FICC Sets 1 P.M. Deadline for Repo Collateral Substitutions

by James Conmy

As of Monday, June 4, Fixed Income Clearing Corporation's (FICC) window for repo collateral substitutions firmly closes each day at 1 p.m. Eastern time. Any substitution requests coming in after that are not processed until the next business day.

FICC established this deadline, or "hard close" in industry parlance, following more than two years of changes to collateral substitution procedures based on discussions with an industry working group and increased automation by FICC's Government Securities Division. The Securities and Exchange Commission (SEC) approved the change in April.

"Setting a strict deadline for submitting repo collateral substitutions marks the culmination of a multiyear initiative to reduce risk and cost in this market by standardizing and automating the substitution request process," said David Cosgrove, DTCC vice president, Operations.

A half-hour gain
The deadline for substitution requests under previous rules was 12:30 p.m. FICC processed substitution requests or replacement collateral that came in later, but firms had to pay a penalty fee and FICC worked only on a "good-faith basis," meaning it could not guarantee completion of the transaction.

Under the new SEC-approved deadline of 1 p.m. that took effect June 4, firms can still submit late substitution requests or new collateral specifications after FICC's 12:30 p.m. closing, but only for another half-an-hour and only with the understanding that FICC will process the request on a "good-faith basis." Any request that comes in after 1 p.m. will have to wait until the next day.

An exception to the rule will accommodate order flow when the Securities Industry and Financial Markets Association designates a "high-volume" day, such as the end of a quarter or a Treasury refunding. On these days, FICC will extend the 1 p.m. deadline by one hour to 2 p.m.

Growing volumes
Since the early 1990s, the U.S. market for repurchase agreements, or repos, has been averaging growth of more than 15% a year, according to a study by Celent, a financial research firm. Currently, outstanding term repo trades run to as much as $2.7 trillion a day. In this large and growing market, swapping the collateral behind a repo - usually for a security of equivalent value - has emerged as a common industry practice.

In the past, FICC routinely processed most substitution requests manually. However, in recent years, the sharp climb in the number of substitutions has underscored the need to establish industry-wide procedures and automation.

What makes the substitution process somewhat complicated is that 9 out of 10 term repo trades coming into FICC for clearance and netting are "blind-brokered." Because the dealers speak only to the inter-dealer broker and not to each other, they don't know who the other side of the trade is. As a result, collateral substitution requests all have to be coordinated through the broker, and then that information must be provided to FICC for processing. This often led to situations in which the original and substitute collateral flowed into FICC's clearing banks from dealers before the broker even had a chance to post a substitution request.

Quarterly spikes
Substitution needs tend to climb at the end of each quarter when term repo transactions settle or firms recall securities they need to allocate to newly starting term repos. In mid-2004, when the end of the quarter coincided with a hike in interest rates, so many substitution requests remained unprocessed at its participants that FICC requested an extension of the Fedwire closing time to process all outstanding requests and reduce the potential loans that could have been incurred by the Street. 

At that point, FICC set about to automate its substitution process internally so requests could be processed electronically. The company also began discussions with dealers and inter-dealer brokers on ways to coordinate their still largely manual substitution requests with FICC's new automated process.

Steady progress
Today, FICC can process thousands of substitutions electronically within a short time frame. What's more, a reworking of the timetable last spring breaks the whole substitution process into separate, more manageable pieces. Brokers now have more time to give FICC notice that a substitution is planned, and a notice automatically queues up other steps so that FICC and its banks will be prepared to handle the new collateral.

In an innovative step to remove risk and streamline the process even more, FICC now automatically instructs its bank to receive the original collateral and deliver it back to the dealer as soon as a substitution request comes in. At the same time, FICC substitutes general collateral for any replacement allocations that may not arrive in time.

"This allows us to keep the repo contract in force because there is a generic CUSIP in place as collateral to support the contract until we get the actual substitute collateral," Cosgrove said.

No more penalties
Now FICC is further strengthening this market's processing environment by extending the deadline by one-half-hour and making it mandatory for firms to submit their requests by 1 p.m. No longer will they have the option to pay a penalty for FICC to handle the substitution.

"Because this was a manual process for so many years," Cosgrove said, "some participants still want to come in after the deadline with the expectation that we can accommodate their requests. But now that we have completely automated the process, it is no longer possible to do it manually, penalty or not. The result is a more streamlined and secure market for collateral substitutions." @

[To learn more, contact Bart Schiavo at bschiavo@dtcc.com or 212.855.7590.]