New Central Counterparty for Mortgage-Backed Securities Passes Pilot Test with Flying Colors
Fixed Income Clearing Corporation (FICC) compared more than $780 million worth of mortgage pools in September as part of the first full pilot test of its soon-to-go-live central counterparty, which will mitigate risk in mortgage-backed securities trading and guarantee completion of the transactions.
During the course of the pilot tests, which FICC limited to two classes of securities and five participating firms, the central counterparty netted out or eliminated more than half of the eligible pools and related payments for the transactions. FICC clears an average of more than $9.2 trillion in mortgage-backed securities trades in the U.S. market each month.
Designed to reduce post-trade risks and costs for the fixed income markets, the central counterparty is awaiting final regulatory approval from the Securities and Exchange Commission (SEC), which previously agreed that live “pilot testing” of the system should take place on a limited, controlled basis.
Quantifying the benefits
Currently, mortgage-backed securities trades handled through FICC clear and settle on a bilateral basis. While FICC restricts its mortgage business to “agency paper”—securities issued by government-sponsored agencies—the trades are not guaranteed if one of the counterparties, such as a broker/dealer, goes bankrupt or is otherwise unable to complete settlement.
The new central counterparty will dramatically change this model. “As a result of the netting process and FICC stepping in as the counterparty to guarantee the trades, firms will avoid the risks and expense of having to exchange billions of dollars worth of payments and securities when the trades settle,” said Sean Delap, DTCC vice president, Clearance and Settlement/Fixed Income. “The pilot tests represent the culmination of more than three years of work, and it’s rewarding to see how much risk the new system can wring from the current settlement methodology.”
During the test period, firms submitted 1,205 mortgage pool instructions. FICC’s netting system found 884 or 73% of the instructions eligible for pool netting, and was able to eliminate 456 for a netting factor of 51.6%. “Those are solid numbers given the limited scope of the test,” Delap said. “When we have more participants and more securities involved, we expect the netting factor will really start to climb.”
Participating in the pilot test, which began in mid-September for mortgage-backed securities trades scheduled to settle September 17, were Fannie Mae, Credit Suisse, Goldman Sachs, J. P. Morgan Securities and Morgan Stanley & Co.
To prepare for participation in additional upcoming pilot testing, FICC recommends that companies have their staff go through FICC’s pool netting training and simulation exercises, which are available on the DTCC Web site. In addition, firms have to complete the “end-to-end” tests that FICC runs to determine whether participants or vendors have the communications links and related procedures in place to participate in the CCP activity.
Another test scheduled
FICC has scheduled another round of live testing for October involving the same initial pilot firms and eligible securities. Additional firms are expected to join the pilot group for a third round of testing in November.
“We want to make sure the system functions flawlessly,” noted Kate Connelly, DTCC Director, Clearance and Settlement/Fixed Income, “and we want to give additional firms experience dealing with what amounts to a substantial change from longstanding industry procedures.”
The September live pilot test followed FICC’s introduction of new notification-of-settlement technology at the end of July, plus the successful completion in mid-August of end-to-end practice tests for all the firms in the pilot group. @