by James Conmy

Just as securities traders increasingly use algorithms - complex mathematical formulas - to speed up and determine how they buy and sell stocks and bonds, DTCC's Fixed Income Clearing Corporation (FICC) will begin employing algorithms to make big changes in the clearing and settlement side of mortgage-backed securities trading.

As part of the planned launch of a central counterparty (CCP) for mortgage-backed securities trades, FICC intends to use algorithms to sort out mortgage pools and select those that offer the best netting efficiencies for meeting mortgage-backed security trade obligations.

In a paper issued in June spelling out more details of plans to implement the CCP services, FICC noted the benefits of winnowing down the number of mortgage pool deliveries needed to satisfy "to-be-announced" (TBA) trade obligations. For FICC, it streamlines the process of settling pool obligations. For FICC's customers, it reduces the number of settlements they need to process.

Finding the most active pools

To net the pools, FICC will use a mathematical formula to determine the most actively traded pools that can be netted and settled against itself as the CCP. FICC will then automatically close out the settlement obligations outstanding for the pools that have been netted and release the corresponding margin as soon as the net obligations are settled.

"We think we'll be able to net out more than two-thirds of the pools, and this comes after we've already eliminated about 95% of the par value of trades through TBA netting earlier in the process," said Murray Pozmanter, DTCC managing director, Clearance and Settlement Product Management.

 The remaining, less active pools will not be netted. Instead, they will be left alone for settlement between the trading parties, which is how they are handled today.

"This allows us to focus on the pools that will benefit the most from pool netting, and means our customers can avoid paying additional settlement costs for thinly traded pools where the lower volume makes netting and settling through FICC a less effective tool," Pozmanter said.

"It also means expedited return of margin collateral to our customers, fewer securities movements to settle a mortgage-backed security obligation and fewer fails. Most importantly," he added, "it means we can provide guaranteed settlement, which is the ultimate goal of the CCP."

Step three

Mortgage pool netting is the third step in FICC's drive to phase in full CCP services for mortgage-backed securities trades. When full CCP services are up and running, FICC will take on the role of counterparty to TBA trade netting and allocation. Testing for the third phase, where FICC becomes CCP for pool netting, is scheduled to begin in the first quarter of 2008, with the goal of rolling out the new CCP pool netting service before the end of 2008.

The first phase of this initiative - matching specified pool trades through FICC's Real-Time Trade Matching (RTTM) system - began operation on June 22. The second step is currently in the midst of customer testing. Its aim is to make it easier for customers to cancel an existing mortgage pool that may not be suitable for settlement - and substitute a different pool - using only a single message in FICC's Electronic Pool Notification service.

 How pool netting works

To be eligible for netting, pools will have to be linked to an open TBA position. This means specified pool trades will be excluded from the netting process. Because their full trade terms are known at the time of the trade, there is no open TBA position. They are the position.

Customers will have two routes to submit pool data for netting consideration. They can provide pool data via RTTM Web, or they can submit the data using ISO-based messaging formats. In either case, the seller's pool data must match the data submitted by the buyer.

Once the pools have been submitted and matched, they will stay in the netting "holding pen" until the actual pool net takes place, which occurs on the evening of delivery date minus one day.

This is when FICC will turn on its algorithms to see which pools will best benefit from pool netting, and which pools with similar terms can be paired off on a multilateral basis. Using yet another algorithm, FICC will also analyze how customers can minimize the number of deliveries they will need to make to satisfy their pool obligations.

Ready for settlement

Once netting-eligible pools are defined, FICC will net the pools into a single net position per pool number or attempt to pair off any pools that don't meet the requisite netting criteria against similar pools. When those steps are complete, FICC will replace the TBA obligations with the appropriate pool receive or deliver obligations, and settle the transactions.

Trades involving pools that don't match will settle between the original buyers and sellers outside the clearing corporation.

Once pool netting begins, FICC customers that also trade U.S. government securities will have the opportunity to cross-margin their positions with their government securities portfolio. The anticipated result, according to FICC, will be to reduce total margin requirements.

CCP guarantee for mortgage-backed industry

As part of the clearing services it provides to the industry, FICC has routinely netted mortgage-backed securities trades, conse-quently reducing the number of transactions requiring financial settlement. But FICC has never offered guaranteed settlement of the trades. Now, with the implementation of a central counterparty function, FICC will be in a position to provide guaranteed settlement.

After nearly two years' consultation with various firms active in the market, FICC began to draw up plans to create a CCP. The white paper FICC issued in April 2006 announced its intention to create a CCP and detailed the first three steps FICC had planned for the creation of the new CCP.

Since then, FICC has disseminated information on the various steps in the plan. The Pool Netting Service Paper, published June 8, is the latest publication to spell out how the CCP will function and what steps customers will have to take. To view and download the document, visit www.dtcc.com and click Clearance and Settlement, then Fixed Income. @

 [For more information, contact Kate Connelly at KConnelly@dtcc.com or 212.855.7611.]