IntroductionIn September 2017, the SEC approved to postpone the effective date of Financial Industry Regulator Authority (FINRA) amendments1 to Rule 4210 for Covered Agency Transactions until June 25, 2018. The amendments seek to establish margin and capital requirements. Covered Agency Transactions are collectively known as: To Be Announced (TBA) transactions (including adjustable rate mortgage (ARM) transactions), Specified Pool Transactions and agency Collateralized Mortgage Obligations (CMOs) with forward settling dates. In the period leading up to the June 25 effective date, firms should consider addressing complexities and functional interdependencies across front, middle and back offices, finance, credit risk, KYC/client onboarding, legal and compliance groups. Implementation of reference data and margin capabilities, client outreach plans and development of associated governance structures will be key to supporting adherence to rule requirements for covered agency transactions. Firms should also consider reviewing current capabilities against legacy rule requirements, as they have been a focus area in recent FINRA examinations.The following sections summarize rule requirements for covered agency transactions and discuss some of the key considerations for firms assessing rule-readiness and implementation planning.

1 FINRA Rule: http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=9383.

FINRA 4210Implications of the Covered Agency Transactions Rule amendment February 2018

1 | FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment

Covered agency transactions June 2018 rule amendment — at a glance

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Credit limits and risk management

• Need for counterparty-level credit risk limits incorporating exposure from forward-settling TBAs, specified pools and agency CMOs that are monitored and enforced with a clearly defined credit methodology

• Allowed to set limits at investment manager level but must margin at account level

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Onboarding/KYC

• Ability to identify, store and maintain specific account categories and transactions to be exempted from certain margin requirements

• Conditional counterparty exemptions based on entity type, transaction volume, counterparty net assets and net worth

• Ongoing review of appropriate counterparty classification and volumes for exemption

Collateral management

• MTM margin: daily mark-to-market (MTM) will be exchanged to cover potential losses (subject to de minimis amount of $250,000)

• Maintenance margin: 2% of net position per underlying security CUSIP for non-exempt accounts

• Closeout: liquidation proceedings to be initiated for delinquent margin calls on T+5 where a FINRA extension request is not granted

Net capital

• Capital deductions for uncollected margin at the end of T+1 to be deducted from net capital

• Establish and monitor “tentative net capital” thresholds on a client (5%) and member firm (25%) level over a 5-day rolling period

• Prohibition of any further transactions with the broker-dealer that breach tentative net capital thresholds

Regulatory extensions and notifications

• Using FINRA Regulatory Extension (REX) system to apply for extension requests (unresolved disputes are expected to be the main driver)

• Reporting to FINRA on transactions breaching prescribed concentration thresholds

2FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment |

Assessing Rule 4210 compliance and readiness The amendments to the FINRA 4210 rule specify a number of requirements for covered agency transactions. Implementation of the amended rule will demand for multiple functional groups to update and/or develop policies, procedures and capabilities to establish compliance with the new FINRA 4210 rule requirements.

While designing capabilities and compliance approach, firms may want to consider the following questions:

• When will margin be collected, who is responsible and what types of margin will be accepted?

• How will client reference data (including exemption status) attributes be identified and maintained?

• How and when will net capital charges be taken for margin deficiencies?

• How do margining activities comply with 15c3-32 Customer Protection Rule lock up processes?

• What level of pre-trade controls (e.g., risk limits) and process governance (e.g., document execution) is appropriate?

• How will counterparty positions be liquidated?

• What is the process to manage a counterparty default?

Standing up and maintaining a centralized governance structure with key stakeholders from front, middle and back offices, finance, credit risk, KYC/client onboarding, legal, and compliance teams will be key to holistically addressing these questions. This structure will also help form a basis to assess readiness for the June 2018 effective date, establish a client outreach strategy and prioritize the implementation of functional capabilities.

Client outreachIf not done so already, firms should consider setting and managing client expectations as early as possible, as developing and implementing a client outreach and communications strategy will be critical to meeting compliance timelines and assessing readiness.

This strategy should consider what changes (if any) firms might want to make to legal documentation (e.g., Master Securities Forward Transaction Agreements), in addition to documenting data capture needs for exemption classification and margining purposes.

Outreach activities should be coordinated across front office, legal, and KYC/client onboarding teams. Oversight and coordination across client outreach and associated internal activities will be key to a successful implementation given the potential range and complexity of client responses.

As an industry standard has not yet been adopted for client outreach, firms have found balancing client requests, along with their own risk management position, a significant challenge to date in preparation for the June 2018 effective date.

Client outreach coordinationMany firms manage client data in functional silos, which could introduce additional risk when attempting to identify exemption status across clients and subaccounts (in the case of investment advisor clients).

Firms should therefore consider appointing a central owner to lead the prioritization, tracking and external client communications. One of the first tasks the central lead should consider is to identify and agree on their firm’s principals on nonnegotiable terms. This should help manage functional area expectations and client idiosyncrasies as firms and their clients prepare for the June 2018 effective date.

In parallel to overseeing ownership of client outreach responsibilities and principals, client outreach leads should consider conferring with their technology organization to align business and data requirements. Technology solutions related to client reference data requirements should consider flexibility around accommodating changes on client exemption status, subaccount designations and cascade reference data on a daily basis. These solutions should also consider the consistency of collected data with broader enterprise data.

As a fallback, client outreach plans should also consider how to guide operations when client exemption classifications are not available. Some firms have considered a “default” approach, for example, considering clients without a designated status as nonexempt until otherwise confirmed. Others are considering a more conservative approach by halting trading with counterparties until status is determined.

An additional layer of complexity is added when firms book investment advisor block trades that are subsequently allocated to subaccounts with unknown exemption status. In these instances, firms should consider whether to request for reallocation or take a default approach to establish exemption classification.

2 SEA Rule 15c3-3: http://www.finra.org/industry/interpretationsfor/sea-rule-15c3-3.

3 | FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment

Firms should also consider implementing a process and supporting capability to periodically re-attest exemption classifications. Although FINRA does not provide explicit guidance on attestation periods, firms have been considering establishing multiple review timelines by grouping clients based on their risk of classification changing over a specified period. For example, exemption status for clients with net assets of approximately $40 million and cash transaction positions of approximately $10 million would be reviewed at shorter intervals. To support this approach, firms have considered building a reminder capability to notify front office and client-onboarding of clients who are due for exemption re-attestation.

Legal documentation and rule integrationMaster Securities Forward Transaction AgreementsFirms may choose to adopt the use of the Master Securities Forward Transaction Agreement (MSFTA) to enforce margining and liquidation rules.

In addition to margining and liquidation, firms have also considered incorporating exemption classifications into MSFTA documentation as a means for clients to self-designate; incorporated into Securities Industry and Financial Markets Association’s (SIFMA’s) sample FINRA 4210 addendum.3 When contemplating this approach, firms should consider what controls are required to ultimately accept a self-identified exemption status from a client. For example, firms have considered building a procedural capability to validate entity-level exemptions by referencing publically available information or recently gathered KYC documentation on file and systemic capability for independent verification of transaction exemptions.

Although MSFTAs help legally enforce margin and liquidation requirements under the rule, the industry has not agreed to adopt a standardized use of MSFTAs. SIFMA’s issuance of sample Rule 4210 language to include in MSFTA amendments have provided some guidance and industry uniformity, however, counterparties are negotiating standardized documents.

While member firms seek to embed rule requirements in MSFTAs, clients may be challenged by the range and volume of firm-specific documentation. Clients have been known to try to negotiate either specific FINRA 4210 addendum terms (e.g., T+5 trade liquidation) or by submitting their own MSFTA form agreements for execution. Clients are also referring to the rule requirements as a means of compliance

control without looking to sign supporting legal agreement terms. To assist with increasing efficiency with the negotiation process, firms should look to educate front office staff involved with legal negotiations on negotiable terms.

While MSFTAs have been the focus of FINRA 4210 industry discussions on legal documentation, member firms and their clients are also reviewing the potential impact to netting and clearing arrangements.

Master Netting AgreementsFirms have also considered incorporating MSFTAs in Master Netting Agreements or possibly removing existing MSFTAs depending on the benefits realized.

The cost of implementing technology and operational procedures may outweigh the material benefit to netting margin call across traded products.

Clearing arrangementsThe rule amendment notes that covered agency transactions cleared via a registered clearing agency (e.g., Fixed Income Clearing Corporation - Mortgage Backed Security Division) are exempt from FINRA 4210 margin requirements.

However, the potential exists for clients who intend to clear all their transactions to eventually hold, or end up holding, bilateral positions. The following two scenarios have been identified as areas where this may result:

• The client trading a product which is not eligible for clearing (e.g., CMO)

• The unlikely event that a client transaction fails to clear

To prevent these scenarios from resulting in non-4210 compliant bilateral positions, firms may take a conservative approach and require the execution of MSFTAs or other clearing agreements (similar to cleared derivative transactions) to address firm and counterparty responsibilities in these scenarios. Alternatively, firms are considering continuing to trade with these types of counterparties without legal agreements should this fit within their risk profile and policies.

3 SIFMA FINRA 4210 Amendment Form: https://www.sifma.org/wp-content/uploads/2017/06/2018-MSFTA-Amendment.pdf.

4FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment |

Enterprise strategic vs. FINRA 4210-specific solutionsUpfront agreement on maintenance margin, mark to market (MTM) margin, T+5 liquidation timelines and client self-designation of exemption status may reduce operational complexities post go-live. Regardless of the use and/or execution of the MSFTA or other legal documentation, firms will need to establish an infrastructure that can assist with identifying and periodically reviewing counterparties in-scope for margining, collecting acceptable margin and determining what steps to take for margin deficiencies.

The extension to June 2018 for covered agency transaction margining requirements provides firms with the additional opportunity to assess their current and expected business size and volumes, and pursue tactical and/or strategic solutions that best fit both business and operational needs.

Firms will need to assess their current technology capabilities to determine if existing enterprise platforms have the potential to implement changes to accommodate FINRA 4210 margining activities or build a FINRA 4210-specific solution.

Leveraging existing enterprise platforms could provide implementation efficiencies and cost benefits. The consistency of platform could reduce internal and external learning curves and expedite implementation timelines. The economies of scale using an existing platform could also benefit ongoing maintenance costs as upgrades and enhancements could be managed as part of wider releases. The creation of FINRA 4210-specific solutions however provide more flexibility in approach, timeline and ongoing maintenance. By taking this approach, firms could be less bound by system limitations, resourcing or other conflicting priorities already in the work pipeline.

When assessing whether to pursue enterprise strategic solutions or FINRA 4210-specific solutions, firms should consider their business’ size and growth expectations, transaction volumes and counterparty materiality amongst other firm specific attributes. Consideration should also be given to assessing system and reference data integration and planning a phased implementation that could possibly extend beyond the June 2018 effective date.

Reference data infrastructureReference data is fundamental to the firm’s ability to identify, classify and margin covered agency transactions. It is critical to have consistent counterparty and trade reference data to help manage the following areas of the covered agency transaction life cycle:

• Establishing and monitoring of credit risk limits (a December 2016 requirement)

• Establishing and maintenance of account/transaction exemption status

• Pre-and post-trade controls to identify missing exemption data

• Collecting of maintenance margin and MTM margin for nonexempt counterparties

• Net capital deductions for margin deficiencies on non-exempt accounts

• Incorporating certain exempt transactions into tentative net capital thresholds

Firms should consider implementing an integrated or centralized reference data solution to minimize data flows, data-entry touchpoints and reconciliation processes. Such consolidation will also provide audit benefits for internal reviews and FINRA examinations, ongoing monitoring and maintenance efficiencies. Reference data managed in functional silos may lead to inconsistent reference data and process bottlenecks due to the numerous data entry points across multiple systems and associated reconciliation processes to monitor data consistency.

As part of their margining and net capital processes, firms should consider building logic to support key variables (e.g., counterparty type, notional volume) into their decision-making algorithms to identify account and transaction exemptions for rule compliance.

4 See FINRA response to question 11 of the Covered Agency Transactions FAQs: http://www.finra.org/industry/responses-frequently-asked-questions-regarding-covered-agency-transactions-under-finra-rule.

5 | FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment

Collateral management infrastructure When assessing the best approach to margining covered agency transactions in preparation for the June 2018 effective date, firms are considering how they could best integrate maintenance margin and MTM margin calculations into their existing margining processes and capabilities. While the requirements have similarities to other regulations (e.g., margining requirements for over-the-counter derivatives transactions), firms should consider the following:

• How will exemption classifications be integrated with the margining process?

• Will the existing margining process be able to handle the margining of additional traded products (i.e., covered agency transactions) and incorporate cross-margin capabilities?

• How will securities margin be managed if an eligible form of collateral?

• How will this integrate with 15c3-3 lockup calculations and process?

• Will maintenance margin and MTM margin be netted together for margin calls?

• What sort of aged margin tracking capabilities are available?

While addressing each question is equally important for preparing margining capabilities, the tracking and reporting of under-margined accounts is critical for addressing additional requirements under the June 2018 rule amendment, which include the performing of net capital calculations and the identifying of transactions for T+5 extension5 requests or liquidation.

Process design and capability of handling of aged margin call extensions and position liquidations has been a challenge for firms. As margining is new to this market, firms anticipate having frequent unresolved disputes reaching the T+5 rule requirement either requiring the firm to request an extension from FINRA or to liquidate the transaction.

One of the main challenges faced by firms and their clients is around how long to maintain aged margin extensions. While firms should have the ability to request two extensions of 14 days each within the FINRA REX system,6 an industry standard has not yet been established on how to approach. This uncertainty has posed a challenge to firms and their clients around setting expectations and negotiating legal terms for when covered agency transactions will be liquidated.

Capital charges, thresholds and 15c3-3Firms should consider how margin deficiencies will be communicated to their finance team for capital charge purposes on a daily basis (e.g., producing a report for manual deduction or direct feed into the firm’s general ledger). When considering their net capital capability approach, firms should look to include requirements around how capital charges for covered agency transactions will be incorporated into their tentative net capital threshold monitoring process for individual clients and overall charges. Firms should focus on how they will combine capital charges across extended settlements for legacy rules with capital charges for covered agency transactions when performing these threshold checks. Since this could involve multiple traded products, data sources may vary.

Firms should also consider how they will incorporate client margin into their 15c3-3 customer protection process. Some firms are simply looking to lock up all margin received. Others are looking to align more closely to the 15c3-3 rule and lock up only excess MTM margin less any pre-approved haircuts and all maintenance margin received7 per Reserve Formula and Possession and Control requirements for cash and securities collateral respectively.

As these capital and 15c3-3 requirements are a direct result from margining of covered agency transactions, firm should look to assess and include these requirements as part of their overall margining capability.

5 Transaction extensions must be approved via the FINRA Regulatory Extension system (REX).

6 Per question 10 of September 2017 FINRA FAQ Response: http://www.finra.org/sites/default/files/faq_coveredtransactions_rule4210.pdf.

7 Per FINRA September 2017 responses to 15c3 FAQs: http://www.finra.org/sites/default/files/faq_coveredtransactions_sec.pdf.

6FINRA 4210 June 2018 | Implications of Covered Agency Transactions rule amendment |

Conclusion and next stepsLooking ahead to the June go-live, firms should continue toincrease their focus on how to address potential barriers tocompliance readiness in light of industry challenges and ruleuncertainty.

This increased focus should consider the following four keyareas:

• Client outreach strategy and integration of rules in legaldocumentation

• Creation of a centralized account exemption referencedata capability or building the capability and controls tosupport exemptions across FINRA 4210 processes

• Creation of a specific covered agency transaction margincapability vs. incorporation of covered agencies into anew or existing enterprise-wide margining capability

• Incorporating net capital calculations, thresholdmonitoring and 15c3-3 into margining requirements

Continued investment in these areas will position firms tocomply with rule requirements and minimize unexpectedbusiness impact as the industry continues to evolve andadapt to the June 2018 go-live of the rule amendment.

Why EY?We can assist broker-dealers with this time-sensitive and complex initiative by leveraging our deep pool of resources with diverse and relevant skill sets, utilizing accelerators developed from executing similar engagements and delivering a pragmatic approach that meets the immediate tactical needs and position for a more robust future state.

• The right team with the right experience: We know the industry, and we combine that insight with a deep understanding of compliance, operations, technology and forensics focused on broker-dealer issues with perspectives on industry trends, key challenges and leading practices. We are currently working with many of the top broker-dealers on compliance and regulatory-related issues.

• A proven approach: We have direct experience identifying and remediating FINRA 4210-related issues, having conducted multiple engagements related to FINRA 4210, where we have assisted broker-dealers across the diagnosis, design, remediation and implementation phases of an engagement. We host periodic roundtables conducted in the compliance and regulatory space to understand priorities that can be built into specific engagements.

• The ability to accelerate project execution: Through leading methodologies and tools, we have the diverse skill sets required to execute such a complex engagement, along with subject-matter resources, who are used effectively to facilitate decision-making for clients. We utilize lists of leading industry practices and controls, along with an initial set of hypotheses of potential issues that can be leveraged to jump-start the diagnosis phase of the engagement. In addition, analytical tools and approaches specifically used for FINRA 4210 in other engagements can be leveraged directly.

• Independent and objective: We will provide objective, fact-based observations based on our experience and our understanding of your goals and objectives.

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