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14-02 FINRA Requests Comment on Proposed Amendments to FINRA Rule 4210 for Transactions in the TBA Market; Comment Period Expires: February 26, 2014
Request for Comment
Agency Mortgage-Backed Securities
Referenced Rules & Notices
FINRA Rule 4210
FINRA Rule 6710
SEA Rule 15c3-1
FINRA is seeking comment on proposed amendments to FINRA Rule 4210 to establish margin requirements for transactions in the To Be Announced (TBA) market.1 The proposal, designed to reflect the growth of the TBA market and to replace current interpretive materials under Rule 4210 that have become outdated, is informed by the set of best practices adopted by the Treasury Market Practices Group (TMPG) of the Federal Reserve Bank of New York (FRBNY). Consistent with the overarching goal of many regulatory initiatives since the financial crisis, the proposal aims to reduce counterparty credit risk. The proposal would accomplish this in the TBA market by addressing, among other things, maintenance margin and variation (also referred to in the proposed rule language and this Notice as mark to market) margin requirements, risk limit determinations, concentrated exposures, and exemptions for de minimis transfer amounts and for transactions cleared through registered clearing agencies. The proposed rule amendment is available as Attachment A at www.finra.org/notices/14-02.
Questions regarding this Notice should be directed to:
The comment period has been extended to March 28, 2014.
FINRA encourages all interested parties to comment on the proposal. Comments must be received by February 26, 2014.
Comments must be submitted through one of the following methods:
Marcia E. Asquith
Office of the Corporate Secretary
1735 K Street, NW
Washington, DC 20006-1506
To help FINRA process comments more efficiently, persons should use only one method to comment on the proposal.
Important Notes: All comments received in response to this Notice will be made available to the public on the FINRA website. In general, FINRA will post comments as they are received.2
Before becoming effective, a proposed rule change must be authorized for filing with the SEC by the FINRA Board of Governors, and then must be filed with the SEC pursuant to SEA Section 19(b).3
Background & Discussion
Most trading of agency mortgage-backed securities (MBS) takes place in what is generally referred to by industry participants as the TBA market, which is characterized by transactions with forward settlements as long as six months past the trade date.4 Agency MBS is one of the largest fixed income markets, with $5 trillion of securities outstanding and approximately $750 billion to $1.5 trillion in gross unsettled and unmargined dealer to customer transactions.5
Historically, the TBA market is one of the few markets where the exchange of margin has not been a common practice, thereby creating a potential risk from the counterparty exposure. Futures markets, for example, require the daily posting of both initial and maintenance margin and variation margin on all exchange cleared contracts. Market convention has been to exchange margin in the repo and securities lending markets, even when the collateral consists of exempt securities. The FRBNY recognized the existence of this gap and charged the TMPG with establishing standards regarding the margining of forward-settling agency MBS transactions. The TMPG has noted:
To the extent that they remain unmargined, uncleared agency MBS transactions can pose significant counterparty risk to individual market participants. Moreover, the market's sheer size . . . raises systemic concerns. If one or more market participants were to default on forward-settling agency MBS trades, the agency MBS market could transmit losses and risks to a broad array of other participants. While the transmission of these risks may be mitigated by the netting, margining, and settlement guarantees provided by a [central counterparty], losses could nonetheless be costly and destabilizing. Furthermore, the asymmetry that exists between participants that margin and those that do not could have a negative effect on liquidity, especially in times of market stress.6
The best practices the TMPG7 adopted are only recommendations—they are not requirements.8 Unsecured credit exposures that exist in the TBA market today can lead to financial losses by members. Permitting counterparties to participate in the TBA market without posting margin can facilitate increased leverage by customers, thereby potentially posing a risk to the member extending credit and to the marketplace as a whole. Further, FINRA's current interpretive guidance9 for the TBA market has not been updated since the financial crisis. In view of the growth in volume in the TBA market, the number of participants and the credit concerns that have been raised in recent years, FINRA believes there is a need to establish FINRA rule requirements that will extend responsible practices to all members that participate in this market.
Accordingly, FINRA is seeking comment on proposed amendments to FINRA Rule 4210 to establish margin requirements for the TBA market. Specifically, the proposed rule change applies to TBA transactions (inclusive of ARM transactions), Specified Pool Transactions, and transactions in CMOs, with forward settlement dates (for purposes of the proposed amendments, these are defined below collectively as Covered Agency Securities—for simplicity, throughout this Notice the terms "Covered Agency Securities" and "TBA market" are used interchangeably). The proposed rule change is informed by the TMPG best practices. Further, the scope of products the proposed amendments cover is intended to be congruent with those covered by the TMPG best practices, including updated guidance that the TMPG has released since the TMPG issued the original best practices.10
Summary of Proposed Amendments
Broadly, the proposed rule change provides that all members would be required to collect variation margin for transactions in Covered Agency Securities when the current exposure exceeds $250,000. In addition, members would be required to collect maintenance margin for transactions with non-exempt counterparties (as discussed further below). A summary of the key aspects of the proposed amendments follows:
Request for Comment
FINRA is requesting comment on all aspects of the proposal, including costs and burdens that the proposal could impose. In particular, FINRA seeks comment on the following issues:
1 For simplicity, throughout this Notice the term TBA market is used to refer to TBA transactions (inclusive of adjustable rate mortgage (ARM) transactions), Specified Pool Transactions, and transactions in Collateralized Mortgage Obligations (CMOs), with forward settlement dates. As further discussed in this Notice, the proposal defines these transactions as Covered Agency Securities.
2 FINRA will not edit personal identifying information, such as names or email addresses, from submissions. Persons should submit only information that they wish to make publicly available. See NTM 03-73 (November 2003) (NASD Announces Online Availability of Comments) for more information.
3 See SEA Section 19 and rules thereunder. After a proposed rule change is filed with the SEC, the proposed rule change generally is published for public comment in the Federal Register. Certain limited types of proposed rule changes, however, take effect upon filing with the SEC. See SEA Section 19(b)(3) and SEA Rule 19b-4.
4 See, e.g., the SEC's Staff Report of the Task Force on Mortgage-Backed Securities Disclosure.
5 See Report of the TMPG, Margining in Agency MBS Trading (November 2012) (referred to as the "TMPG Report"). The TMPG is a group of market professionals that participate in the TBA market and is sponsored by the FRBNY.
6 See the TMPG Report.
7 See Best Practices for Treasury, Agency Debt, and Agency Mortgage-Backed Securities Markets.
8 Absent the establishment of a rule requirement, the TMPG best practices could become more widely adopted overtime by other market participants. However, this will take time and in the interim would leave firms at risk.
9 See Interpretations/01 through/08 of FINRA Rule 4210(e)(2)(F). Such guidance references TBAs largely in the context of Government National Mortgage Association (GNMA) securities. The modern TBA market is much broader than GNMA securities.
10 See, e.g., TMPG Releases Updates to Agency MBS Margining Recommendation (March 2013).
11 FINRA Rule 6710(u) defines "TBA" to mean a transaction in an Agency Pass-Through Mortgage-Backed Security or an SBA-Backed ABS where the parties agree that the seller will deliver to the buyer a pool or pools of a specified face amount and meeting certain other criteria but the specific pool or pools to be delivered at settlement is not specified at the time of execution, and includes TBA transactions "for good delivery" and TBA transactions "not for good delivery." FINRA Rule 6710(v) defines "Agency Pass-Through Mortgage-Backed Security" as a type of Asset-Backed Security issued in conformity with a program of an Agency or a government-sponsored enterprise (GSE), for which the timely payment of principal and interest is guaranteed by the Agency or GSE, representing ownership interest in a pool(s) of mortgage loans structured to "pass through" the principal and interest payments to the holders of the security on a pro rata basis. FINRA Rule 6710(bb) defines SBA-Backed ABS similarly, though with reference to Asset-Backed Securities issued in conformity with a program of the Small Business Administration. FINRA Rule 6710(m) defines "Asset-Backed Security" to include, in part, a security collateralized by any type of financial asset, such as a loan, lease, mortgage, or a secured or unsecured receivable. Lastly, the term "Agency" is defined under FINRA Rule 6710(k).
12 Rule 6710(x) defines Specified Pool Transaction to mean a transaction in an Agency Pass-Through Mortgage-Backed Security or an SBA-Backed ABS requiring the delivery at settlement of a pool(s) that is identified by a unique pool identification number at the time of execution.
13 FINRA has filed paragraph (dd) of FINRA Rule 6710 for approval by the SEC. See SR-FINRA-2013-046. The rule will define CMO to mean a type of Securitized Product structured in multiple classes (or tranches) backed by Agency Pass-Through Mortgage-Backed Securities, mortgage loans, certificates backed by project loans or construction loans, other types of mortgage-backed securities or assets derivative of mortgage-backed securities, and includes a real estate mortgage investment conduit (REMIC) and an Agency-Backed Commercial Mortgage-Backed Security as defined in FINRA Rule 6710(ee) (which, like Rule 6710(dd), the staff has filed for approval by the SEC).
14 Under the proposal, a "counterparty" is defined as any person that enters into a Covered Agency Security transaction with a member and includes a "customer" as defined in paragraph (a)(3) of FINRA Rule 4210.
15 See Interpretation /03 of FINRA Rule 4210(e) (2)(F). Under the current interpretation, the risk limit determination is an alternative available to alleviate otherwise required net capital deductions or margin requirements, as applicable. FINRA notes that, as a matter of practice, most members have availed themselves of this relief and have applied risk limit determinations to TBA transactions in general. (To recap, Interpretation /03 of FINRA Rule 4210(e)(2)(F) provides that, in lieu of deducting from capital 100 percent of any marked to the market losses in exempt accounts and having to obtain margin as well as any marked to the market losses from non-exempt mortgage bankers' accounts, members may make a determination in writing of a risk limit for each such exempt account and non-exempt mortgage banker's account.)
16 FINRA believes that this requirement extends logically from the SEC's new Rule 17a-3(a)(23), which, in part, requires a broker-dealer with specified amounts of aggregate credit items or capital to document the "credit, market, and liquidity risk management controls established and maintained by the broker or dealer to assist it in analyzing and managing the risks associated with its business activities..." See Exchange Act Release no. 70072 (July 30, 2013), 78 FR 51824 (August 21, 2013) (Financial Responsibility Rules for Broker-Dealers).
17 Broadly speaking, exempt accounts include FINRA members, non-member registered broker-dealers, "designated accounts" under FINRA Rule 4210(a)(4) (including banks, savings associations, insurance companies, investment companies, states or subdivisions, or pension plans), and persons meeting specified net worth requirements and other conditions.
18 FINRA staff has consulted with the SEC staff concerning the net capital treatment of variation margin posted by a broker-dealer with a counterparty. It is anticipated that the SEC will issue guidance, such that if certain conditions are met, the resulting receivables can be treated as an allowable asset in computing net capital.
19 See Interpretation /04 of FINRA Rule 4210(e)(2) (F).
20 The proposal defines a "mortgage banker" as an entity, however organized, that engages in the business of providing real estate financing collateralized by liens on such real estate. FINRA notes that the definition is meant to in elude for example banks and credit unions, to the extent they originate mortgages.
21 This means that mortgage bankers must post variation margin and may need to post maintenance margin. Under FINRA's current interpretation, mortgage bankers with more than $1.5 million of net worth are not required to post variation or maintenance margin, within risk limits established by the member. See Interpretation /02 of FINRA Rule 4210(e)(2)(F).
22 See Exhibit I to Interpretations to FINRA Rule 4210(e)(2)(F). Note however that under the current interpretations transactions with delivery dates or contract maturity dates of 120 days or less from trade date do not currently require variation or maintenance margin, though any mark to market loss must be deducted from net capital. Further, FINRA currently allows five business days for the call to be met, before a capital charge is incurred. See Interpretation /05 of FINRA Rule 4210(e)(2)(F).
23 For purposes of the proposed rule change, FINRA would interpret "central bank" to include, in addition to government central banks and central banking authorities, sovereigns, multilateral development banks and the Bank for International Settlements. This approach is consistent with the approach taken in the standards established by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO). See BCBS and IOSCO Margin Requirements for Non-Centrally Cleared Derivatives.
24 FINRA staff's review of the off balance sheet schedule that was filed as of June 30, 2013, by all carrying and clearing members identified 47 members that reported TBA balances as of that date. A review of TRACE data for the one year period October 2012 through September 2013 showed a daily average number of transactions in Covered Agency Securities of 8,276 with an average total daily dollar volume of $192 billion. One hundred sixty-four member members reported good delivery TBA transactions during this period. The category of securities with the largest number of members reporting, at 543, is agency CMOs with a settlement date greater than three business days from trade date, where there was a daily average number of trades reported of 181 during this one year period with an average original face amount of $1,992,000.