DTCC RECOMMENDS DAILY NETTING OF MORTGAGE-BACKED SECURITIES TRADES

Posted May 6, 2009

NEW YORK – The Depository Trust & Clearing Corporation (DTCC) is recommending the introduction of daily trade netting for mortgage-backed securities transactions to further expand its planned central counterparty services, cut the high cost of processing these trades, and bring greater risk protection to this multi-trillion-dollar market.

In a white paper issued by DTCC’s Fixed Income Clearing Corporation (FICC) subsidiary, the company says that netting all TBA (to be announced) mortgage-backed security trades daily — and then having FICC step in as the counterparty to each net position — would not only reduce costs and risk, but effectively retire the current clearing model which has governed how mortgage-backed securities trade have been processed for the past 30 years.

“The idea is to streamline the somewhat complex current ‘balance order’ netting process,” says Murray Pozmanter, Managing Director, Clearance and Settlement/Fixed Income, DTCC. “The industry’s process today requires trading firms to allocate pools of mortgages against the TBA obligations we establish, and then to settle all those pools with multiple counterparties at different prices. What we’re recommending — netting trades daily and then having FICC step in as the allocation and settlement counterparty — would sharply lower operational risks and expenses for the industry.”

FICC clears trades of mortgage-backed securities issued in the secondary market by government agencies or government-sponsored enterprises, such as Fannie Mae and Freddie Mac. In 2008, FICC processed mortgage-backed securities trades valued at more than $111 trillion.

Under current market practices, mortgage-backed securities trades are netted only once a month, beginning 72 hours prior to the monthly settlement date established for each particular kind of TBA security. As a result, trading firms must submit their TBA trade activity prior to the netting cut-off on the associated “72 hour day” — a practice that the white paper says can sharply limit the number of trades incorporated in the current netting process.

If FICC becomes the central counterparty to all TBA obligations on a daily basis, the white paper says, it will then be the contra-side to all the allocations, allowing for a substantial reduction in the number of allocations that must be performed, as well as the associated securities deliveries that need to be made.

Netting frees up capital and lowers risk by offsetting individual trades against each other, thus reducing the total number of trade obligations requiring financial settlement.

“Eliminating the 72-hour cutoff will let us wring far more costs and risk from the process as more trades are included in netting,” says Pozmanter. “This, in turn, will let us reduce the number of settlements stemming from TBA trading and that will help to stabilize the operation of the market, especially during periods of market uncertainty. Since all obligations will settle versus FICC as the central counterparty, the whole notification of settlement (NOS) process can be retired.”

Once the industry has reached agreement about the proposal, FICC plans to submit the plan to the Securities and Exchange Commission for review and approval. The white paper, “Service Description for Central Counterparty (CCP) for Mortgage-Backed Securities—the Next Steps” can be found at http://www.dtcc.com/downloads/leadership/whitepapers/MBSCCP_Next_Steps.pdf