FINRA Requests Comments on Proposed Amendments to Reduce Counterparty Credit Risk for Transactions in the TBA Market

On January 27, 2014, the Financial Industry Regulatory Authority, Inc. (“FINRA”) requested comments on proposed amendments to FINRA Rule 4210 that would establish, among other things, margin requirements for transactions in the To Be Announced (“TBA”) market¹ and close-out requirements on firms that failed to timely post margin in that market.² As FINRA explained, the TBA market includes transactions in adjustable rate mortgages (“ARMs”); Specified Pool Transactions; and Collateralized Mortgage Obligations (“CMOs”), with forward settlement dates.³ FINRA further stated that the proposed amendments are based on the best practices adopted by the Treasury Market Practices Group (“TMPG”) of the Federal Reserve Bank of New York (“FRBNY”), and are designed to reduce counterparty credit risk in the TBA market.⁴ According to FINRA, the proposed amendments would address this issue by imposing, among other things, maintenance margin and variation (or mark to market) margin requirements in the TBA market.⁵ The comment period expires on March 28, 2014, and interested parties should provide their views to FINRA about the proposed amendments.⁶

Background

FINRA stated that most trading in agency mortgage-backed-securities (“MBS”) occurs in the TBA market, and that agency MBS is one of the largest fixed income markets.⁷ According to FINRA, however, “[t]he 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.”⁸ The TMPG similarly commented that a default on forward-settling agency MBS transactions could subject other market participants in the TBA market to significant losses and risks.⁹ Therefore, in October 2013, the TMPG recommended that TBA market participants should “substantially complete” the transition to a system of margining by December 31, 2013.¹⁰

The Proposed Amendments

Under the proposal, FINRA members would be required to collect variation margin for subject transactions when the current exposure exceeds $250,000.¹¹ Members also would be required to collect maintenance margin (i.e. initial margin) from non-exempt counterparties (exempt accounts include, but are not limited to, broker-dealers, specified institutions, and high net worth persons).¹² According to FINRA, the proposed amendments would include the following:

• Covered Agency Securities: TBA transactions (including ARM transactions) and Specified Pool Transactions, respectively, where the difference between the trade date and the contractual settlement date is greater than one business day; as well as CMO transactions (issued in conformity with a program of an Agency) where the difference between the trade date and the contractual settlement date is greater than three business days.¹³
• Risk Limits: A firm’s credit risk office or credit risk committee, unless the member firm is of limited size and resources, would be required to make a written determination of a risk limit to be applied to each counterparty to a transaction in a Covered Agency Security.¹⁴
• Transactions with Exempt Counterparties: Maintenance margin would not be required for transactions with exempt counterparties, as described above.¹⁵ Variation margin would still be mandated for such transactions, and firms would be required to deduct the amount of any uncollected mark to market loss in computing the firm’s net capital pursuant to Rule 15c3-1 under the Securities Exchange Act of 1934.¹⁶
• Transactions with Non-Exempt Accounts: For such transactions, firms would be required to collect variation margin and maintenance margin equal to two percent of the value of the securities, regardless of the type, volatility or tenor of the security.¹⁷ Firms would face the above-described net capital implications for uncollected margin.¹⁸
• Concentrated Exposures: Firms would be required to provide written notification to FINRA and would be prohibited from entering into any new transactions that could increase credit exposure if net capital deductions exceed certain thresholds over a five business day period.¹⁹

FINRA’s Request for Comment

FINRA requested that firms provide comments on all aspects of the proposed rule changes, including the following issues:

• Market Participants and Consistency with Other Regulatory Regimes: What types of market participants, including retail investors, would be affected by the proposed rule changes?²⁰
• Impact on Market Participants: What is the proposal’s impact on liquidity and pricing; the potential for liquidity constraints at mid-size and smaller dealers; non-FINRA members; and consumers in the mortgage market? What is the scope of operational, compliance, and clearing costs (initial and ongoing)?²¹
• Non-Exempt Accounts: What role do non-exempt accounts play in the TBA market and should FINRA reconsider its approach to such accounts?²²
• Mortgage Bankers: What role do mortgage bankers play in the TBA market and how would the requirement to post variation margin affect them?²³
• Eligible Collateral: Is it appropriate to expand acceptable collateral to include corporate debt and equity securities?²⁴
• Close-out Requirements: Is the time period in the close out requirement (five business days) appropriate? What factors should be considered in determining whether to grant an extension under the proposed rules?²⁵
• Collection of Call: Is the timeframe for the margin call (by the close of business the next day) appropriate?²⁶
• Risk Limit Determinations: What would be the impact of the proposed risk limit determination requirements?²⁷
• De Minimis Transfer Amount: Is the $250,000 de minimis transfer amount appropriate?²⁸
• Effective Date: How much time is needed to implement the proposed changes?²⁹

Conclusion

The proposed amendments to FINRA Rule 4210 could have significant impacts on the TBA market and its participants. Accordingly, interested parties should use the current comment period to express their views about FINRA’s proposed rule changes prior to the March 28, 2014, deadline.

For more information about the subject matter of this alert, please contact the authors or a Bingham partner with whom you regularly work.

¹ FINRA Requests Comment on Proposed Amendments to FINRA Rule 4210 for Transactions in the TBA Market, Regulatory Notice 14-02 (Jan. 27, 2014) (the “Notice”), available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p439087.pdf.

² Id. at 4 - 5.  Under the proposed amendments, a firm would be required to take liquidating action if margin is not posted within five business days from the date the loss was created for transactions with both exempt and non-exempt accounts, discussed infra.

³ Id. at 9 n. 1. 

⁴ Id. at 1. 

⁵ Id. 

⁶ Morgan Stanley’s Comments, received by FINRA on Feb. 7, 2014, are available at http://www.finra.org/Industry/Regulation/Notices/2014/P439088. On Feb. 12, 2014, FINRA extended the expiration of the comment period from Feb. 26, 2014 to Mar. 28, 2014. 

⁷ Notice at 2.

⁸ Id.

⁹ Id. at 1- 2 (citation omitted).

¹⁰ TMPG, Frequently Asked Questions: Margining Agency MBS Transactions (Oct. 25, 2013), available at http://www.newyorkfed.org/tmpg/marginingfaq10252013.pdf.

¹¹ Notice at 3. Firms would be required to deduct the amount of margin outstanding under the net capital rule (Rule 15c3-1 under the Securities Exchange Act of 1934). Id. at 5. 

¹² Id. at 3 and 10 n.17.

¹³ Id. at 3-4. Transactions cleared through a registered clearing agency that are subject to the margin requirements of the agency would not be subject to the proposed requirements. Id. at 4. The proposed amendments also would not apply to transactions with central banks. Id. at 5.

¹⁴ Notice at 4.

¹⁵ Id. 

¹⁶ Id. 

¹⁷ Id.

¹⁸ Id. at 5.

¹⁹ Id. (five percent of the member’s tentative net capital for a single account or group of commonly controlled accounts or 25 percent of the member’s tentative net capital for all accounts combined).

²⁰ Notice at 5 - 6.

²¹ Id. at 6 - 7.

²² Id. at 7. 

²³ Id.

²⁴ Id.

²⁵ Id.

²⁶ Notice at 7.

²⁷ Id. at 8.

²⁸ Id.

²⁹ Id.