GC Friday Interview: Ted Leveroni, Executive Director of Derivatives Strategy and External Relations, Omgeo

As the person in charge of growing Omgeo's derivatives business, Ted Leveroni has lately been paying a lot of attention to new regulation that will likely have a large impact on the derivatives industry. In November of last year, the Treasury Market Practices Group (TMPG), a working group affiliated with the New York Federal Reserve, issued a recommendation that says all forward settling mortgage-backed securities (MBS) trades, typically transacted as To Be Announced trades (TBAs), need two-way margining. By December 31, 2013, firms need to be substantially complete in implementing this directive, so 2014 will see collateralization of most MBS trades. However, getting ready for this new measure in time for the new year has been a challenge for many firms, particularly on the asset management side.
By Jake Safane(2147484770)
As the person in charge of growing Omgeo’s derivatives business, Ted Leveroni has lately been paying a lot of attention to new regulation that will likely have a large impact on the derivatives industry. In November of last year, the Treasury Market Practices Group (TMPG), a working group affiliated with the New York Federal Reserve, issued a recommendation that says all forward settling mortgage-backed securities (MBS) trades, typically transacted as To Be Announced trades (TBAs), need two-way margining. By December 31, 2013, firms need to be substantially complete in implementing this directive, so 2014 will see collateralization of most MBS trades. However, getting ready for this new measure in time for the new year has been a challenge for many firms, particularly on the asset management side.

What are the main challenges associated with preparing for margining?

TL: There’s a lot of challenges. For operational challenges, it’s a new process for a lot of firms and new relationships. A lot of new things need to be put in place in order to do this. And then there’s the overall macro liquidity and collateral impacts to what is going to be a lot of collateral moving back and forth. It’s not something that’s not without challenges and impacts, but it’s a little bit less talked about than all this derivatives regulation—Dodd-Frank, EMIR, Volcker Rule—all that kind of stuff that gets all the press. This seems to be happening a little more quietly to the public, but for those of us involved in it, it’s a real pressing issue.

What are firms doing to prepare for the implementation?

TL: It’s a little bit like saying ‘How do you get to Scotland’? It’s a big difference depending on where you’re starting from. First, firms have to look at where they are today. The collateralization process is very similar to collateralization of swaps. And so if you’re a firm that has a big swaps book business, has expertise in collateralization of swaps, has swaps collateral systems that are either vendor systems or in-house systems that can be leveraged to manage this, then it’s a much easier step. From there it’s just getting the contracts, the MSFTAs (Master Securities Forward Transaction Agreement, which basically state how you’re going to manage the collateral, what’s eligible for collateral, when you’re going to make the call. That’s negotiated between the counterparties and is really your biggest step. But your operations only need to be tweaked in order to handle the collateralization. The issue is that there a lot of firms that don’t have large swaps businesses, but they do have very large MBS businesses. So they’re faced with having to do a lot of new things in order to get up and running with the new recommendation. They’re going to have to negotiate contracts with their brokers. They’re going to have to go to their custodians and make sure they have the proper custodial relationships to support the collateral process. Then they’re going to have to look for expertise outside of themselves to learn how you collateralize things. And then they’re going to need systems to support that. Once you’re up and running, collateralization is not an extremely difficult operational process, but building it with a tight timeframe, when you may not have the knowledge capital in-house, is a significant challenge.

Why is there a difference between who is ready and who is not?

TL: Some firms took it seriously immediately back in November (2012), so they’re in better shape. But there are a lot of firms who thought this doesn’t apply to me. Because the TMPG, being affiliated with the Fed, they only have direct impact on banks. They don’t directly impact investment managers. So there was a lot of confusion in the beginning by the asset manager community saying “that’s a TMPG recommendation so I don’t need to deal with it because they don’t govern me.” Well, the fact of it is, the recommendation is that banks have to have two-way margin. So that means that indirectly it forces asset managers to comply with this because the banks won’t trade with them otherwise. So there was a long period of confusion of whether it was going to apply to them. And then one of the biggest challenges was a delay in preparation. Putting an MFSTA in place can take months. It’s a legal contract, and anything when you get lawyers involved and have terms being negotiated that have potential impact on your trading and on your portfolio management and risk, they’re going to be very careful in negotiating that. So I think it was widely underestimated by firms without experience with these standard forms as to how long it would take.

Will there be shrinkage in the MBS market while some firms are getting ready to handle margining?

TL: It could have real impacts. The one thing that we don’t know, and it’s difficult to estimate, is what happens to firms that are in the process of getting up and running but aren’t ready by the end of the year. Because the recommendation says you have to be substantially complete in your implementation, so it’s very difficult to find out what that means. So firms are concerned that brokers won’t trade with them if they’re not ready, but it’s really up to the brokers and their own legal teams to determine what steps they have to take on a case-by-case basis with each of the firms that haven’t complied yet. So there’s certainly the possibility of investment managers not having access to the market because they’re not ready yet. And that would impact liquidity.

I think the second issue is, because it’s a lot of work to get these MSFTAs in place, some brokers are going to lose business because there will be firms that may have traditionally traded with four, five or six brokers, but now are only prepared to trade with one or two. There’s a real possibility, especially early in the year, there will be changes in the liquidity of TBAs.

Are there benefits of the recommendation in terms of mitigating risk?

TL:That’s what makes this debate around this recommendation complicated. In general, collateralization of counterparty risk makes a huge amount of sense, and we’ve seen the benefits of it in the past, and we’ve seen the consequences if you don’t properly collateralize in the past. And there is risk in forward settling MBS transactions. There is a counterparty risk there, and counterparties do default. If they default and you have a trade that’s supposed to settle next week, you’re going to be out money. So collateralization in principle makes sense. There’s no doubt that the more you collateralize, the more risk you take out of the market. I think the question is: Is the cost of taking that risk out of the market disproportionate to the amount of risk you’re taking out? And that’s always a difficult determination to see where that line should be drawn.

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