about two percent of the contract value of the trade. Mark-to-market margin is the subsequent variation margin reflecting the consistent repricing of the TBA trade due to market changes.
The margin requirements for TBAs and other fixed-income transactions under the amended Rule 4210 represent the most hotly-debated aspect of the new requirement, effective on December 15, 2017. Effective December 15, 2016, the other part of the new rule requires broker-dealers to include TBA and other forward-settling fixed-income transactions when establishing risk limits with counterparties. Broker-dealers typically do that for other securities transactions as a matter of good risk-management practice. As the self-regulatory agency for broker-dealers, FINRA’s rules apply strictly to all of its members, but they have a trickle-down effect on any counterparty a member does business with.
If calculating margin correctly for TBAs and similar transactions sounds hard enough, handling contractual obligations will be even harder. “I anticipate that fund managers and broker-dealers will need to spend a lot of time reassessing and renegotiating their relationships, starting with determining who must post margin under the new rules and who can be exempt,” says Nihal Patel, an attorney in the financial services group of Cadawalder, Wichersham & Taft in New York.
Asset managers and broker-dealers have been debating the nitty-gritty details of changes to FINRA’s amended Rule 4210 for at least two years. Now, with the US Securities and Exchange Commission approving the final version of the amended regulation, the rubber hit the pavement. For small to mid-tier asset managers and broker-dealers, the new rule represents a dramatic departure from the current practice of either not collateralizing transactions, or relying strictly on variation margin.
Larger asset managers and broker-dealers will also need to adjust their policies and procedures because they were likely using contracts based on the recommendations of the Federal Reserve Bank of New York-sponsored Treasury Market Practice Group (TMPG) made in 2012. The recommendations, effective the following year by , called for two-way margining — both the fund manager and broker-dealer posting mark-to-market margin. No maintenance margin is required. FINRA’s rule is not explicit on whether two-way margin is required, but does requires one-way margin, if necessary.
Trades in US. agency mortgage-backed securities differ from other financial transactions in that they are typically not settled until at least one month after the deals are struck, instead of three days. Hence, the nomenclature TBAs. Such a lengthy timetable increases the potential 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, according to the TMPG.
Like the TMPG’s recommendations, FINRA’s amended rule applies to trades conducted outside the processing requirements of the Mortgage-Backed Securities Division (MBSD) of the US Fixed Income Clearing Corp. (FICC), which requires margin to be posted. The bank and broker-dealer members of the MBSD have already met the TMPG’s recommendations. Not so for fund managers that represent the bulk of bilateral trade volume in TBAs and similar financial instruments. Fund managers cannot become direct members of the MBSD. Only individual funds can and so far only a handful have been able to meet the MBSD’s stringent risk management requirements.
FINRA does give asset managers a break from either posting either maintenance margin or both maintenance and mark-to-market margin under certain circumstances, which include the legal designation of the fund manager and the value of the trade. However, those exemptions are causing plenty of angst for broker-dealers who are worried about the potential for legal liability if they don’t obtain margin when they should have.
“Because broker-dealers have no access to underlying fund clients they will have to rely on information received from asset managers about each of their fund clients,” says Mary Kopcyzinski, chief executive officer of regulatory solutions firm 8of9 Consulting in New York. “FINRA says they are allowed to rely on representations from their asset managers, but because broker-dealers will be on the hook for any mistakes, it is likely they will take a conservative approach and always ask for margin. Everyone will be treated as non-exempt and the burden of proof for being exempt will be very high.”
Asset managers clearly don’t want to assume any legal liability. Nor do they want the hassle of proving they are exempt because it will mean a lengthy fact-finding process with their customers. One potential solution: split the difference. “Asset managers already provide significant client information to dealers, who can use that data to make their determinations, says Donald Caiazza, senior legal counsel of the fixed-income division at Fidelity Asset Management in Boston. “This is why we think the possibility for ensuring the accuracy of the information should be divided between broker-dealers and aset managers.”
Robert Mendelson, senior advisor for risk oversight and operational regulation at FINRA, acknowledges that the regulatory agency has not decided whether a representation made by a fund manager about a fund’s exemption from margin requirements can be relied upon by a broker-dealer to avoid a penalty in the event of an error.
One of the most troublesome aspects for broker-dealers in granting fund managers exemptions from maintenance margin is how to prove the fund manager “regularly” settles transactions in a “delivery versus payment (DVP)” basis and that all of the outstanding contracts with the counterparty have an absolute dollar value of less than US$10 million. DVP settlement. The exchange of cash for securities at the time of settlement occurs in a minority of TBA trades. Most are rolled-over or extended.
“FINRA has not clearly defined what it means by regularly,” says Kopcyzinski. “Therefore, it will be difficult for fund managers and broker-dealers to come to terms over whether an exemption applies.” Says another broker-dealer operations manager, “I have no clue about what we are going to do with the term regularly other than ignore it, so it won’t apply.”
Mendelson counters that FINRA has clearly defined the term regularly settle. “FINRA’s members may use the customer’s history of transactions with members as well as other relevant information. Members should be able to rely on the reasonable representations of their customers, when necessary,” he says.
The MTA Debate
Yet another difficult aspect of new Rule 4210 is the need to collect the full amount of mark-to-market margin over US$250,000. Broker-dealers can wave their right to collect mark-to-market margin if the amount is less than the US$250,000. It sounds like a reasonable figure, but broker-dealers have often made exceptions for their largest fund manager clients. They wanted a far higher minimum transfer amount (MTA) and FINRA no longer gives them that option.
Mendelson defends the US$250,000 figure. “The MTA is a common concept in the marketplace designed to eliminate operational problems related to daily small flows. The number was selected so as not to provide an advantage to any one type of firm, large or small,” he says.
However, broker-dealers argue that the amount of MTA creates operational difficulties in the event of a disagreement over mark-to-market margin which could be by as little as one thousand dollars. What happens if the fund manager believes it owes only US$249,000 in mark-to-market margin while the broker-dealer thinks it owes US$251,000?
If the broker-dealer doesn’t receive the necessary variation margin from a fund manager counterparty within five days after a margin deficiency is discovered, the broker-dealer will have to immediately liquidate the trade. Margin calls — or requests for more margin — are typically made on the day a deficiency is found. Unwinding a trade can take a legion of compliance, legal, operations, credit and risk management experts. Five days of leeway in meeting a margin call from the time it is made is also far cry from the current 15 days that FINRA allows for other fixed-income transactions under Rule 4210.
Mendelson says that FINRA will allow broker-dealers to ask for an extension to the five-day window through its Regulation Extension System (REX), which will be adapted for TBA and similar trades. FINRA has not decided on the length of the extension or how many will be granted through the platform. REX already allows broker-dealers to ask for extensions on the time they have to pay for securities they bought or the time they have to deliver securities they sold.
Attendees at the SIFMA-hosted event were concerned about how to account for foreign holidays as well as time-zone differences from the US for cross-border transactions within the five-day window. They questioned when FINRA would start the clock on the potential liquidation process. Several brokerage operations managers tell FinOps Report they expect FINRA will rely on the last business day the margin call was made. “We will likely be able to settle disputes in margin calls for TBAs far more quickly than the five-day timetable for liquidations,” says James Bary, global head of institutional securities margin solutions at Morgan Stanley. “No one wants to deal with liquidations.” Other operations managers of large brokerages at the event were equally as confident, but worried about their smaller peers.
Of course, technology can go a long way to helping fund managers and broker-dealers make the right calculations and reduce the potential for large-scale disputes which could drag on for days. Fund managers and broker-dealers will need either dedicated collateral management systems which can accommodate TBA transactions or must add TBA trades to their existing systems. Either way they could be faced with plenty of integration work. To make the necessary margin calculations, the collateral management platforms must be fed data from front-end order management and trade execution systems, which must also be readjusted to take into account the conditions for margin requirements.
For fund managers and broker-dealers to set up new operating procedures for how they will establish the exempt status of an investment fund, and how they will handle discrepancies in collateral values, they will likely need to change their contracts. Fund managers and broker-dealers, which have been using the Master Securities Forward Transaction Agreement (MSFTA) published by SIFMA in 1996, have the luxury of using either one-way, two-way or even no margining. Fund managers and broker-dealers may have already hard-wired terms in existing agreements that conflict with FINRA’s new requirements.
Fund managers must also rework their own private client agreements. Each underlying fund managed by a fund manager has specific requirements for managing assets and most say that all monies must be put to work at all times or be fully invested. If cash needs to be readily available to use in the event of a margin call, the manager will need to sell the securities quickly which could impact portfolio performance. “Asset managers will need to accept the harsh reality that they will have to educate their customers and do a lot of repapering of their agreements,” says Kopcyzinski
Fund managers whose funds must follow the Investment Company Act of 1940 face even more challenges. They can only post collateral through their custodian banks, which in turn will set up margin accounts under the name of the individual fund for the benefit of the broker-dealer. “Fund managers will need to set up 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,” says Patel. “While not specific to TBAs, the SEC has never been clear about how these arrangements should be set up if a broker-dealer is to treat the collateral posted to the custodian as in its possession or control for the purpose of following SEC Rule 15c3-3.”
Adopted in 1972, the customer protection rule prescribes the minimum amount of cash and securities that broker-dealers must safeguard in specially protected accounts. The idea is to ensure that if a brokerage goes bust, its customers can get their hands on the bulk of the funds they have entrusted to the firm.
Although fund managers and broker-dealers might still gripe about the new Rule 4210, they appear to have come to terms with what it means. At this point they are hopeful FINRA will issue additional guidance to ease the operational and legal pains. “There are a lot of interpretative questions raised by the rule. Ideally, FINRA will explain the conditions under which it will grant extensions to the liquidation timetable, the length of the extension and the number of extensions that would be permissible.” says Patel. “Also useful will be guidance as to how to address foreign holidays and time-zone differences from the US, and of course, what the word regularly means.”
FINRA’s Mendelson says that his regulatory agency encourages broker-dealers to bring interpretative questions about its new Rule 4210 to its attention. FINRA will be issuing further clarifications in 2017 before the full breath of the new rule takes effect.