Modernizing FINRA Rule 4210

After years of delays, FINRA has enacted amendments to Rule 4210.  The new Covered Agency Transaction requirements became effective May 22nd, 2024.

Rule 4210 Amendments Overview

FINRA Rule 4210 (Margin Requirements) describes the margin requirements that determine the amount of collateral customers are expected to maintain in their margin accounts, including both strategy-based margin accounts and portfolio margin accounts.

The amendments cover the following transactions:

•  To Be Announced (TBA) transactions (inclusive of adjustable rate mortgage transactions) with settlement dates later than T+1
• Specified Pool Transactions with settlement dates later than T+1
• Transactions in Collateralized Mortgage Obligations (CMOs), issued in conformity with a program of an agency or Government-Sponsored Enterprise (GSE), with settlement dates later than T+3.

Listen to this week’s Oyster Stew podcast as Oyster Consulting experts Jeff Gearhart and Jose Fernandez, along with Stephen Mellert, Managing Director of Matrix Application LLC, share their insights into what the new margin rule requirements mean for market makers, the capital implications, and the importance of automation. 

Firms today face a myriad of challenges and regulatory requirements that can be overwhelming to manage alone. Technology advancements are driving faster trading environments and regulators are intensifying their focus on compliance. Firms must navigate a maze of rules and regulations to maintain market integrity and client trust. Oyster Consulting’s regulatory compliance and operations experts provide the guidance and support you need to comply with the Rule 4210 amendments.

Transcript

Transcript provided by TEMI

Bob Mooney:   Welcome to the Oyster Stew Podcast. I’m Bob Mooney, General Counsel of Oyster Consulting. After nearly a decade of delays, FINRA is enacting amendments to Rule 42-10. The new covered agency transaction requirements became effective May 22nd of this year. In today’s podcast, recorded on May 10th, Oyster’s Jeff Gearhart and Jose Fernandez talk with Stephen Mellert, co-founder of Capital Markets Engineering and Trading, and developer of the Matrix Application MarginCalculator. Jeff, Jose and Stephen share their operations expertise and insights into what the new rule means for market makers, the capital implications, and the importance of automation. Let’s get started – Jeff?

Jeff Gearhart:   Thanks, Bob. Joining me today is Stephen Mellert from Matrix Applications. Matrix has developed a margin calculator tool or a software product that is used by various firms in the industry to track the margin, value, collateral requirements, etc. And of course, he’s well-versed on (Rule) 4210 and the related processes. Also, Jose Fernandez for Oyster Consulting.  In his prior roles as head of operations, overseeing the operations impact of 4210 margin collection pricing, etc. He brings a lot of knowledge as well. So, Stephen, as our honored guest speaker, you get to go first. As you would expect, just with the rule coming into effect on May 22^nd, at this point, do you see any big obstacles or surprises for firms?

Steve Mellert:   Well, first off, thank you for having me. I’m honored to be honored guest, <laugh> and as far as surprises go, no, I don’t think there should be any surprises. I mean, this rule’s been discussed, modified, criticized, and advertised as coming soon since 2012. So, it’s basically a classic case of Boy Cried Wolf, but it’s here now. I don’t see how firms could be surprised that it finally went into effect. Also, FINRA gave a healthy, like nine to ten months to actually implement the final changes and the final amendments. As far as the obstacles go, if your firm doesn’t have a solution by now, you’re probably not going to be able to implement something in-house in time. There’s a lot of coordination between the trading desk, the operations groups, your regulatory reporting groups, credit officers, risk departments. There’s a lot of coordination that needs to take place. So obstacle wise, there are plenty of obstacles. Internally, we don’t have something yet. I think for small firms, many of them lack the technology resources and they’re still using spreadsheets and things; but, as we’ll find that later on the podcast, it gets complicated fast. I’d say a lot of the large firms are not surprised, and by now they all have solutions in place.

Jeff Gearhart:   I think that sounds right to me. I mean, if you’re surprised, then, holy cow, where have you been?

Steve Mellert:   If you’re surprised you shouldn’t be trading TBAs <laugh>.

Jeff Gearhart:  Jose, from your experience, you’ve handled the collateral movements, the pricing, everything related to those functions. What do you think on the topic?

Jose Fernandez:   Yeah, I think as Stephen just mentioned there are certain things that should be in place by now, and if you haven’t done it, then, shame on you. But in the end, really, what we’re talking about here is careful and considerable coordination between the departments.

As you think about front office, middle office, back office, your risk teams, even your legal team as you think of NTAs, and the like, and I think that probably the one thing to really take away from this is a coordinated effort that is applicable and touches various areas within an organization. And for that reason, that coordination is a constant one, not just ahead of the rule becoming effective, which we’re talking about 12 days or something from now, but also going forward. That’s going to be the key.

Jeff Gearhart:   Okay. I think automation is going to be essential if you’re a firm of any size and any degree of activity. Stephen, developing the MarginCalculator tool or software, can you share any perspective on what firms may or may not do correctly? And then even elaborate a little bit about what the tool can do and how it can make the whole process easier to manage.

Steve Mellert:   Sure. I mean, we were very methodical in our approach. We went line by line through the rule, interpreting it from “is there counterparty, a FINRA member? Or a mortgage bank, or a federal banking agency? Gross exemption qualifiers and small cash counterparties? We went through everything and basically created almost a waterfall and built the logic. And so, when you’re trading and putting your trade into the system, it does look through and checks all the different categories and attributes of your counterparty, the security and timing, and will then generate your exposure and your margin call, and whether you’ve satisfied the margin call or using collateral and things. I would suggest for firms that are looking at creating some sort of automation, is to map out their counterparties and what their (Master Service Future Trade Agreement) MSFTA parameters are, and also map out all the details from the rule. And then, they need to figure out where you’re getting the data from. I mean, you’re going to have your primary trading system, or you are building this thing inside or outside of that primary trading application. And how and where are you storing the MSFTA data? So, there’s all sorts of reporting and auditing capabilities we built into MarginCalculator. At the end of the day, you need to figure out what would FINRA want to see when they come in to audit you to make sure you’re complying with the rule.

Jeff Gearhart:   Is there a lot of integration in terms of the trading system, credit systems, pricing systems?  How involved is it?

Steve Mellert:   Sure. MarginCalculator takes in a series of files from your books and records trading system. And a firm basically has to make sure they have all the account information and the margin requirements of that counterparty. But also, you need to take in prices from some sort of pricing source. And that might be a source of, usually it’s Bloomberg or ICE, although you can provide your own internal prices, so that may to lead to more disputes down the line. And then you also have to coordinate taking in the margin calls and what time those things came in to satisfy a margin call or not satisfy it. You need to track the aging of the margin calls. So, there are lots of different inputs into the system. And as mentioned, sort of from our perspective, we can take in accounts, the trades, the securities prices, margin movements, and any fails, and we basically put those all into MarginCalculator and then we’ll calculate your exposure.

Jeff Gearhart: That actually sheds a little light on the complexity too. That’s a lot of inputs, if you’re trying to do this on a spreadsheet.

Steve Mellert:   Yes, yes,

Jeff Gearhart:   Absolutely. Jose, you’ve managed this. From your perspective, what went wrong? What were the biggest concerns and the daily management of the collateral process?

Jose Fernandez:   I think, as Stephen has alluded to, quite honestly, it is the tracking of the collateral. Performing the calculations, understanding and being able to have at your fingertips, the language that’s contained in each individual MSFTA to be able to manage that exposure accordingly. And so, as we’ve stated, and we’ll continue to state, we’re trying to do this on a manual basis. It is rather challenging, depending on the activity level that a firm may have. But the key here is automation.  At the end of the day if you can automate this, if you can leverage an application such as MarginCalculator, it’s doing all that work for you. The output’s only as good as the input. Happy to hear that the whole Matrix team has taken the rule and really dissected it and built the tool around it. That should make it easier for firms. But the biggest challenge, again, is really the calculations, the collateral movement documenting that, having a consistent applied, and then being able to adapt or address any concerns that come out of that.

Steve Mellert:   One following point. Jose, you do bring up a good point in that when FINRA comes in to sort of check your books and records and make sure you have the policies and procedures, with a homegrown system or using spreadsheets, you’re going to fail an audit. You’re not going to have the level of detail that FINRA would want to see when they’re conducting an audit to make sure you’ve done A, B, and C by set times one, two, and three.

Jeff Gearhart:   I was going to say that’s a really good point. Firms may be avoiding the cost of a tool. However, you still have to do this. Even if you’re going to take the capital hit, you have to calculate the capital hit. You have to have this information, so you’re not going to avoid some type of process. One question following up on what you said earlier about pricing sources and avoiding disputes. Any thoughts on what the best source is to use? You mentioned Bloomberg and ICE, two standards that probably would avoid a lot, but I recall from my days managing a desk that there could be disputes over collateral value and the exposure of the mark to market.

Steve Mellert:   Well, ICE is basically the bellwether and Bloomberg though, is gaining ground. ICE keeps acquiring other entities. For instance, they acquired Black Knight, acquired EMBS, and that was for mortgage descriptive data in factors, and ICE acquired them. But Bloomberg is gaining ground and being a pricing source, but for the most part, the margin is back and forth. Every day you’re in favor. One day it kind of swings back in your favor the next day. For small firms, it’s less of an impact because there’s small movements. From day to day, you’re not going to have large margin calls. But for larger firms, you are going to have large margin calls going back and forth. And generally, the attitude’s been, “well, it’ll come back to my favor the next day.” Interest is fine, but during times of market stress, like in 2008 or the outbreak of covid, you had better be sure of your calculations and your methods and your pricing source because you really do want to minimize disputes.

Jeff Gearhart:   Right. I was reading FINRA’s releases on the topic, and it mentioned that it’s expecting members to act in good faith in terms of pricing and resolving disputes. But they even suggested that you could use a replacement charge approach to, you know, what it would cost you if you had to cancel transaction and enter a new one. And neither of you imagine anybody trying to do that versus using a valid pricing source. That would be hard to defend, wouldn’t it?

Steve Mellert:   Yes. I think it would be very difficult to defend in MarginCalculator. We do allow you to override a particular price with a particular counterparty. Because perhaps you’re trading some small, some small TBA, or sorry, some small pool that is thinly traded, and one market participant is the one that actually creates the price. You can override that price every day, and the system will actually log the fact that you overrode the price. But in general, I think it would be difficult to sort of enter new transactions in the same price. In MarginCalculator, we do allow you basically to cancel and rebook a new trade online, or you can upload it via the file and MarginCalculator will recalculate the exposure, and it’ll tell you if that rebooking involves returning some margin and requiring more margin from your counterparty.

Jeff Gearhart:   Yeah. Can we talk a little bit more about just what the tool can do? Obviously, it’s valuing collateral money movements. Does it help the setup and management of MSFTAs, or what are the features?

Steve Mellert:   Sure. The system’s very automated. I mentioned earlier, everything’s sort of templatized, so there’s 90 uploads of the data, whether it’s accounts, the trades, securities prices failed, and margin movements. Those are all just simple text file formats. And in fact, we’ve actually mapped our requirements for our files against the largest corresponding clearing agents’ standard files, so it can pull the margin calculated data in automatically every night. So, we’ve simplified it for that, corresponding clearing, and we can do so for others.

But the automation part is key. When the margin clerk or margin manager comes in in the morning, they’ll see their exposures, basically. They can sort by the largest counterparty exposure and then just click on an icon, which will automatically send out an email which contains all the details: all of my trades with you, any margin movements that might have mitigated my exposure, and then the residual exposure that needs that I’m making the margin call for.

And it sends that out in an email along with the prices and all the details. So, it does minimize the amount of disputes that you would have. Now, the system also presumes that it’s not a books and record system. We already have that. Most clients already have that, but it does automatically book the margin movements so that you can see whether you satisfied the margin there and it’s compliant, or it’s waiting for margin to come in or some sort of exception status.

I mean, as far as the MSFTAs go, we don’t really support any, we’re not uploading MSFTAs into the system. We have all the fields in the counterparty details for an MSFTA, but we don’t really store the uploading and interpreting or storing of the actual PDFs and things. That’s actually left up to the broker dealer to maintain their own records.

Jeff Gearhart:   Right. That’s typically part of a credit process, I imagine.

Steve Mellert:   Yes, you’re correct.

Jeff Gearhart:   Jose, when you were managing your operations group, it’s clear, it was pretty complex. Did you use a tool like this? Was it an in-house tool, or what was your approach to managing the whole process?

Jose Fernandez:   Yeah, I think at that particular moment in time, there wasn’t the technology out there. The rule was just being adopted and obviously there was a lot of push-back from the industry. So there wasn’t a lot of vendors that were coming to the table with the solution. So, at that particular moment in time, a lot of it was done manually. And again, I can’t speak enough about the coordinated effort between the different departments, that allowed us to really monitor and track this exposure in line with the rule and the expectations. But yeah, so it was, as we talked, a lot of spreadsheets, a lot of communication and one thing to keep in mind is that it is not one size fits all types of solution.

So, you may have different clients that have different requirements as you think about pricing sources, you think about collateral types as you think about just how they’re set up internally in their internal systems. So, it got complicated real quick, but I think, it’s something that, again, can be done manually. Well, if you’ve got a great team and great coordination and great communication and have some internal tools that you can ensure that everybody’s looking at the same information at the same time, then maybe you can get away with it. But right now, with the volume that most clients are transacting in, it’ll be hard to do without some technology.

Steve Mellert:   And that’s also presuming that no one goes on vacation.

Jose Fernandez:   <Laugh>. Oh, that’s the other thing. Yeah. Key man, woman risk, absolutely, was always an issue.

Jeff Gearhart:   Jose, you and I have talked previously about the capital hits and the ability of a firm to take the capital charge versus collective margin, but given all the factors we’ve discussed here, you still have to have this process. That’s kind of what I mentioned earlier about needing to know what the capital charge is. You see any way around that?

Jose Fernandez:   It’s first and foremost; you’ve got to have that risk determination limit established for every counterparty, which part should be part of your risk program. And so, being able to monitor and track that is going to be key for you to ensure whether a firm makes the decision to take a capital hit in lieu of collective margin, and whether they apply across all their clients or some clients. We continue to talk about the nuances with this rule and trying to comply with it. The capital implications of it are ones that need to be closely monitored, especially when you think about things such as they were expected to send in collateral, and you didn’t receive that collateral right on “DD plus one” as they refer to it.

And then how are you supposed to report that? At the end of the day, let’s say they had a 300,000 negative mark to mark. So now you’re supposed to be reporting 50, but they only, they only send 25. So, what are you supposed to report? So, if you look at the FAQs that are out there that Defender has published, and they go through a bunch of these scenarios and they give you kind of what their expectation is.  I think it’s important for firms to take a look at that and understand what the implication to their net reporting is, based off that expectation from FINRA and help that guide you. But, it gets really complicated, especially if you’re sending partials and if you have a discrepancy in pricing, as we talked about earlier. All of these factors play into how one is expected to apply that to their net capital deductions.

Steve Mellert:   And actually, one thing we had mentioned before about surprises, this is probably the only thing that might surprise firms, and that this capital in lieu of margin feature is relatively new. It has only come out in the last round of amendments. FINRA only recently gave one or two sessions online and walked people through what it looks like. They had a spreadsheet, which they had not shared yet, but they showed on screen. But people haven’t really had a chance to really dive into it. We recently added the capital charge capability to MarginCalculator. So instead of using your cash securities, there’s a capital, as a so-called asset, you can apply the system would produce a cumulative capital that you’ve used. We don’t know what the firm’s tentative tend to net capital or capital details are, but we can provide the inputs for the dealers to perform their own internal calculations. And then, along with the capital charge, you’re basically an unaddressed exposure. So as Jose pointed out the 250, 300 exposure, 250 limit, 50 with capital, if someone didn’t apply the whole thing, we do track that unadjusted exposure to make sure that you can figure out what you need to do to become compliant.

Jeff Gearhart:   Again. Looking at my prior experience with some of your counterparties, it is likely you could get partial deliveries on collateral or late deliveries on collateral? That would become pretty important, regardless.

Steve Mellert:   Yes. And then, so before setting it in today or setting it in tomorrow, when do you send the collateral in? Does it impact all these calculations? The spreadsheet route would be nearly impossible to keep track of everything.

Jeff Gearhart:   Yeah, absolutely. So a quick question here for both of you. This rule applies to you regardless of how you clear. If you’re self-clearing, obviously you control everything, but even if you’re clearing through another broker-dealer, the rule still applies to you. You don’t pass this responsibility off to your clearing broker, or they don’t assume it for you.

Steve Mellert: Yeah, no, absolutely not. I mean, you’re self-clearing. Yeah, a hundred percent of the onus is on your firm. You have to create your own solution. You have got to document your policies and procedures, develop all your reports, and basically you need to stay on top of the rules too, because FINRA keeps coming out with FAQs and guidance and updates the rule. Because I don’t think they’ve necessarily thought of every single permutation that could occur. So your group, whether it’s your regulatory, your compliance group, someone has to stay on top of all this for the introducing brokers. Yeah, they’re sorry, the corresponding clearing firms. For introducing brokers, they’ll do most of the work as the clearing agent, and they’ll kind of dictate what you have to do to satisfy them, make sure that they don’t get in trouble with FINRA. As far as a total solution, you’re probably still going to have to add some sort of features and functions to make sure that you have the ability to answer FINRA’s questions when they come in and audit you. They’re not coming in to audit the correspondent clearer. They’re making sure that you are compliant.

Jeff Gearhart:   That might be a surprise.

Steve Mellert:   Yeah, they probably think, well, I’m going through a large correspondent clear, they’ll take care of it for me. And the answer is no.

Jeff Gearhart:   Given the time it has taken for the rule to come into effect, there really is no excuse for preparedness. So let’s face it, if you’re just thinking of it now, you’re too late. But what should firms be thinking of now that the rule, May 22^nd, is in place. Anything they should do as a double check or just extra confirmation? Any thoughts or considerations there?

Steve Mellert:   Well, as you mentioned before, the boy cried wolf. The wolf is here at the door. So, I think FINRA might be a little bit easy on people if they show that they are working on putting something in place. But if you have nothing in place, they’re not going to look favorably upon you.

Jeff Gearhart:   We’ve approached this topic today from the perspective of firms actively engaged in the marketplace. I really do think each firm needs to review their business activity and how it affects them because there are exemptions or exceptions to the rule or other topics to consider. For example, there’s an exemption for small cash counterparties to meet certain criteria. So, Jose was elaborating on there are a lot of capital implications. This is a big deal from a FINOP perspective, and they do have to be tied tightly into the operations process and with the trading desk. So, a lot to consider there and something to think about. Definitely feel free to reach out to us to dig deeper on any of these topics. Stephen, Jose, appreciate you guys being here. Last chance for any parting thoughts or comments on the rule that’s finally here. By the way, it’s the longest rule I’ve ever seen take until time.

Steve Mellert:   I agree. There was one very vocal broker-dealer member who would ask for 2020-never as the hopeful implementation date. I won’t give them a shout out, but you know, it’s been a long time coming and it’s finally here, and if you haven’t done your homework and gotten a solution in place, we would love to talk to you.

Jose Fernandez:  I will say that one of the comments that I’ve heard someone referring to this as this seven-year itch, so <laugh>,

Jeff Gearhart:   Well, it was really nice of them to time it in the same month as T + 1 and CAIS becoming effective and everything else. So, May is a busy month. Thank you both and join us next time.

Bob Mooney:   Thanks everyone for listening. If you’d like to learn more about our experts and how Oyster can help your firm, visit our website at oysterllc.com. If you like what you heard today, follow us on whatever platform you listen to and give us a review. Reviews make it easier for people to find us. Have a great day.