Message Testing Begins for Mortgage Pool Netting

by James Conmy

Over the next few months, DTCC’s Fixed Income Clearing Corporation (FICC) plans to begin testing newly designed interactive messages with its customers in order to prepare for the introduction of mortgage pool netting. Netting the mortgage pools that are a result of to-be-announced (TBA) trade allocations is a key building block in FICC’s initiative to construct a central counterparty (CCP) for mortgage-backed securities trading.

FICC plans to submit a rule filing to the Securities and Exchange Commission (SEC) in the first quarter of 2008 that spells out its intentions to make substantial changes to its longstanding processing procedures for the $375 billion-a-day mortgage-backed securities trading business. “We’re essentially rewriting several sections of our rule book to establish the procedures necessary to operate the new CCP,” said Murray Pozmanter, DTCC managing director, Clearance and Settlement Group.

Interactive testing

The new CCP pool netting service that FICC will be testing with customers enables firms to submit pool details to the pool netting system for comparison, netting and settlement versus FICC as the central counterparty. This represents an entirely new approach to the handling of the mortgage pools that stem from the TBA obligations.

FICC designed and built these new services after extensive consultation with its mortgage-backed securities customers. “Our aim is to reduce customers’ costs by shrinking the number of pool settlements they need to make, along with the risk and costs that accompany settlement,” said Pozmanter. “At the same time, we intend to keep code and system changes to a minimum.”

Speeding up the trade guarantee

FICC already nets roughly 94% of the mortgage-backed securities TBA trades submitted for clearance, and the addition of pool netting is expected to raise the netting factor to as high as 98%. Only the most active pools will be netted and settled against FICC as the central counterparty. Thinly traded pools, which account for the remaining 2% of trades, will be excluded from the process.

Even though FICC’s longstanding procedures for netting TBA trades will remain largely unchanged, the company is taking on a more strategic role as a clearing corporation that offers the guaranty of trade settlement and acts as a central counterparty to select transactions.

In addition, the timing of FICC’s guarantee to settle the trade will come at the front end of the clearing process. Under the new rules, FICC will guarantee settlement of all TBA and specified pool trades the moment they are reported to members as being successfully compared within FICC’s Real-Time Trade Matching (RTTM) system.

Where to Find Messaging Specs for Pool Netting

To support central counterparty pool netting for mortgage-backed securities trades, firms will have to make some changes to their interactive messaging procedures. A service description giving background information, and a second document providing detailed specifications for the interactive messaging, are available on the DTCC website.

Since testing of the interactive message procedures is scheduled to take place in the first quarter of 2008, FICC recommends that firms begin to review the new specifications as soon as possible.

To obtain the specifications, visit www.dtcc.com. Go to Products & Services and, on the drop-down menu, click User Documentation, then click Participant Documentation under Fixed Income Mortgage-Backed Securities. Another route to the specifications is to visit www.ficc.com. Click the Mortgage-Backed Securities Division tab at the top of the home page. Click the Important Documents link on the left side of the page, then the Participant Documentation link on the menu at the top center of the page.

For questions, contact Kate Connelly at 212.855.7611 or kconnelly@dtcc.com.

Step three

Pool netting is the third step in FICC’s plan to introduce CCP services. In the first step, implemented in 2007, FICC began comparing specified pool trades. The second step, which FICC is currently rolling out, makes it possible for customers to submit mortgage pool substitutions using only a single message to convey details for the original and replacement collateral.

Under the revised process, as participants allocate mortgage pools to their TBA obligations via FICC’s Electronic Pool Notification service, they will need to submit pool details – called “pool instructs” – into the pool netting system via RTTM for comparison versus the counterparty’s submissions. Once a “pool instruct” is compared and assigned to a valid TBA position, that mortgage pool can be included in the pool netting process, provided it meets other eligibility criteria.

FICC is also developing an algorithm to minimize the number of deliveries clearing members are required to make to satisfy their net obligations and to further reduce members’ settlement costs through “internalized” settlement. That allows each customer to deliver and receive through its own clearing bank as many deliveries as possible before having to make interbank settlements. “This will help reduce the overall number of pool settlements and the costs and operational risk inherent in the process,” Pozmanter said.

Phasing it in

For many companies, the systems development needed to implement pool netting may be extensive. As a result, FICC plans to phase in customer testing of the new procedures in three steps, with the goal of completing testing and launching pool netting before the end of the 2008.

Step one will enable customers to begin testing interactive messaging with FICC, so that firms can learn not only how to send “pool instructs,” but also how to modify or cancel their “instructs.”

Step two, scheduled for the second quarter of 2008, will allow customers to receive and process batch data on pool netting details, including information pertaining to the cleared pools and a list of fails.

Step three, set for the last quarter of 2008, will entail full end-to-end testing of all the processes involved in pool netting, including the settlement of net pool obligations against FICC, the ability to substitute pool obligations, cash settlements and risk management details.

“When all our customers are familiar and comfortable with these procedures,” Pozmanter said, “then we will begin operating as a CCP for mortgage-backed securities trading.” @