FICC Moves into the Home Stretch On the New Central Counterparty
Murray Pozmanter, DTCC managing director, Clearance and Settlement Group
August 17 is the target start date for the industry’s new central counterparty (CCP) for mortgage-backed securities (MBS) being launched by DTCC’s Fixed Income Clearing Corporation (FICC). The new MBS CCP, which will fundamentally change the way business is done in this sector of the industry, will bring guaranteed settlement and heightened risk management to mortgage-backed securities trades.
The next step in creating the new CCP, which was first proposed in a white paper in April 2006, involves the testing of pool netting. With this capability, FICC will step in as the CCP to net or eliminate comparable pools of the various mortgages underlying the traded securities, a move expected to reduce risk and costs for customers.
To update readers on this ground-breaking initiative, @dtcc spoke with Murray Pozmanter, DTCC managing director, Clearance and Settlement Group.
A future interview in @dtcc will focus on initiatives in FICC’s Government Securities Division.
Is the date for rollout of the new CCP set in stone?
We will go live on August 17, subject to two conditions. First, we need to secure approval of the Securities and Exchange Commission. We submitted our rule filing in March 2008 and expect to obtain approval sufficiently ahead of our planned launch date. Second, a majority of customer firms need to complete testing.
What will happen with the firms that aren’t ready?
We can operate the CCP even if all our customers are not on board from day one. Remember, the next step we need to complete to implement the CCP is pool netting, which is not necessarily an all-or-nothing proposition. The system can function without our entire membership participating in pool netting. But the more firms that are in the net, the more the savings, so it is clearly in everyone’s interest to get all of our trade activity into pool netting as quickly as possible.
Also, depending on the number of firms that are good to go, we could choose to launch the CCP only for certain products in the first production cycle.
How will you bring the outlying customers into the fold?
We’re considering levying some sort of disincentive fee to encourage firms that are trailing the pack to get up to speed.
When will testing for pool netting begin?
Our goal is to start some firms in pilot by the end of June, which will give us sufficient time to test the plumbing and kick the tires before August 17. That pilot period will be done under the existing rules – not the new CCP rules – and it’s really just an operational run-through that we’re going to do in preparation for full production.
Is there anything else members have to do to get ready for the CCP?
Yes. In addition to testing for connectivity and messaging submission, they have to test output via end-to-end testing. To conduct these drills, firms will be executing test scripts, which will take them through all the phases of the new service, from trade submission to receiving output from the clearing and post-pool netting process. Over the next few weeks, we will start end-to-end testing for participants that are ready. This is like a practice run of the entire process from beginning to end without actually dealing with real trades.
What about testing the entire CCP?
Once all firms in the pilot complete their operational testing, we will select a handful of firms to conduct a full run-through of the system as a CCP. We’ll ask those firms to submit a small number of trades in a designated fixed-income product that has light trading activity. This methodology will allow us to test all the inputs and outputs necessary for pool netting and the full operation of the CCP, as well as our settlement capabilities.
What role does common margining play in the CCP?
Common margining will allow firms to portfolio margin their assets across FICC’s Mortgage-Backed Securities Division and the Government Securities Division, rather than having separate calculations performed for each division. When we go live with the CCP, customers will need to meet some additional risk requirements of our value-at-risk methodology. The impact of these requirements on members is likely to be less if mortgage-backed and government securities transactions can be margined as a single portfolio. We will be submitting a rule filing with the SEC to change our margining rules.
What are you doing to prepare your member firms for common margining?
In early April, members will begin to receive sample outputs that will show them, based on their real portfolio values over the past year, what their common margining requirement would have been versus their existing requirement. We’re also planning to run a parallel period of common margining for the four weeks prior to the August 17 launch of the CCP. During this parallel period, customers will see, on a daily basis, their current and their new margin requirements based on their election of how they want to participate in common margining.
Why are you seeking to admit hedge funds and other buyside firms as members of FICC?
We had begun talking with some buyside firms at least a year ago as they became more interested in the risk protection we offer. Then came the Lehman bankruptcy last September, and that basically split the market into two camps. In one camp were FICC members, which participated in the centralized liquidation and had an exit strategy for their trades through us. In the other camp were all the institutional customers of Lehman. While their asset managers certainly tried to come up with protocols for the liquidation of those trades, they didn’t have any collateral posted. As a result, they were mostly on their own. And that really accelerated the push from the buyside to gain FICC membership. That was the genesis of all of the roundtable discussions we’ve been having with the asset managers, the Asset Managers Forum and others that have been arranged through SIFMA – the Securities Industry and Financial Markets Association.
Any other lessons learned from last year’s market collapse?
If there was a silver lining in the market turmoil, it was that it resulted in a clear validation of our concept for a central counterparty for mortgage-backed securities, as well as for our existing CCP for government securities. We successfully liquidated a huge portfolio of securities, on both the government and the mortgage sides of the business.
On the mortgage side, where we accelerated the rules and acted as “CCP for the day,” we reduced by 90% the market activity that needed to take place to neutralize Lehman’s forward positions. It was a strong validation of the process we’re about to roll out. It reaffirmed that we’re moving in the right direction, and we need to get there as quickly as possible. It was also a strong signal to the buyside about the safety and efficiency of our processes.
Do you expect the CCP to produce the cost savings and risk protection you anticipated when it was first proposed more than three years ago?
Yes. In fact, we’re more confident than ever that it will deliver risk mitigation and cost savings to the mortgage-backed industry. When it comes to risk protection, FICC’s steady hand during the recent market turmoil demonstrates that, while we can’t guarantee there won’t be losses, we certainly are in a good position to try to prevent any from occurring.
FICC has always limited its mortgage-backed business to “government paper,” meaning securities issued by government agencies. Do you anticipate that the industry – and possibly government agencies themselves – will urge FICC to guarantee trades that go beyond the current guidelines?
While we continue to limit our business to what we consider government paper or agency-guaranteed paper, no one knows for sure what Ginnie Mae, Fannie Mae and Freddie Mac will look like in the future given the current shift in the industry and government involvement in those companies.
Murray Pozmanter
The structure of the agencies themselves may change, and the structure of the products they issue may change. There are already programs going into effect involving the agencies in guaranteeing loans they previously would not have bought. The mandate of the agencies is being expanded to restart the securitization market to basically help clear the pipeline and allow for new lending.
If the programs change to include additional types of loans and securities or, more importantly from our standpoint, if those companies begin issuing different types of securities based on some of the new programs they’re becoming involved with, we’ll clearly have to work closely with the agencies themselves and with the trade associations to determine how and to what extent we should be involved.
FICC recently issued a new white paper that talks about moving past pool netting to an entirely different model. Where are you going with this?
With the MBS CCP rollout in sight, we’re thinking of ways to further strengthen the industry. The goal is to increase the amount of netting and reduce the numbers of pool allocations and settlements for our members by retiring the current clearing model that has been at the core of MBSD processing for 30 years.
Currently, FICC produces Settlement Balance Orders between multiple settlement counterparties at multiple settlement prices. We want to change that model and instead run the TBA netting and novation process daily. Then FICC would step in as the counterparty to all net positions and obligations in the system. When that occurs, we’ll be able to retire the whole notification of settlement [NOS] process. @