FINRA has introduced an expansion of Rule 4210 (the Rule), effective Dec. 15, 2017, importing margin concepts into the world of mortgage-backed transactions.
The expansion is centered on mortgage-backed securities forward transactions and, barring narrow exceptions, requires broker-dealers to collect mark-to-market (variation) margin from almost all counterparties as well as maintenance (initial) margin from a large number of counterparties. The Rule also provides dealers with increased liquidation rights following a failure to post margin by the counterparty. This article gives a high-level overview of the covered transactions and of the counterparties covered by the two margin requirements and implications of the new liquidation rights.
Covered Transactions
For the purposes of the Rule, a “covered agency transaction” is one of:
Mark-to-Market (Variation) Margin Requirements
Broker-dealers are required to mark any covered agency transactions to the market daily and collect any net mark-to-market loss from counterparties, subject to limited exemptions. To facilitate the new margin requirements, the Rule requires that the threshold in any agreement be set at zero and any minimum transfer amounts not exceed $250,000.
Exemptions
Broker-dealers do not have to collect mark-to-market margin from the following counterparties:
In addition, the following transactions are excluded from the scope of the margin requirements:
Liquidation
The Rule has introduced increased rights for dealers in the event their counterparties fail to post margin as required for a period of time. Under the new regime, if the counterparty does not post mark-to-market margin entirely covering the net forward exposure, once five business days have elapsed from the date on which the net forward exposure occurred, the dealer may liquidate one or more outstanding transactions in its sole discretion to eliminate such forward exposure.
In practical terms, this right is likely to result in the dealer terminating transactions that are in-the-money to the counterparty, thereby netting amounts due to the counterparty with any margin posting requirements. We would expect that dealers would be incentivized to leave transactions out-of-the-money to the counterparty outstanding, and therefore, counterparties should expect the revised liquidation rights, to the extent they are utilized by a dealer, to result in an overall shift of the trading book with such dealer against the counterparty.
Maintenance (Initial) Margin Requirements
Broker-dealers are required to collect maintenance margin from any party that does not qualify as an “exempt account” for the purposes of the Rule. The Rule requires that a broker-dealer collect the margin in an amount that is the greater of:
Relief
Despite the very narrow exemptions from mark-to-market margin requirements, the Rule does provide broader relief from maintenance margin. Where the counterparty falls within exemptions, known as “exempt accounts,” a broker-dealer is not required to collect maintenance margin.
To qualify as an “exempt account,” an entity must be:
For the purposes of covered agency transactions, “mortgage bankers” (i.e., entities engaging in providing real estate financing collateralized by liens on real estate) can also be treated as an “exempt account” to the extent such covered agency transactions are used to hedge a pipeline of mortgage commitments.
Compliance Considerations
Given the limited nature of the exemption and exceptions listed above, we would expect the vast majority of transactions to attract regulatory margining. This will most likely result in “thresholds” being set at zero and “minimum transfer amount” figures being set at $250,000 or lower in MSFTAs moving forward. SIFMA has released an amendment to the MSFTA making such changes, as well as changes surrounding maintenance margin and liquidation rights. While the SIFMA form generally tracks the Rule, it is to some extent dealer friendly, and therefore, non-dealer counterparties may wish to amend their MSFTAs to provide greater flexibility and protection in the event their margining obligations were to change.
Compliance Date
The Rule will become effective as of Dec. 15, 2017, and FINRA has not moved to exclude existing transactions from the Rule. As a result, we would expect that all transactions, new and existing, will have to be compliant with the Rule as of Dec. 15, 2017, and that all documentation will also have to be amended to facilitate compliance by that date.