Beginning on December 15, 2017, amendments approved by the Securities and Exchange Commission (“SEC”) last year to FINRA Rule 4210[1] will require U.S. registered broker-dealers to collect (but not post) daily variation margin and, in some cases, initial margin, from their customers on specified transactions.[2]
These new margin requirements apply to “Covered Agency Transactions,” which include: (i) “to-be-announced” (or “TBA”) transactions[3] on mortgage-backed securities (“MBS”) and specified pool transactions[4] for which the settlement date is more than one business day after the trade date; and (ii) U.S. agency collateralized mortgage obligations for which the settlement date is more than three business days after the trade date.[5] TBA transactions account for the vast majority of trading in the sizable agency MBS market.[6]
Full variation (or “mark-to-market”) margin is required daily from each separate counterparty, without any “threshold” or similar level of uncollateralized exposure. Positions in the same account may be netted to arrive at a single amount of variation margin to be transferred. Margin transfers may be subject to a minimum transfer amount of no more than $250,000.
Initial (or “maintenance”) margin is also required in an amount equal to two percent (2%) of the contract value of each net long or short position, by CUSIP, of a customer. However, initial margin is not required from “exempt accounts”, which generally include the following:
- an account of a registered broker-dealer;
- a “designated account”, which is defined to include the account of a bank, savings association, insurance company, registered investment company, state or political subdivisions thereof, and pension or profit-sharing plan either subject to ERISA or of an agency of the United States or of a state or political subdivision thereof; and
- an account of any person that has a net worth of at least $40 million and financial assets of at least $45 million and either:
- satisfies certain specified Securities Exchange Act-related reporting requirements; or
- makes available to the broker-dealer such current information regarding its ownership, business, operations and financial condition as reasonably believed by the broker-dealer to be accurate and sufficient for purposes of performing a risk analysis in respect of such person.
In addition, initial margin is not required from non-exempt accounts with respect to a transaction if, generally: (i) the original contractual settlement for the transaction is in the month of the trade date or in the month succeeding the trade date; and (ii) the customer (x) regularly settles[7] such transactions on a delivery-for-payment (“DVP”) basis or for cash and (y) does not engage in “dollar-rolls,”[8] “round robin”[9] trades or other financing techniques for its Covered Agency Transactions.
If an initial or variation margin requirement is not satisfied by the close of business on the business day immediately following the business day on which the margin deficiency arose, then the broker-dealer must deduct the unsatisfied amount from its regulatory net capital, as provided in Rule 15c3-1 of the Securities Exchange Act. Moreover, if an initial or variation margin requirement remains unsatisfied five business days after the date the deficiency arose, then the broker-dealer must promptly liquidate positions to satisfy the deficiency, absent an extension of time granted by FINRA.
The new margin requirements (both initial and variation) do not apply to: (i) transactions that are cleared through a registered clearing agency[10] and that are subject to the margin rules of that clearing agency; or (ii) transactions with any customer that has a gross open position in Covered Agency Transactions with a broker-dealer of $10 million or less if, generally (x) the original contractual settlement for all such transaction is in the month of the trade date or in the month succeeding the trade date, (y) such customer regularly settles such transactions on a DVP basis or for cash and (z) such customer does not engage in dollar-rolls, round robin trades or other financing techniques for its Covered Agency Transactions.
Many market participants currently do not exchange margin on Covered Agency Transactions, which are typically documented under Master Securities Forward Transaction Agreements (known as “MSFTAs”). Therefore, a compliant margin annex may need to be negotiated for existing MSFTAs (or an entirely new MSFTAs with a compliant margin annex may need to be negotiated where currently there is no such master agreement) in connection with Covered Agency Transactions between U.S. registered broker dealers and their customers.[11] In addition, market participants should keep in mind that triparty control agreements with custodians also may be necessary where customers are registered investment companies.
[1] SEC Release No. 34-78081 (June 15, 2016), available here. These amendment are generally intended to implement recommendations from 2012 of the Treasury Markets Practices Group.
[2] Amended Rule 4210 also generally required a designated credit risk officer or committee of a U.S. registered broker-dealer to determine in writing and enforce, in accordance with the broker-dealer’s written risk policies and procedures, a risk limit for each customer to Covered Agency Transactions by December 2016. In the case of registered investment advisors, broker-dealers were permitted to set these risk limits at the level of the advisor, as opposed to the level of each advisory client. Nevertheless, FINRA has noted that it “expects [broker-dealers] to exercise appropriate diligence in understanding the extent of their risk and to craft their risk limit determination accordingly” in making risk determinations as to advisory accounts. SR-FINRA-2015-036, Partial Amendment No. 3, at 13 (filed May 26, 2016).
[3] The TBA market facilitates the forward trading of MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae. See SIFMA TBA Market Fact Sheet, at 1, available here (the “SIFMA Fact Sheet”). In a TBA trade, the parties agree on six parameters of the securities to be delivered (issuer, maturity, coupon, price, par amount and settlement date), but the actual identity of the securities to be delivered at settlement is not specified. See James Vickery and Joshua Wright, TBA Trading and Liquidity in the Agency MBS Market, Federal Reserve Bank of New York, Staff Report no. 468 (August 2010) (“Staff Report”), at 7. TBA trades generally settle within three months of the trade date and, to facilitate logistics for settlement, the market sets a single settlement date for each month for each of several types of trades. Id. at 8. Consistent with industry practice, the seller notifies the buyer of the details of the pool to be delivered two business days before the settlement date (this is known as the “48 hour rule”). See generally SIFMA, Uniform Practice Manual, located here.
[4] In specified pool trades, the actual identity of the pool to be delivered is specified on the trade date.
[5] Note, however, that U.S. registered broker-dealers are not required to apply the margin requirements with respect to Covered Agency Transactions with a customer that involve multifamily housing securities or project loan program securities and satisfy specified criteria.
[6] Staff Report, at 2. In June 2015, an average of $184 billion of agency MBS was traded each day by primary dealers. SIFMA Fact Sheet, at 1. This volume dwarfs the size of the corporate bond and municipal markets, and is second only to the U.S. Treasury market. Id.
[7] The term “regularly settles” is intended to provide broker-dealers with flexibility as to how they implement the requirement. FINRA Regulatory Notice 16-31, at n. 18 (August 2016). FINRA expects that broker-dealers are “in a position to make reasonable judgments as to the observed pattern and course of dealing in their customers’ behavior by virtue of their interactions with their customers.” Id. FINRA has noted that it views the term “regularly” as conveying the “prevailing or dominant pattern and course of the customer’s behavior” and that, in making their determinations, broker-dealers may use the customer’s history of transactions with the broker-dealer and any other relevant information of which the broker-dealer is aware, and also should be able to rely on the reasonable representations of their customers. Id.; see also SR-FINRA-2015-036, Partial Amendment No. 1 (filed January 13, 2016) and Partial Amendment No. 2 (filed March 21, 2016).
[8] See FINRA Rule 6710(z) (defining “dollar roll” to mean “a simultaneous sale and purchase of an [agency MBS] . . . for different settlement dates, where the initial seller agrees to take delivery, upon settlement of the re-purchase transaction, of the same or substantially similar securities”).
[9] “Round robin” trades are transactions resulting in equal and offsetting positions by one customer with two separate dealers for the purpose of eliminating a turnaround delivery obligation by the customer. See Rule 4210(e)(2)(H)(i)(i).
[10] The term “registered clearing agency” means a clearing agency, as defined in Section 3(a)(23) of the Securities Exchange Act. FINRA Rule 4210(f)(2)(A).
[11] To facilitate the amendment of existing MSFTAs to make them compliant with new FINRA Rule 4210, SIFMA has published a Form of Amendment to Master Securities Forward Transaction Agreement to Confirm with FINRA 4201 – February 2017.