Marginig is typically required for future settled instruments like futures and forwards. TBA trades, a type of agency backed MBS with around $180 billion daily volume, has escaped this requirement. The New York Fed estimates up to 1.5 trillion is uncleared and unmargined. It was not until 2014 that rules were proposed by FINRA, a broker-dealer self-regulatory body, to require margin for TBA. Even the proposed rules for margining (2% of trade value) still contains exemptions to the margin requirements.
As its name suggests, To-Be-Announced, are agreements to buy/sell pools of agency backed mortgages of which only some parameters are known. The exact content of these pools are unspecified until 48 hours before settlement when the actual mortgage constituents are “Announced”. Similar to Treasury futures, sellers have the freedom to use ‘cheapest-to-deliver’ securities to fulfill their obligations. The intended effect is to make mortgages ‘fungible’, interchangeable, adding liquidity in the mortgage market. TBA also bring efficiencies to mortgage lenders and originator providing a tool to hedge and lock-in rates.
FINRA margining rules proposals, reflects the post-crisis trend to centralize and reduce counterparty risk to enhance transparency and stability in the financial system. Although FICC, the fixed income clearing division of the DTCC provides clearing services for TBA, some participants will still opt for direct counterparty risk when evaluating the trade-offs. Operational cost is not the only disincentive to move to a centralize clearing, another obstacle is the risk mutualization requirement, the sharing of responsibility if one or several of the members fail to fulfill its obligations. For some participants this is not even an option, as is for some insurers and pension funds are specifically prohibited from participation in such loss-sharing commitments.
Distributed ledgers can provide an alternative option for OTC TBA trades providing a way to reduce counterparty risk efficiently without imposing risk mutualization. One way to accomplish this is to pass some of the clearing functionality to the existing counterparties’ custodian(s). This is particularly suitable for TBA which are inherently assignable i.e the obligations of a party can be transferred to another party enabling the duplication of the key functionality that clearers provide, novation, a process where the clearer becomes the counterparty to both buyer and seller.
The idea of merging custodial and clearing functionality is not novel, JP Morgan for instances offers Direct Custody and Clearing (DCC). The difference here is that most of the operational process: margining management and settlement arrangements can be encoded into a smart contract. Since most of the clearing operations are localized in the smart contract, the underlying distributed ledger can keep in sync the counterparties when ownership changes during novation preventing erroneous risk calculations, as it can occur in tradition multi-ledger system.
In addition to process automation, more granular level of customization can be agreed pre-trade: valuation, initial and variance margin, margin call fulfillment options, etc. In the case of multiple trades, further enhancements can be provides such as matching and netting functionality that central clearers traditionally provide.
Centralization is not a panacea
The flexibility provided by smart contracts and the auditability of the underlying replicating ledger makes it possible for OTC derivatives to achieve the intended regulatory goals of transparency and reduced counterparty risk. At a wider scope, reduction of systematic risk can be better achieved by avoiding concentration of risk into market wide clearers. Mutualization of risk may deceptively work for a long time as long as only a small fraction of the loss-sharing group fails i.e there is an implicit assumption of low-correlation of probability of failure between the loss-sharing group, but such an assumption is not a guarantee.
- Mandatory margin on TBAs: TBD, but not for long. Dan Ryan, PwC
- To Be Announce: The future of TBAs, Josheph Tomo, Citigroup
- Margining in Agency MBS, Treasury Market Practices Group