MBS Novation: The Path to Modernization of a $100 Trillion Trading Market (2013)

MBS Novation:The path to modernization of a $100 trillion trading market

MBS NOVATION: THE PATH TO MODERNIZATION OF A $100 TRILLION TRADING MARKET | EXECUTIVE SUMMARY

EXECUTIVE SUMMARY

The mortgage-backed securities (MBS) market has grown to more than US $100 trillion per year in trading volumes. In addition to the increasing volumes (see Exhibit 1 below), pressures have grown to modernize and streamline the complex post-trade process, in part due to repercussions of 2008’s MBS market turmoil. Today, the path to a modernized central counterparty (CCP) platform has been clearly defined for the securities industry.

MBS Novation is the culmination of years of work by the Fixed Income Clearing Corporation (FICC) to modernize the MBS post-trade life cycle under a CCP model. After transition steps are completed, MBS Novation system testing is scheduled to commence in June of 2014, with industry roll-out in early 2015. It will bring daily netting to the “To Be Announced” (TBA) market, while inserting the FICC as the central counterparty for each trade. This will result in increased efficiencies to the market by streamlining settlements as well as reducing systemic and operational risk for financial institutions.

To date, many firms have managed MBS TBA trade processing through proprietary technologies. However, firms moving to MBS Novation using legacy, in-house systems will have multiple migration challenges due to budget constraints, internal resources and a limited time frame. The clock is ticking toward a 2014 testing date, with significant transition steps to manage in the interim. These combined pressures are forcing firms to consider an alternative way to achieve MBS Novation readiness — by leveraging a third-party solution offered by a firm with deep experience in the MBS market and expertise in FICC CCP initiatives.

MBS Novation is the culmination of years of work by the FICC to modernize the MBS post-trade life cycle under a CCP model.

EXHIBIT 1 MBS Yearly Par Volume Traded (2001 – 2012)

Source: TABB Group

MBS Yearly Par Volume Traded (USD T’s)

120

100

80

60

40

20

02001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

2

MBS NOVATION: THE PATH TO MODERNIZATION OF A $100 TRILLION TRADING MARKET

The Move to MBS NovationThe transition to MBS Novation has been fostered by the need to streamline the historically complex MBS post-trade process. The two most common ways to trade Agency MBS securities are in the TBA and Specified Pool markets, with TBA processing following a long and complicated life cycle (See the chart below for MBS Trade Types).

MBS TRADE TYPE DESCRIPTION

TBA In a TBA trade, the seller and buyer agree to the type of security, coupon, face value, price and settlement date at the time of the trade, but do not specify the actual securities which will be settled. Two days before settlement, the seller determines the cheapest securities to satisfy the commitment and notifies the buyer of the specific pools that will be delivered.

Specified Pool Unlike TBA trading, at the time a specified pool trade is executed the buyer knows exactly which pool will be delivered. In most cases, the buyer is willing to pay up to receive pools with desired characteristics.

TBA trades settle on a monthly basis, with each type of MBS product having a unique notification and settlement date selected by the Securities Industry and Financial Markets Association (SIFMA). The gap between trade and settlement date could therefore be as short as two days or as long as 60 days. Each notification date creates a flurry of activity as trade counterparties transmit notifications specifying the securities they plan to deliver. The sheer cost of labor involved in the lengthy and time-consuming TBA allocation process has driven the need to modernize.

The Lehman Brothers bankruptcy in September of 2008, requiring winding down $328 billion of outstanding MBS trades, provided additional impetus for change. In the aftermath of a financial crisis, in which banks collectively lost more than $9 billion due to write-downs in Q4 2008 alone, fixed income businesses have come under increasing pressure to streamline operations, enhance risk management and increase transparency for counterparty exposure. At the time, these needs clashed with a period of financial austerity, when industry profit margins were being squeezed and technology budgets were being cut.

3


MBS Novation’s daily TBA netting will result in reduced settlements and enhanced risk management.

The Benefits of MBS NovationMBS Novation will bring the full scope of CCP services to fruition. Through the combination of daily TBA and Pool Netting, FICC will become a true CCP, resulting in the processing of all MBS trades through a unified and coordinated flow, from trade match through settlement. See Exhibit 3 for a depiction of the FICC’s plans, which include deploying additional services, including fail netting.

Operational efficiencies and risk management benefits with MBS Novation:

• Reduced counterparty risk

• FICC harmonized mark-to-market processing limits exposure

• Improved capital allocation and balance sheet usage

• Reduction in trades requiring allocation and settlement

• Fail netting will further streamline settlements

Simplifying Implementation Utilizing a Third-Party Solution Provider

MBS Novation will be the largest and most complex of all CCP phases implemented for the MBS market. In 2014, the FICC expects to make system testing available for all participants. In preparation, sell-side firms will need to have their allocation processing systems configured and updated in accordance with new requirements. Sell-side implementation options are twofold — either upgrading a legacy system or leveraging a third-party vendor with a proven track record in MBS CCP implementation.

The Path to MBS NovationIn April of 2012, the FICC launched its CCP for MBS — the first new CCP to be launched in the US cash market in a quarter of a century. In addition, it is the only CCP to receive regulatory approval from the Securities and Exchange Commission (SEC) for MBS trading. By guaranteeing settlement of all matched MBS trades, FICC took an important step toward implementing the MBS Novation program as the culmination of a multi-step initiative. (See Exhibit 2 for a timeline).

EXHIBIT 2 Timeline for MBS Novation

June 2007 March 2008 Sept. 2011 March 2012 April 2012 June 2014

CCP1 Real time trade matching (RTTM) of specified pool trades improving the MBS matching process

CCP2 Pool substitution functionality in addition to Electronic Pool Notification (EPN)

SPT1 Factor updates to specified pool trades and Notification of Settlement (NOS) submissions

SPT2 RTTM for broker-specified pool trades and subsequent give-up process

CCP3 Pool Netting and explicit guarantee of settlement by FICC

MBS Novation Daily TBA netting will result in reduced settlements and enhanced risk management

4


EXHIBIT 3 The MBS Post-Trade Lifecycle Incorporating MBS Novation

Source: TABB Group

SellerBuyer

Contractual Settlement Day

Delivery vs. Payment Settlement

CSD

Trade Execution

Matching & Novation

Daily end-of-day TBA Netting

TRA

DE

DA

TE

“48-Hour Day”

Pool Allocation

Pool Comparison

CSD

-2

“24-Hour Day” Pool Netting

CSD

-1

Buyer SellerSeller Buyer

FICC RTTM: Trades are submitted to RTTM, and matched and novated

FICC Netting: FICC runs TBA Netting on matched TBA trades and generates net TBA obligations

FICC Electronic Pool Notification

FICC RTTM: Members may submit pool information to RTTM (but not required to). EPN will submit the allocations to Pool Netting real-time.

TBA Trade

Trade-for-Trade

SellerBuyer

FICC @ Settlement Bank

Pools

Trade-for-Trade Obligations

TBA Obligations

FICC Netting: FICC runs Pool Netting and generates obligations to settle versus FICC. The net begins after Fedwire closes.

Pools to be settled vs. FICC

Pools

$ $

5


TABB further estimates that 20% of the industry’s MBS technology spend will go towards development, with the remaining 80% allocated to maintenance of existing systems. The need for integrated technology has never been greater, with firms across the industry allocating increasing levels of resources to support technology efforts. In the current cost-sensitive environment, firms face increasing pressures to manage technology and development expenses efficiently.

A number of sell-side firms continue to operate proprietary systems, and they typically implement innovations such as MBS Novation by adding new functionality on top of legacy systems. This often is a complex and expensive endeavor, especially in terms of finding expertise and allocating in-house labor. Legacy system upgrades must typically work around “band aids” from previous enhancements, increasing complications and

As firms prepare for MBS Novation, the TABB Group projects that sell-side MBS technology spend will reach $165.5 million in 2013 (See Exhibit 4). In 2014, MBS related technology costs will continue to rise as more firms roll out MBS Novation solutions. Estimates of the cost to upgrade and refit stand-alone systems range from $2.0 million to $3.0 million per firm.

According to the TABB Group, sell-side IT spend for MBS trade processing is projected to reach over $200MM in 2014 as firms prepare for MBS Novation.

expanding resource requirements. The costs of in-house development and system maintenance will only rise with the need to prepare for MBS Novation.

To counter the pressures involved in upgrading legacy systems, many sell-side firms are discovering the benefits of leveraging a third-party solution that is MBS Novation-ready. TABB Group research shows that the balance of external vs. internal technology spending on MBS Novation initiatives by sell-side firms is 56% and 44%, respectively (Exhibit 5). This demonstrates growing acceptance by financial firms for external solutions to address complex, time-sensitive industry developments.

Using a third-party system allows firms to share in the cost of industry initiatives, rather than footing the bill for 100% of internal development plus annual maintenance. Outsourcing and third-party systems also offer an optimal solution for dealing with situations in which industry best-practices emerge, or when specific business needs or regulatory changes require a rapid response.

TABB further estimates that 20% of the industry’s MBS technology spend will go towards development, with the remaining 80% allocated to maintenance of existing systems.

EXHIBIT 4 Sell-Side MBS Allocation IT Spend (2010-2015)

Source: TABB Group

*Projected Figures

153

250

200

150

100

50

02010 2011 2012 2013* 2014* 2015*

156.4 160.0 165.4

200.2

242.3

EXHIBIT 5 2013 Sell-Side IT Spend on MBS Allocation (2013)

Source: TABB Group

$164.5 M Sell-Side IT Spend on MBS Allocation for 2013

56% 44%

External Spend Internal Spend

6


ConclusionMBS Novation represents a significant step forward for the MBS industry. It will be a major improvement to risk management and increase operational efficiencies by reducing settlements and fails. At the same time, the rapidly approaching implementation of MBS Novation poses significant demands on individual firms, especially in regard to allocating technology resources and meeting budget constraints.

Third-party solutions are emerging as the preferred alternative for meeting mortgage-backed securities’ evolving industry and regulatory changes, such as MBS Novation— both on time and on-budget. However, not all third-party providers can offer the size, scale and experience to master this complex $100 trillion market. Make sure you ask the right questions and thoroughly evaluate vendors before making this critical strategy choice.

Broadridge offers a proven track record in delivering timely, efficient FICC client solutions.

No part of this document may be distributed, reproduced or posted without the express written

permission of Broadridge Financial Solutions Inc. © 2013 Broadridge Financial Solutions, Inc.

Broadridge and the Broadridge logo are registered trademarks of Broadridge Financial Solutions, Inc.

MKT_510_14

Contact UsTo further discuss the information in this report, please email us at [email protected].

About BroadridgeBroadridge Financial Solutions, Inc. (NYSE:BR) is the leading provider of investor communications and technology-driven solutions for broker- dealers, banks, mutual funds and corporate issuers globally. Broadridge’s investor communications, securities processing and business process outsourcing solutions help clients reduce their capital investments in operations infrastructure, allowing them to increase their focus on core business activities. With 50 years of experience, Broadridge’s infrastructure underpins proxy voting services for over 90% of public companies and mutual funds in North America, and processes more than $5 trillion in fixed income and equity trades per day. Broadridge employs approximately 6,400 full-time associates in 13 countries. For more information about Broadridge, please visit broadridge.com.

Author InformationMatthew Connor, General Manager Broadridge Mortgage Backed Solutions Broadridge Financial Solutions [email protected]

Mark Best, Director Broadridge Mortgage Backed Solutions Broadridge Financial Solutions [email protected]

Michael Acevedo, Product Manager Broadridge Mortgage Backed Solutions Broadridge Financial Solutions [email protected]

Economy & Finance

MBS Novation: The Path to Modernization of a $100 Trillion Trading Market (2013)