Margining_paper.indd

This document is available

on the Treasury Market

Practices Group website,

www.newyorkfed.org/tmpg.

Margining

in Agency

MBS Trading

November 2012

Contents

1. Introduction ................................................................ 1

2. Historical Background ................................................... 2

3. What Risks Is Margining Meant to Address?` .................... 3

4. How Does Margining Mitigate Risks? ............................... 4

5. Operational and Legal Issues .......................................... 5

6. The Case for Industry-Driven Margining Practices ............. 7

Appendix: Margining Examples .......................................... 9

This document is available

on the Treasury Market

Practices Group website,

www.newyorkfed.org/tmpg.

November 2012

Margining in Agency

MBS Trading

1. Introduction

Most purchases of agency mortgage-backed securities (MBS) are

forward transactions that settle about one month after the trade

is agreed upon, and some can also settle farther in the future.

Parties to forward-settling transactions bear counterparty credit

risk—the risk that a counterparty is unable or unwilling to meet its

contractual obligations.

If one party to a forward transaction does

not meet its obligations, the other party may experience a loss if it

has to replace the transaction at a worse price. One common means

of mitigating the counterparty credit risk of forward transactions is

for the counterparties to agree to post collateral, or margin, as the

market value of the securities  uctuates. The posting of margin is a

common practice in the trading of agency MBS between members of

the Mortgage-Backed Securities Division (MBSD) of the Fixed-Income

Clearing Corporation, which became a central counterparty (CCP) in

April 2012. However, margining is less common in bilateral agency MBS

trading between dealers and customers that are not MBSD members.

This contrasts with practices in other forward, repo, securities

lending, and derivatives markets, where margining has been pursued

with greater consistency and with a more developed body of market

conventions.

In these markets, margining has developed as a standard

practice between participants, both in uncleared transactions and as

part of central counterparty risk management systems, and in some

cases has been enshrined in statutory law.

Most agency MBS trading is conducted in the To-Be-Announced (TBA) market, with de ned

settlement dates for each month in the future. Liquid contracts are available up to two months

forward, and some trade at more extended tenors. Parties that trade agency MBS outside of the

TBA market may bear counterparty credit risk as well, since many non-TBA trades also settle

on the TBA schedule.

In the over-the-counter (OTC) markets, these practices have generally been based on

recommendations of the International Swaps and Derivatives Association (ISDA), the Securities

Industry and Financial Markets Association (SIFMA), and other industry groups.

To the extent that they remain unmargined,

uncleared agency MBS transactions can pose

signi cant counterparty risk to individual

market participants. Moreover, the market’s

sheer size—it is one of the largest  xed-

income markets, with $5 trillion in agency

MBS outstanding and roughly $750 billion to

$1.5trillion in gross unsettled and unmargined

dealer-to-customer transactions—raises systemic

concerns. If one or more market participants

were to default on forward-settling agency

MBS trades, the agency MBS market could

transmit losses and risks to a broad array of

other participants. While the transmission of

these risks may be mitigated by the netting,

margining, and settlement guaranties provided

by a CCP, losses could nonetheless be costly and

destabilizing. Furthermore, the asymmetry that

exists between participants that margin and

those that do not could have a negative effect

on liquidity, especially in times of market stress.

This paper evaluates the nature of the risks

posed by unmargined agency MBS trading, describes

how margining could address those risks, and

discusses the operational and legal considerations

associated with the more widespread use of

margining. It concludes that market ef ciency

and  nancial stability would be enhanced by

broader use of margining for uncleared agency

MBS transactions.

2. Historical Background

The  rst forward-settling contracts in the

United States were developed for commodities,

and market participants took the initiative

to centralize clearing of these contracts

on exchanges in the form of standardized

futures contracts organized around a central

counterparty. An important aspect of these

structures was the collection of capital—or

margin—from participating members to serve as

protection against loss. Eventually, other forward-

settling markets moved from OTC structures to

centralized clearing and margining, including

Treasury futures—one of the largest forward-

settling markets—in 1974.

In recent decades, margining has also become

a central part of the development of the OTC

derivatives markets, whose transactions entail

counterparty credit risk that is similar to that of

forward-settling agency MBS. The development

of margining practices for such derivatives

transactions was motivated in part by  nancial

market stress events and the failure of major

counterparties. For example, the market stress

evident in the late 1990s, centered around the

Russian sovereign default, the Asian  nancial

crisis, and the failure of Long-Term Capital

Management, helped to further the market’s

move toward the development of more robust

risk management standards for swaps.

More recently, market events have spurred

the move toward increased central clearing

of derivatives and refocused attention on

counterparty credit risk management for

transactions not cleared by central counterparties.

Traditionally, margining of uncleared derivatives

transactions had been a credit risk mitigant

that dealers demanded of only some of their

counterparties. However, after the failure of

Lehman Brothers in 2008, dealers and customers

alike began to move toward greater use of

margining on a bilateral basis. The movement in

policy and industry practice toward margining

accelerated in November 2008, when the G-20

Summit on Financial Markets called for measures

to reduce systemic risks in the OTC derivatives

markets—a general call that has since been

interpreted as supporting the use of margining.

In the United States, the move toward

increased use of margining for OTC derivatives

transactions was codi ed in Title VII of the

Dodd-Frank Act, which requires designated

swap dealers and major swap participants to

post margin on centrally-cleared swaps, among

This resulted in publications such as the 2001 ISDA Margin

Provisions and the 2002 ISDA Master Agreement for swaps.

other requirements.

Notably, the Act requires

margining for both non-centrally-cleared OTC

derivatives and cleared transactions.

While counterparty exposures in the

$5trillion agency MBS market are similar in

nature to those of other forward-settling and

OTC derivatives transactions,

the trend toward

margining has not advanced as far in agency

MBS trading. While the CCP accounts for a

signi cant volume of transactions in agency

MBS, many bilateral agency MBS transactions

are not submitted to the MBSD and are not

margined. Overall, the daily average of customer-

to-dealer transaction volume is approximately

$100billion,

and anecdotal evidence suggests

that roughly two-thirds of volume remains

unmargined. Because the majority of transactions

settle just once a month and trading is conducted

using forward settlement, gross unsettled and

unmargined bilateral agency MBS transactions

could be in the range of $750 billion to

$1.5trillion at any point in time.

While some

of these trades could be netted down due to

dollar rolls and coupon swaps, gross unsettled

exposures are still an important measure of credit

risk as well. Moreover, the size of even the net

unsettled and unmargined positions could result

in substantial exposures if one or more market

To implement this legislation, a variety of regulatory bodies are

reviewing their rulemaking processes, including the Commodity

Futures Trading Commission, the Securities and Exchange

Commission, the Federal Deposit Insurance Corporation, the

Of ce of the Comptroller of the Currency, and the Federal Reserve.

For noncleared swaps, the rules have not yet been  nalized.

Additional consultative principles for margin requirements for

non-centrally-cleared derivatives have also been developed by the

Basel Committee on Banking Supervision and the Board of the

International Organization of Securities Commissions.

The months-long exposures prevalent in unsettled MBS trades are

of a different order of duration from the exposures in many OTC

swaps, which may last multiple years in some cases. However, the

same principles and procedures of credit risk management apply,

just as they do in other forward-settling markets, such as those for

Treasury and commodity futures, repos, and securities loans.

Estimate is derived from data published by the Financial

Industry Regulatory Authority (FINRA).

Estimate is derived from data published by FINRA and the

Federal Reserve Bank of New York.

participants were to default—raising systemic

concerns.

3. What Risks Is Margining Meant to Address?

In a security forward transaction, a buyer agrees

to a price at which to purchase a security from

a seller, with settlement designated at some

future point. In the case of agency MBS, that

settlement date is as much as three months

in the future and on average twenty- ve days

forward.

For example, a buyer might purchase

$100 million in agency MBS in a TBA transaction,

with settlement scheduled  fteen days in the

future. Until settlement occurs, each party to

the transaction is subject to counterparty credit

risk, owing to changes in the market value of

the securities purchased.

Under standard agency MBS master agree ments,

in the event of a counterparty failure or default

a  rm may terminate all unsettled agency MBS

transactions with the counterparty and calculate

a net loss or gain amount for all unsettled

transactions. To determine the gain or loss, the

nondefaulting  rm may enter into replacement

transactions or rely on indicative quotes or other

evidence of prevailing market prices.

If the seller of the security in our example

above were to fail as an institution after placing

the trade but prior to settlement, the buyer

could choose to purchase the security in the

open market. If, by the time of the failure,

market prices had increased by 5percent, the

buyer’s replacement cost would be $105 million;

if no margin had been posted, the buyer’s loss

Agency MBS trades in the TBA market settle once a month.

According to TRACE data published by FINRA, 70percent of

TBAs trade for the most immediate settlement date, up to one

month forward. Nearly 30percent of TBAs trade for the following

month’s settlement date.

In the case of a purchase, if the market value of the contract

has appreciated, the defaulting counterparty would be obligated

upon termination to reimburse the nondefaulting party for its

loss. In the case of a sale, if the market value of the contract

has depreciated, a defaulting counterparty would be obligated to

reimburse the nondefaulting party for its loss.

would be $5 million. In practice, a  rm would

likely have more than one trade to replace, and

market prices could move much more. In such

a case, the uncollateralized losses for a large

defaulting institution, or a collection of  rms,

could rise to the billions of dollars.

The default of one or more market partici-

pants, especially large ones, on an uncleared

bilateral transaction could result in chaotic

trading. If the  rst party to default had a large

net long or net short position outstanding,

market functioning could deteriorate amid

one-sided trading and price volatility as its

counterparties sought to replace their trades

at the same time. If the  rst party to default

did not have a large net long or net short

position outstanding, one-way trading may

not occur. Nevertheless, in either scenario the

counterparties to the defaulting  rm could

suffer substantial losses if their positions

were not margined. If the losses had or were

perceived to have a destabilizing effect on these

counterparties, there could be a contagion

effect through ex post margin calls, reluctance

to establish new transactions, or redemptions

by investors. While margining of eligible MBS

transactions among MBSD members mitigates

some of this contagion risk, and could provide

a partial  rewall that interrupts a cascade of

defaults, it would not eliminate such risk.

Thus, uncertainty about the unmargined

exposures of  rms and funds could lead to a

rapid liquidity drain, a sudden failure, and a

systemic event. Though not related speci cally

to agency MBS, similar scenarios played out with

collateral runs, margin calls, or redemptions

associated with Bear Stearns and Lehman

Brothers in 2008, Long-Term Capital Management

in 1998, and the Prime Reserve Fund in 2008.

4. How Does Margining Mitigate Risks?

Reducing Counterparty Credit and Systemic Risks

Counterparties in agency MBS trading can

reduce the credit risk inherent in their

forward transactions by exchanging margin. To

implement the margining process, counterparties

typically agree that they will post collateral

when their counterparty’s cost of replacing a

trade is higher than the original price of the

transaction. The margin functions as a buffer,

or cushion, for absorbing losses in case the cost

of replacing the position is higher than that

of the original transaction. As such, margining

can mitigate the risk of cascading institutional

failures and one-sided or chaotic trading and

help preserve market liquidity. This implies

margining can potentially exert a countercyclical

force and increase  nancial stability more

broadly.

Continuing with our example transaction,

suppose that the seller had posted $2.5 million in

margin to the buyer. If the seller defaults, the buyer

may apply the $2.5 million to defray its $5 million

loss on the canceled trades.

One bene t of

margining is that the nondefaulting party should

have prompt access to collateral to cover its

losses, rather than having to seek reimbursement

of the losses from the defaulting party.

Parameters of Margin Processes

Margin agreements for many  nancial products

require counterparties to post margin on a daily

basis, in an amount equal to any mark-to-market

change in the net value of the unsettled forward

transactions between the parties. This margin

is colloquially known as “variation margin.”

Variation margin is often a symmetrical regime

in the sense that either counterparty may be

obligated to post margin, depending on the

 uctuation in the net value of the trade and the

collateral already posted.

See the appendix for other margining examples.

In addition, certain market participants, such

as CCPs, may require “initial margin” to be posted

in order to cover, to a predetermined level of

con dence, the market risk for the estimated

period of time it will take to replace a transaction

that was terminated because of default or failure

to perform by one of the counterparties—a

process that may take a number of days. Where

it applies, the calculation of initial margin is

generally determined by considering the market

value at risk (VAR) over the period necessary

to replace a defaulted trade. Such VAR analyses

often consider the potential for market value

 uctuations based on historical price changes,

over a certain time interval and at a speci ed

level of con dence or statistical signi cance.

While margining serves to reduce the risk

of net forward exposures, it does not fully

eliminate such risk. Moreover, while margining

reduces credit risk, it can introduce additional

operational and other risks.

Therefore,

evaluation of margining practices must pay

careful attention not only to how thoroughly

the process reduces counterparty credit risk

or how cost effectively it does so, but also

to the level and nature of operational risk

that the process incurs. Certain parameters

of margining agreements are crucial to these

analyses, including thresholds, minimum transfer

amounts, frequency of deliveries and returns,

acceptable collateral types, and margin triggers.

For example, to reduce the burden associated

with margining, market participants may set

a margining threshold—a level of unsecured

exposure below which counterparties agree

not to exchange any collateral.

Similarly,

participants may set a minimum transfer amount

(MTA), a net change in exposure below which

they agree not to exchange collateral. That is,

Accordingly, some have described margining as a process

that partially converts credit risk into operational and other

risks. See the ISDA’s “Market Review of OTC Derivative Bilateral

Collateralization Practices,” p. 5.

Thresholds are counted as an exposure against which broker-

dealers must hold capital.

even if the threshold is exceeded, collateral is

posted only if the net new collateral transfer is

of suf cient size. For example, if a  rm owed

$80,000 more in collateral than its threshold

level but its MTA was $100,000, it would not

post anything that day.

The frequency at which counterparties

agree to reevaluate their margins and post

collateral is another operational parameter used

to adjust the nature and level of credit and

operational risks in forward transactions.

Each

of the margining parameters should therefore

be carefully considered in order to ensure

appropriate management of counterparty and

operational risks at the  rm level, bearing in

mind that an individual  rm’s risk management

will affect the  nancial stability of the agency

MBS market as a whole.

5. Operational and Legal Issues

To implement margining of agency MBS

transactions, market participants must

address a number of operational and legal

issues, whether they join a CCP or establish

bilateral margin arrangements. While the

margining terms offered by a CCP are

often standardized, the terms of bilateral

margining may be customized in any number

of ways to suit individual relationships and

operational requirements. Nevertheless, all

margining processes should accomplish a

variety of common functions. In general, the

key functions would be measuring forward

exposures, marking open positions, calculating

the margin amount, communicating margin

While market participants sometimes use various market- or

credit-based triggers to initiate or adjust margining requirements,

this approach has several negative consequences. For example,

waiting to margin until a credit or other trigger has already

been breached could leave a  rm open to substantial credit risk.

Further, from a  nancial stability perspective, widespread use

of credit rating triggers is likely to generate procyclical forces,

potentially sending a counterparty into a downward spiral of

accelerating collateral calls. Accordingly, credit-based triggers

are not recommended by groups like the Bank for International

Settlements (BIS). See “The Role of Margin Requirements and

Haircuts in Procyclicality,” BIS, pp. 17-8.

calls to counterparties, and delivering and

receiving collateral.

More speci cally, middle- and back-of ce

resources and systems would be needed to mark

unsettled positions using current and readily

available pricing sources. To determine net

forward exposures would require similar types

of resources to maintain collateral accounts and

monitor balances. If securities were pledged

as collateral, current pricing information and

margin calls would be needed to ensure the

suf ciency of the collateral. Systems and

resources must also be prepared to communicate

and respond to margin calls, reconcile possible

disputes, and manage collateral  ows and

settlement. Finally, while accounting for

margining is a task that a typical  nance area

could handle, these activities may introduce

additional complications. Many of these and

other functions necessary to conduct margining

are similar across asset classes, and the existence

of margining for other forward transactions and

derivatives may reduce the costs associated with

implementing margining for agency MBS.

U.S. broker-dealers are required by regulation

to establish a number of additional operational

controls. For example, they must maintain

records that identify the owner and location

of the securities, and they must issue account

statements to customers on at least a quarterly

basis (as opposed to the requirement that

such statements be sent for a delivery-versus-

payment/receipt-versus-payment repo account

only if there is activity during that period).

Dealers may also be required to evaluate good

control-location status, or the segregation at the

custodial bank or the securities depository of

customer and dealer securities.

As a commercial

matter, customers may put in place comparable

arrangements for segregating dealer collateral.

See SEC Rule 17a3 under the Securities Exchange Act of

1934 and National Association of Securities Dealers Rule 2340,

respectively.

See SEC Rule 15c3-3.

In addition to these operational issues,

implementation of margining would require

participants to put in place written agreements

de ning the terms of their margining practices

with each of a  rm’s uncleared bilateral

counterparties, a process that would likely

take a period of time. Under current law, the

requirements for dealers and investors differ.

For dealers, the 1934 Securities Exchange Act

requires that a written margin agreement be put

in place for each customer from whom margin

may be collected.

For funds registered under

the Investment Company Act of 1940, a tri-

party control agreement among the dealer, the

fund, and the fund’s custodian may be required

in order to post margin. Some investors may

also be required by their bylaws to obtain board

approval for margining. Additionally, investors

may need to execute or amend custodial and tri-

party agreements to cover the margin process as

well as agreements with their asset managers to

process margin on their behalf.

SIFMA’s Master Securities Forward Transaction

Agreement (MSFTA) is currently the only industry

standard template that has been developed for

margining agency MBS forwards. Like the MSFTA,

any written agreement that market participants

employ should re ect the parties’ agreement on

all aspects of the margining regime, including

collateral eligibility, timing and frequency of

margin calls and exchanges, thresholds, valuation

of exposures and collateral, and liquidation.

Written agreements covering agency MBS forwards

will also typically provide (as the MSFTA does)

that unsettled agency MBS transactions with a

counterparty that has defaulted may be canceled

and otherwise liquidated. A net loss or gain

amount may then be calculated for all unsettled

transactions and applied against any margin

posted prior to default by the defaulting party.

See SEC Rule 17a3.

6. The Case for Industry-Driven

Margining Practices

As an industry group dedicated to promoting

best practices, the Treasury Market Practices

Group (TMPG) believes it is appropriate to

proactively support margining practices for

forward-settling transactions, such as agency

MBS, in order to promote the integrity and

ef ciency of the market. The TMPG recognizes

that there are a number of operational and

legal costs to the expanded use of margining.

However, given the sizable portion of the

MBS market that is currently unmargined and

the associated systemic risks, margining can

substantially bene t the agency MBS market

by meaningfully mitigating counterparty

risks associated with unsettled positions and

supporting stability during periods of market

stress.

Recall that the margining of agency MBS

is consistent with the broad trend across the

 nancial system to increase collateral and capital

to fortify a variety of institutions and markets

against the types of risk realized during the

recent  nancial crisis. Alongside the Dodd-Frank

Act’s requirements for collateralization of swaps,

the Basel III capital accord—which  nancial

institutions are already preparing to implement—

generally calls for greater capital reserves to be

held against a variety of asset classes.

In this context, developing additional

margining practices for agency MBS should not

be substantially more expensive nor otherwise

more dif cult than undertaking efforts to

establish margining for other equally important

markets. In fact, while there are initial start-

up costs to developing and implementing a

margining regime for agency MBS, there may

be some economies of scale to margining across

different markets once  rms establish the

necessary systems and hire appropriate staff.

Furthermore, wider adoption of margining

could promote a “level playing  eld” in the

agency MBS market and thereby improve

liquidity and promote sound risk management

practices. Participants that margin transactions

today incur costs not borne by unmargined

participants. This introduces an asymmetry

that disadvantages  rms that employ margining

as part of sound risk management. Put

another way, participants that do not margin

transactions may gain a competitive advantage

in an unsound way. Market ef ciency can also be

impacted when trading occurs with unmargined

participants, resulting in bid-ask spreads that

are wider than they otherwise would be because

they re ect counterparty credit risk in addition

to other transaction costs. Widespread use of

margining could address both of these issues,

encouraging broader use of sound counterparty

risk management practices and improving market

liquidity for all participants.

Finally, the need to collateralize agency MBS

transactions is also no less urgent than it is

in other markets. The TBA market has yet to

experience the same types of disruptions or to

transmit the same kinds of counterparty risk as

some OTC derivatives markets not adequately

margined in 2008. Yet the TBA market’s sheer

size—outstanding securities of over $5 trillion,

average daily trading volume between customers

and primary dealers of around $100 billion, and

daily forward gross unmargined exposures of

$750 billion to $1.5 trillion—suggests that the

market may pose substantial risks, not only to

individual participants but also to the  nancial

system as a whole.

Accordingly, while agency MBS products may

themselves expose market participants to less

credit risk because they are agency-guaranteed

securities, it is dif cult to argue that trading

in agency MBS exposes participants to less

counterparty credit risk than trading in other

markets, and thus that trading in agency MBS

has less need for risk mitigation. Indeed,

stable and standardized margining practices

could exert a countercyclical force in periods of

 nancial market distress by helping to prevent

opportunistic or panic-driven collateral runs,

thereby increasing  nancial stability.

Bank for International Settlements. 2010 “The

Role of Margin Requirements and Haircuts in

Procyclicality.” CGFS Papers, no. 36, March.

Basel Committee on Banking Supervision

and International Organization of Securities

Commissions. 2012. “Margin Requirements for

Non-Centrally-Cleared Derivatives.” July.

Capel, Jeannette, and Anouk Levels. “Is

Collateral Becoming Scarce? Evidence for the

Euro Area.” DNB Occasional Studies 10, no. 1.

Depository Trust and Clearing Corporation. 2006.

“A Central Counterparty for Mortgage-Backed

Securities: Paving the Way.” April.

Duf e, Darrell, Ada Li, and Theo Lubke. 2010.

“Policy Perspectives on OTC Derivatives Market

Infrastructure.” Federal Reserve Bank of

NewYork Staff Reports, no. 424, March.

International Swaps and Derivatives Association.

2005. “Collateral Guidelines.”

____. 2011. “2011 Best Practices for the OTC

Derivatives Collateral Process.” November.

International Swaps and Derivatives Association,

Collateral Steering Committee. 2010.

“Market Review of OTC Derivative Bilateral

Collateralization Practices.” March.

International Swaps and Derivatives Association,

Managed Funds Association, and Securities

Industry and Financial Markets Association.

2010. “Independent Amounts.” March.

Treasury Market Practices Group. 2010. “Best

Practices for Treasury, Agency Debt, and

Agency Mortgage-Backed Securities Markets.”

September 14.

Vickery, James, and Joshua Wright. 2010.

“TBA Trading and Liquidity in the Agency MBS

Market.” Federal Reserve Bank of New York

StaffReports, no. 468, August.

References

Example A

On day T, there is a $100 million trade amount

(face value × price) with no existing collateral.

No variation margin is required because there is

no forward exposure.

Example B

On day T+1, the value has gone up one point by

end of day, resulting in a forward exposure for

the counterparty of $1 million. The closing

market value is $101 million. The total margin

required of the dealer is now $1 million,

representing variation margin, so the margin

call is $1million.

Example C

On day T+2, the closing market value drops to

$99 million, resulting in a forward exposure of

$1 million for the dealer. $1 million in collateral

was previously posted by the dealer, so an

excess margin of $2 million is returned by the

counterparty.

Example D

On day T+3, the closing market value drops

further, to $97.5 million, resulting in a forward

exposure for the dealer of $2.5 million. The

total margin required of the counterparty is

$2.5 million, of which $1.0 million in collateral

was posted previously, so only $1.5 million in

additional collateral is required.

The Treasury Market Practices Group (TMPG) is a group of

market professionals committed to supporting the integrity and

ef ciency of the Treasury, agency debt, and agency mortgage-

backed securities markets. The TMPG is composed of senior

business managers and legal and compliance professionals from a

variety of institutions—including securities dealers, banks, buy-

side  rms, market utilities, and others—and is sponsored by the

Federal Reserve Bank of New York. More information is available

at www.newyorkfed.org/tmpg.

Appendix: Margining Examples