The asset management industry faces a clear and present danger to their day-to-day operations in the New Year with the implementation of The Federal Reserve Bank of New York’s Treasury Market Practice Group’s (TMPG) margin recommendations for all forward-settling agency mortgage-backed securities (MBS), typically transacted as To Be Announced trades (TBAs). Without immediate action, fund managers could start 2014 with operational deficiencies, legal gridlock and a lack of collateral know-how on staff.
The significance of the TMPG’s recommendations – which are not optional and should be considered requirements–is compounded by an aggressive implementation timeline and extent of the MBS market. Market participants are expected to have a complete margining solution by the end of the month and the sheer size of the MBS market – approximately $270 billion in value traded daily, the majority of which are TBA trades – means the impact will be felt across the asset management industry.
In order to mitigate risk, the TMPG recommends that counterparties enter into a master collateral agreement that defines the margining aspects of relationships, like the frequency of collateral calls, the timing of these calls and collateral eligibility. Up until now, however, no margin is typically required for these types of trades, so the vast majority of firms will need to introduce a brand new robust, flexible and sophisticated collateral management process. Plus, a significant proportion of the $5 trillion MBS agency market remains forward-settling and bilateral, and not collateralized. It is this reality that lead to the TMPG’s actions, highlighting approximately $750 billion – $1.5 trillion in gross, unsettled, unmargined MBS trade exposure existing today.
This is no small amount, especially when considering that the TBA market is essential for the proper functioning of the retail mortgage market. In fact, it could be argued that should a major counterparty default occur in this market, it could have a disproportional impact on the general public. This is no hollow threat given the current lack of collateralization on bilateral TBAs. When you look at the settlement process of a TBA it is evident that parties are open to counterparty default risk for the period between execution and settlement. According to FINRA estimates, the average time between execution and settlement today is about 25 days, but can last as long as long as three months.
The lack of collateralized TBA transactions introduces compliance challenges when considering the specific capabilities of these firms and their current business relationships. A few of the primary issues include legal set-up, relationship formalization, and operational/technology preparation.
I. Legal set-up The recommendation states that collateralization should be performed under a formalized collateral agreement. The industry standard for such a collateral agreement between parties trading in forward-settling mortgage-backed securities is the Master Securities Forward Transaction Agreement (MSFTA). Fortunately the Securities Industry and Financial Markets Association (SIFMA) recently revised their standard recommended template for the MSFTA which can be used as a starting point for negotiations between counterparties. However, it is only a starting point, and the detailed terms must be negotiated and agreed between the trading parties.
II. Relationship formalization Some buy-side firms are able to deliver collateral directly to their counterparties, however others are not legally permitted to physically deliver collateral. Those entities will need to formalize a tri-party control relationship between their organization, their custodian, and their counterparty.
III. Operational/technical preparation For those firms trading TBAs without operational or technical expertise in collateral operations, building an in-house solution or leveraging existing licensed technology is not an option. They will need to find a suitable collateral management solution that can process and manage collateral under an MSFTA.
For firms that already have collateral management departments that leverage sophisticated and flexible collateral management technology across other asset classes, it will be important that they review their processes and technology to ensure that they can handle all forward-settling MBS margining.
Market risk reduction is a goal everyone should work toward. This development will promote safety in the TBA market, as long as you take the correct precautions to safeguard TBA transactions.The asset management industry can take steps today to come into compliance with these new regulations and help reduce market risk in the TBA market.