What is happening?
"EPN Pair-Off" service is a newly introduced feature by the Fixed Income Clearing Corporation (FICC), specifically their Mortgage-Backed Securities Division (MBSD).
This service seems to aim at streamlining the process of pairing off To-Be-Announced (TBA) trades between Buy-Side and Sell-Side firms. In finance, a TBA trade refers to a contract for the purchase or sale of mortgage-backed securities (MBS) to be delivered at a future agreed-upon date, but the specific securities to be delivered are not specified at the time the contract is made. Pairing off, in this context, refers to offsetting the positions in these contracts.
The EPN Pair-Off service allows users to enter TBA trades either directly in EPN or through the RTTM Web to pair off those trades for reporting purposes. The 'EPN' refers to Electronic Pool Notification, a service provided by FICC that facilitates the communication between MBS market participants.
They introduced a new message type '(PO)' for TBA Pair Off notifications. The system calculates the money differences for the final money of trades submitted, which are then reported through the Pair Off reports available for firms that sign up for the service.
This functionality can be accessed via different methods including MQ, API, or directly in the MBSD RTTM Web. For firms that don't have the ability to process bulk submissions, they can manually process a TBA pair off through the RTTM web interface.
Why would they want to do this?
To-Be-Announced (TBA) trading in mortgage-backed securities (MBS) is quite complex and has its unique operational challenges. One of the main reasons claimed for introducing services like the EPN Pair-Off appears to be to reduce these operational complexities and to enhance efficiency to:
- Streamline Trade Settlement: In TBA trading, the specific securities to be delivered aren't specified at the time the contract is made. This can lead to a large number of open contracts that need to be settled at a future date. The EPN Pair-Off service can help streamline this process by allowing firms to pair off or offset matching buy and sell contracts.
- Reduce Operational Risk: By automating the pair-off process and allowing it to be done electronically, firms can reduce the operational risks associated with manual handling.
- Enhance Transparency: The service also appears to offer reporting features that can enhance transparency for firms. These reports could potentially provide useful data and insights that can be used for better decision making.
- Cost Efficiency: By automating the process, firms can also potentially save on costs related to trade settlement. Manual handling is not only riskier but also costlier in terms of time and resources.
What sort of abuses could this allow?
Given the complexity of To-Be-Announced (TBA) trading there is a huge potential for misuse, where unscrupulous actors could take advantage of such systems. Here are a few potential risks and loopholes I can think of (I am sure Apes will point out others!):
- Misrepresentation of Trades: One potential loophole could involve misrepresenting trades to take advantage of the system. This could include creating false pair-offs, potentially to manipulate a firm's financial reporting or to conduct fraudulent activities.
Manipulation of Timing: Some market participants might take advantage of the timing in the TBA market, by delaying the disclosure of trade specifics until they are advantageous, a practice known as "gaming".
- One example of gaming that's discussed in the context of TBA trading is "fails charges gaming." This involves traders intentionally failing to deliver securities when the fails charge is less than the cost of financing the position.
- Operational Risks: With any system, there's a risk of operational issues or glitches that could be exploited. For example, if the system doesn't accurately track and pair off trades, it could potentially be manipulated.... We sure have seen a ton of glitches during this journey...
- Insider Trading: Information about large pending trades can potentially be used for insider trading. While systems like EPN Pair-Off are intended to streamline operations and improve transparency, there is a risk that some users might have inappropriate access to information that can be misused....
- Inappropriate Access or Cybersecurity Risks: Given the electronic and automated nature of the EPN Pair-Off system, there's also a risk of cybersecurity threats. Hackers could potentially gain access to the system, modify trades, or steal sensitive information. I guess this is why there have been so many cybersecurity blurbs of late as well?
- MBSD Pair-Off available in PSE.
- Given the complexity of To-Be-Announced (TBA) trading and the potential for misuse, there are several potential areas where unscrupulous actors could take advantage of such systems.
To help mitigate these risks, firms and regulators need to ensure robust controls and monitoring mechanisms are in place.
- These could include system checks to prevent the misrepresentation of trades, limits on the timing of trade disclosures, regular audits of trades, stringent access controls, and strong cybersecurity measures.
- Furthermore, regulatory oversight is crucial to ensure that any potential abuses are promptly identified and addressed!