To Be Further Delayed: Margin Requirements for Covered Agency Transactions Now Slated for October 25, 2023

The latest delay for the FINRA Rule 4210 amendments regarding covered agency transactions —originally approved in the summer of 2016—should serve as a cautionary tale regarding the outer limits of self-regulatory organization (SRO) rulemaking authority.

FINRA has filed a proposed rule change with the US Securities and Exchange Commission (SEC) on February 24, 2023 that would seek to once again delay the effective date of changes to FINRA Rule 4210 that were previously implemented starting on December 15, 2016. The amendments were supposed to become effective on April 23, 2023. FINRA is proposing to move the effective date to October 25, 2023. The latest setback for this troubled rule amendment further places market participants in regulatory and financial limbo, given the years and resources already devoted to preparing systems for a final implementation date.

Background

On June 15, 2016, the SEC approved amendments to FINRA Rule 4210 that establish margin requirements for “Covered Agency Transactions,” which would include (1) To Be Announced (TBA) transactions, inclusive of adjustable-rate mortgage (ARM) transactions; (2) Specified Pool Transactions; and (3) transactions in collateralized mortgage obligations (CMOs), issued in conformity with a program of an agency or government-sponsored enterprise (GSE), with forward settlement dates (2016 Amendments).

Broadly and subject to certain exceptions, the 2016 Amendments would require broker-dealers to

• collect daily mark-to-market margins from all counterparties for their Covered Agency Transactions; and
• collect a maintenance margin of 2% for accounts that are not “exempt accounts,” as defined in FINRA Rule 4210(a)(13), as amended by the 2016 Amendments;
• make and enforce a written risk limit determination for each such counterparty in a Covered Agency Transaction (Risk Limit Determination Requirements); and
• include any mark-to-market loss or maintenance margin deficiency from their Covered Agency Transactions toward certain concentration thresholds.

The 2016 Amendments also included several exceptions or allowances, including

• an exception for transactions that are cleared at and subject to margin requirements of a clearing agency;
• an exception for counterparties that have gross open positions in Covered Agency Transactions amounting to $10 million or less if the counterparty regularly settles on a Delivery Versus Payment (DVP) basis or for cash and meets other specified conditions;
• a limited exception for nonexempt accounts that regularly settle Covered Agency Transactions on a DVP basis or for cash and meet other specified conditions;
• an aggregate $250,000 de minimis transfer amount with a single counterparty, so that if the aggregate required but uncollected maintenance margin or mark-to-market loss does not exceed that amount, the margin need not be collected or charged to net capital;
• a conditional exception for transactions in multifamily housing securities or project loan program securities;
• an allowance to treat mortgage bankers that hedge their pipeline of mortgage commitments as exempt accounts; and
• an allowance to not apply the new margin requirements to any counterparty that is a federal banking agency, central bank, or other similar instrumentality of sovereign governments.[1]

Originally, the 2016 Amendments had a staggered implementation schedule: (1) a December 15, 2016 effective date for the Risk Limit Determination Requirements; and (2) a December 15, 2017 effective date for all other requirements.

Delays in Implementation and 2022 Amendments

As discussed in a previous blog post on this subject, delayed implementation of the 2016 Amendments was prompted by continuing dialogue with industry and market participants, including the staff of the SEC and the Federal Reserve System, regarding the impact of the new margin requirements on smaller and midsized firms. This dialogue eventually led to FINRA proposing additional amendments to alleviate these concerns (Proposed Amendments).[2] The SEC, pursuant to delegated authority, approved the Proposed Amendments on January 20, 2022 (2022 Amendments).

In brief, the 2022 Amendments would broadly

• eliminate the 2% maintenance margin requirement that applies to nonexempt accounts, eliminating the need for broker-dealers to distinguish exempt account customers from other customers (nonexempt accounts) for purposes of the Covered Agency Transaction margin;
• subject to specified conditions and limitations, permit broker-dealers to take a capital charge in lieu of collecting margin for excess net mark-to-market losses on Covered Agency Transactions; and
• make revisions designed to streamline, consolidate, and clarify the Covered Agency Transaction rule language.

Plot Twist: 2022 Amendments Stayed

While the 2022 Amendments were meant to address industry concerns that small and medium-size broker-dealers would be at a competitive disadvantage to larger broker-dealers (that have more capital) and banks (that do not have similar margin collection requirements) in the Covered Agency Transaction market, some in the industry took issue with it. On January 27, 2022, a trade association and a market participant (Petitioners) filed with the SEC a notice of intention to petition for review of the 2022 Amendments. On February 22, 2022, the Petitioners filed their formal petition for review of the 2022 Amendments pursuant to Rule 430 of the SEC’s Rules of Practice.

In brief, Rule 430 of the SEC’s rules of practice permit “[a]ny person aggrieved by an action made by” a delegated authority to seek review of the action subject to certain procedures. These procedures include that the person seeking review (1) file a written notice of intention to petition for review within five days after actual notice to the party of the action—in this instance, the action approving the 2022 Amendments by the staff of the SEC’s Division of Trading and Markets (TM Staff) pursuant to delegated authority;[3] and (2) file a petition for review within five days after the written notice of intention is filed that includes a clear and concise statement of the issues to be reviewed and the reasons why review is appropriate.[4] This process is a prerequisite for judicial review of any actions taken by delegated authority.

The petition for review outlines a number of reasons as to why the SEC has to (1) review the actions taken by TM Staff in approving the 2022 Amendments, (2) deny the amendments, and, importantly, (3) reject FINRA’s proposal to establish an effective date on which the margin regime for Covered Agency Transactions would take effect.

The problems identified by the Petitioners include, in broad brushstrokes, (1) that FINRA lacks the statutory authority to impose the margin requirements; (2) that no problems exist that need to be solved with the margin requirements; and (3) that regional broker-dealers will be adversely impacted by depleting required capital needed to operate.

In light of the petition, and pursuant to Rule 431 of the SEC’s Rules of Practice, the SEC has granted the petition for review and stayed the order approving the 2022 Amendments pending further SEC action. As of the date of this LawFlash, the SEC has yet to act.

Implications

It has been more than six years since the 2016 Amendments were approved by the SEC pursuant to delegated authority. Since that time, there has been no major event in the market for Covered Agency Transactions of the type that the 2016 Amendments were designed to address. In short, the raison d'etre for the 2016 Amendments has yet to materialize, and the longer these margin requirements are delayed without an impact to the capital markets, the harder it seems for FINRA to justify any final implementation schedule.

More importantly, however, the delays associated with the 2016 Amendments and the stay of the 2022 Amendments have broader implications for FINRA, in that they show market participants the additional means at their disposal to resist actions taken by the SEC staff through delegated authority in general, and with respect to SRO rulemakings in particular, such as those by FINRA, the various exchanges, and clearing agencies. At a minimum, this may serve as an additional check-and-balance to SRO rulemakings and should serve as a cautionary tale to the SROs regarding their regulatory and interpretive overreach.

While Rule 19b-4(c) of the Securities Exchange Act of 1934 is intended to limit an SRO’s ability to create policies, practices, or interpretations outside the formal rulemaking process, the cumulative process around FINRA Rule 4210 and Covered Agency Transactions should give SROs caution regarding the limits of their rulemaking and interpretive authority.

Finally, we note that the continued delays have an economic impact, as market participants may be expending resources to prepare back-office systems and revise agreements for rules that are continually delayed—and may never be fully implemented.