How to reduce risk by implementing margining agreements

Given the enormity of the forward settling MBS market ($750B – $1.5T), the Treasury Markets Practice Group (TMPG) recommends an exchange of two-way variation margin to mitigate the risks associated with unmargined agency MBS transactions.

Participating asset managers of all sizes are taking heed and working to implement margining agreements to reduce risk and meet client and counterparty expectations.

The challenge for asset managers is weighing the benefits (risk mitigation, client and counterparty expectations) against the impact to operations and on legal resources. A number of managers are already margining other securities and merely levering their collateral management processes.

However, many asset managers are not moving toward voluntary compliance. Managers who do not develop the infrastructure to support TBA margining may be unable to meet investment mandates, or restricted to a less favorable asset mix- resulting in unintended negative outcomes.

While many managers and dealers continue to trade without the benefit of bi-lateral margining, there’s increasing momentum toward complying with the TMPG’s best practices guidelines.

Dealers are feeling increased pressure to sign MSFTA’s (Master Securities Forward Transaction Agreement) with counterparties due to the proposed amendments to FINRA Rule 4210. The amendment echoes the TMPG recommendation, but goes further to include requirements for maintenance margin and other changes which could re-open negotiations with their counterparties.

Given FINRA’s proposed amendments and resultant comment period, a large number of asset managers are pausing on renegotiating the MSFTA’s until the rules are finalized. Once in place, managers and dealers will need to pick up the ball, negotiate agreements and implement margining.

Why Compliance Is Worth the Effort

With the trend toward increasing regulations and an appetite for finding ways to stabilize markets, asset managers may want to consider margining to limit their counterparty risk and prepare for what may be mandatory in the near future. Additionally, asset managers with systems and operations that currently support other marginable products (e.g., OTC Derivatives) may not find adding TBA’s overly onerous.

Asset managers should weigh the costs of either outsourcing collateral management or converting systems/operational processes against the actual potential for loss in their overall risk profiles. Until dealers start demanding that all of their counterparties agree to margining, there may not be strong incentives for some asset managers to do so. Yet, by complying early on, managers would not be caught in a rush to negotiate terms with dealers, nor be faced with the pressure of regulatory driven projects that may impact a substantial number of client portfolios.

Lastly, it will be interesting to see if there is any impact to MBS markets should asset managers decide to use other security types to meet investment management mandates. Another consideration is how clients may react to dealer demands for additional information to satisfy credit requirements and the potential for increased costs due to operational and legal requirements.

What Are Asset Managers Doing?

Some managers who maintain a relative high exposure to forward-settling agency MBS are substantially complying or working toward implementing margining with their larger dealers, albeit pausing given FINRA’s amendments are in flux.

Most managers have yet to take action given their MBS exposure and risk versus benefit assessment. Each manager must evaluate their current and anticipated investment strategies, risk tolerance, client views, regulatory trends, and the state of their operational preparedness before deciding which path to take.

Where to Start?

Assess your current and anticipated future exposure to:
o Agency MBS
o TBA transactions
o Specified pool transactions
o Adjustable rate mortgages (ARM) transactions
o Collateral mortgage obligations (CMO) transactions

Assess your firm’s risk profile, client and dealer expectations, and risk mitigation value versus cost and impact

Assess your systems and operational capabilities to support margining, including:
o Identification of trades and ability to mark collateral
o Mark-to-market calculations
o Reconciliations
o Communication with custodians

Assess your ability to support legal documentation, including impact to legal team and volume of agreements with dealers

How Adeptyx Can Help

Adeptyx has a seasoned team of professionals who have extensive experience helping clients navigate their most complex operational and system challenges. Our senior project managers have direct experience with assessing and implementing collateral management tools and the TMPG’s recommendations for forward-settling agency MBS.

We can:
1. Help assess the impact of the TMPG recommendations/FINRA 4210 to your firm
2. Assess infrastructure readiness, steps to take, impact to your legal team, and anticipated costs
3. Assess and recommend alternatives; outsource collateral management, build internal processes and controls, buy margining solution
4. Help design a customized, achievable roadmap
5. Help with project management and implementation; ops and systems, legal contracts and tracking with broker/dealers, service providers, custodians, and vendors

The regulatory environment continues to trend toward tighter controls and closer scrutiny to protect investors. TBA margining helps reduce systemic risk and, arguably, improves market liquidity. Therefore, asset managers should anticipate that TBA margining will become mandatory and prepare accordingly on their terms.

Adeptyx possesses the industry expertise to help you develop your strategy and implement the right solution.

Contact us to learn more and how we may be of service.

Posted in Fixed Income