FICC’s risk management processes help to provide the mortgage-backed securities industry with a stable and reliable environment for the clearing and settlement of trades.

Overview

FICC’s risk management processes help to provide the mortgage-backed securities industry with a stable and reliable environment for the clearing and settlement of trades. Risk management is also the means by which FICC’s Mortgage-Backed Securities Division (MBSD) maintains sufficient liquidity to protect itself and its members from the risks inherent in the settlement process, including the possibility of a member default.

Among the tools FICC employs to help manage risk are requirements that members post collateral and that securities be marked to market prices daily. When it is operational, MBSD’s central counterparty (CCP) service will also allow FICC to guarantee mortgage-backed securities trades at the point when the MBSD validates/compares them, which is usually within seconds of the trade’s submission to its RTTM® (Real-Time Trade Matching) system. In addition, FICC carefully manages which firms or institutions are eligible to be a member of the MBSD as well as the trading exposure of its members.

Who Can Use the Service

Risk management is automatically provided to all clearing members of the MBSD.

Benefits

When its central counterparty service is operational, the MBSD will guarantee all trades as soon as they are validated by RTTM, which largely eliminates counterparty risk for its members. MBSD’s netting service reduces customers’ overall settlement obligations by netting trades regardless of the identity of the contra-side. This frees up valuable capital by greatly reducing the number of trades requiring settlement, which, in turn, lowers clearing costs.

Under FICC’s risk management practices, members of the MBSD have a choice about how they can margin for the trades they submit. If they are dual members of the FICC’s Government Securities Division (GSD) and MBSD, they can also decide whether they would like to participate in portfolio margining across the two divisions, potentially reducing the amount of collateral that must be posted in either division.

How the Service Works

With the MBS market’s lengthy settlement period comes an increased risk that one party to a trade will not fulfill its settlement obligations. To provide maximum protection for its members, MBSD continually assesses the risk associated with each member’s underlying trade obligations, requiring margin to be posted for identified risks.

MBSD assesses member risk using a Value at Risk (VaR) methodology.

Margin deposits are maintained in each member’s MBSD Clearing Fund account. Each member has the flexibility to choose from a variety of methods to satisfy its daily margin requirement. Approved forms of collateral that may be deposited into the Clearing Fund include cash, U.S. Agency mortgage-backed securities, U.S. Government Agency and U.S. Treasury securities.

VaR Measures Three Key Variables:

• Market volatility. This factor drives gains and losses for a given portfolio, and is the most challenging part of a VaR model.
• Time horizon. This refers to the period of time required to close out a portfolio.
• Confidence level. This factor determines in percentage terms how much protection a firm requires. For example, if a 99% three-day VaR is $10 million, it means that the maximum expected loss during a three-day liquidation period is at or about $10 million 99% of the time.

For mortgage-backed securities, VaR calculations must factor in other complexities that require intensive computer simulations, involving a number of complex, overlapping variables. These include interest rates, mortgage rates, prepayment speeds, seasonality in the housing market (activity peaks in the summer and declines in the winter), as well as a portfolio’s diversification and hedging where applicable.

DTCC’s Risk Management group has built a highly sophisticated pricing engine that will have the capacity to calculate key variables that impact portfolio valuation. In addition, the VaR model uses a three-day liquidation period, and a confidence level of 99%, which is fairly standard in the industry. The three-day VaR with a 99% confidence level is the same as that implemented for GSD, and is a pre-condition for portfolio margining.

Pool Netting

In Pool Netting, used in conjunction with MBSD’s central counterparty services, MBSD employs an algorithm to compare and net out as many as possible of the mortgage pools submitted in preparation for settlement of MBS trades. FICC, in turn, steps in as the counterparty to the remaining pools, guaranteeing delivery and/or payment for the pools. This process further reduces the number of securities and the amount of money that has to change hands in order to complete the trade, and lowers overall settlement costs.

Portfolio Margining

Members have a choice about whether they would like to participate in common or portfolio margining between the two divisions of FICC.

Firms that function as prime brokers, or maintain more than one account with FICC’s MBSD, can post margin for each of those separate accounts, which is how MBSD historically managed Clearing Fund collateral. Customers that maintain more than one account for clearing mortgage-backed securities trades will be able, if they wish, to aggregate their portfolios into a single account, and can then post margin against that unified portfolio obligation.

Clearing Fund deficiency call payments for MBSD customers are due at 9:30 a.m. U.S. Eastern Time, reflecting their positions at the close of business the previous day. FICC is obligated to notify firms whether they need to make up any collateral deficiency by 7 a.m., although on most days the deficiency call will have been issued sometime during the night.

Members have flexibility in what they can use as collateral for their margin accounts. They can use the Clearing Fund Management system, an Internet-based administrative tool that gives customers hands-on management of their daily collateral needs.

For More Information

If you would like further information about Risk Management for mortgage-backed securities, please contact your relationship manager via the Relationship Services Group Hotline at (800) 422 0582, or by email at rmsupport@dtcc.com.