Potential Economic Knock-on Effects of Financial Regulations Sol Steinberg 5/15/2012

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Table of Contents

Impact of Regulation on Markets ................................................................................................................ 4

What are the Regulations ............................................................................................................................ 4

Basel III ................................................................................................................................................... 4-5

Dodd-Frank Act ......................................................................................................................................... 5

EE Mandate / SEFs ................................................................................................................................ 5

Volcker Rule .......................................................................................................................................... 5

European Market Infrastructure Regulation (EMIR) .............................................................................. 5-6

Positive / Negative Consequences and What Risks the Regulations Produce or Exacerbate ................... 6

Positive Consequences .............................................................................................................................. 6

Central Counterparty Clearing House (CCPs) ..................................................................................... 6-7

Market Transparency ............................................................................................................................ 7

Reduction of Operational Risk ........................................................................................................... 7-8

Negative Consequences ............................................................................................................................ 8

Central Counterparty Clearing House (CCPs) ..................................................................................... 8-9

Increased Liquidity Risk ......................................................................................................................... 9

Financial Costs .................................................................................................................................... 10

Reputational Risk ........................................................................................................................... 10-11

IT Risk .................................................................................................................................................. 11

Who / What it Affects ................................................................................................................................ 11

Central Counterparty Clearing House (CCPs) .......................................................................................... 11

Pricing of Cleared vs. Uncleared Interest Rate Swaps ................................................................... 11-15

Portability and Segregation Model ................................................................................................ 15-16

Regulators / Governments ...................................................................................................................... 17

Basel III ................................................................................................................................................ 17

Volcker Rule ................................................................................................................................... 18-19

Financial Institutions/Non-Bank Financial Institutions ...................................................................... 19-22

Basel III ........................................................................................................................................... 22-24

EE Mandate / SEFs .............................................................................................................................. 24

Volcker Rule ................................................................................................................................... 24-25

Taxpayers / General Public ..................................................................................................................... 25

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Volcker Rule ................................................................................................................................... 25-26

What to do about it .................................................................................................................................... 26

Central Counterparty Clearinghouse (CCPs) ........................................................................................... 26

Pricing of Cleared vs. Uncleared Interest Rate Swaps ................................................................... 26-27

Portability and Segregation Model ................................................................................................ 28-29

Regulators / Governments ................................................................................................................. 29-30

Volcker Rule ................................................................................................................................... 30-31

Financial Institutions/Non-Bank Financial Institutions ...................................................................... 31-32

EE Mandate / SEFs .............................................................................................................................. 32

Volcker Rule ................................................................................................................................... 32-33

Taxpayers / General Public ..................................................................................................................... 33

Summary ..................................................................................................................................................... 33

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Impact of Regulation on Markets

The collapse of Lehman Brothers and Eurozone crisis revealed the moral hazard, lack of governance,

excessive risk taking, and greed within the global financial system. Since 2008, regulators have

constantly put forth efforts to identify, state, and propose solutions in order to prevent another financial

meltdown. As new regulations come forward, governments, regulators, and other international bodies are

consistently recognizing that there are a myriad of interconnected problems that exist on a global scale.

New vocabulary terms have been created to identify and address the pertinent issues at hand. Some

examples are systemically important financial institutions (SIFIs), globally systemic important banks (G-

SIBs), and financial market infrastructures (FMIs) to name just a few. An immediate conclusion that

insiders and outside observers can state is that there is still uncertainty surrounding the finite and concrete

answers that are necessary to restore financial integrity to the markets.

What are the Regulations

A. Basel III

Basel III was one of the primary regulations introduced to combat the 2008 financial crisis.

Basel III is a global regulatory standard on bank capital adequacy, stress testing, and

market liquidity risk agreed upon by the members of the Basel Committee on Banking

Supervision in 2010-2011. This, the third of the Basel Accords was developed in

response to the deficiencies in financial regulation revealed by the late-2000s financial

crisis. Basel III strengthens bank capital requirements and introduces new regulatory

requirements on bank liquidity and bank leverage (Wikipedia).

The aforementioned regulation covers four basic elements: definition of capital, enhancing risk coverage

of capital, leverage ratio, and international liquidity framework.

Basel II presently requires a capital buffer of 8% of risk-weighted assets (RWA) (Mahapatra). Tier I

Capital is established at a minimum of 4% of RWA (Mahapatra). Common equity can be at a minimum

of 2% of RWA (Mahapatra). Tier II Capital can be comprised of debt instruments with a maturity of at

least 5 years and make up a maximum of 4% of RWA (Mahapatra). Tier III Capital can also be included

in Tier II Capital (Mahapatra).

Under Basel III, the capital buffer will remain at 8% of RWA; however, Tier I Capital is established at a

minimum of 6% of RWA, and common equity will make up at least 75% of Tier I Capital. Finally, Tier

III Capital no longer exists under Basel III (Mahapatra).

The Credit Valuation Adjustment (CVA) is the cornerstone of enhancing risk coverage of capital.

Mahapatra states that the CVA “is a measure of diminution in the fair value of a derivative position due to

deterioration in the creditworthiness of the counterparty.” In other words, the CVA determines the capital

that banks need to accumulate to protect themselves from counterparty risk.

Another key aspect of Basel III is the Liquidity Coverage Ratio (LCR). The LCR is “designed to ensure a

firm’s ability to withstand short-term liquidity shocks through adequate holdings of highly liquid assets”

(Tarullo). “The LCR is intended to promote resilience to potential liquidity disruptions over a thirty day

horizon (Bank for International Settlements).” High quality assets need to be comprised of at least 60%

of Level 1 assets, which includes cash, central bank reserves, and sovereign debt qualifying for a 0% risk

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weight under Basel II (AFME). High quality assets should not contain more than 40% of Level 2 assets,

which includes sovereign debt qualifying for a risk weight under Basel II (AFME).

Another key aspect of Basel III is the Net Stable Funding Ratio (NSFR), which “is intended to avoid

significant maturity mismatches over longer-term horizons” (Tarullo). The NSFR’s objective is to limit a

bank’s reliance on short-term wholesale funding during times of market uncertainty (Mahapatra).

B. Dodd-Frank Act (DFA)

The Dodd-Frank Act is a federal law that was passed as a counterweight to the causes of the financial

crisis. Even though the DFA was passed in 2010, there are still provisions that have yet to be

implemented. Furthermore, there is an element of opacity that surrounds the interpretation and

implementation of the law itself.

EE Mandate / SEFs

The Electronic Execution Mandate, or the EE Mandate, of Title VII mandates that interest rate swaps be

executed on designated contract markets (DCM) or swap execution facilities (SEFs) (ISDA Research).

Presently, interest rate swaps are executed between a dealer and end client on a bilateral basis. The

Commodity Futures Trading Commission (CFTC) aspires to reduce transaction costs, increase

accessibility to interest rate swaps, and increase market transparency of the aforementioned derivatives

through DCMs and SEFs (ISDA Research).

Volcker Rule

The Volcker Rule was established under the DFA to restrict proprietary trading by financial firms. Paul

Volcker, the originator of the legislation, believed that proprietary trading induced systemic risk. In more

detailed terms,

“the Volcker Rule prohibits an insured depository institution and its affiliates from

engaging in proprietary trading; acquiring or retaining any equity, partnership, or

ownership interest in a hedge fund or private equity fund; and sponsoring a hedge fund or

a private equity fund (Skadden).”

The insured depository institution in question cannot have more than 3% of a fund (Skadden).

Furthermore, the insured depository institution’s aggregate investments in funds cannot exceed more than

3% of Tier I Capital (Skadden).

C. European Market Infrastructure Regulation (EMIR)

The G20 leaders committed to regulatory reform of OTC derivatives in September 2009 (HFW). In

September 15th, 2010, the European Union announced the European Market Infrastructure Regulation

(EMIR) in order to comply with the aforementioned commitment (HFW). The three main requirements

of the EMIR are the following: clearing OTC derivatives that have been declared subject to the clearing

obligation through a CCP, creating risk management procedures for OTC derivatives transactions that are

not cleared, and reporting derivatives to a trade repository (Norton Rose Group). The EMIR strongly

resembles Title VII, the Wall Street Transparency and Accountability Act of 2010, in regards to the

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treatment of OTC derivatives and CCPs. For example, collateral must be collected for OTC trades,

financial institutions are encouraged to utilize electronic facilities to reduce operational risk, and

derivatives contracts will be further standardized (Norton Rose Group). EMIR is scheduled to be

implemented by the end of 2012 (Norton Rose Group).

Positive / Negative Consequences and What Risks the Regulations Produce or

Exacerbate

A. Positive Consequences

Central Counterparty Clearing House (CCPs)

Central Counterparty Clearing Houses (CCPs) are a cornerstone of Title VII of the DFA. CCPs will be

responsible for clearing OTC derivatives by the end of 2012. CCPs will replace the commonplace

bilateral trade system between the dealer and end user that was partially responsible for the financial

crisis. As Dudley summarizes,

“……the structural characteristics of over-the-counter derivatives market itself amplified

the shocks created by the housing bust in several ways. First, the collateral calls

generated by sharp movements in the mark-to-market value of the OTC derivative trades

drained liquidity buffers and provoked the fire sales of assets. These fire sales increased

volatility and provoked still greater margin calls. This dynamic was one reason why the

market prices of these assets overshot to the downside – that is they fell more than needed

simply to reflect the increase in expected credit losses. In other words, the illiquidity risk

premiums embedded into the prices of these assets became very large.”

CCPs were introduced into the DFA in order to reduce global systemic risk through multiple ways.

First, CCPs will be able to net positions between different parties and off-set contracts. As the number of

trades and positions increasingly flow through the respective clearinghouse, the potential to net positions

and off-set the contracts also increases

“As an example of position netting, A may sell a contract; B may buy an identical

contract and then sell it; and C may buy this contract. In a bilateral OTC market, B’s

offsetting positions remain open, and one of its counterparties on these contracts could

lose from its default. In contrast, if all of these contracts are cleared through a CCP, B’s

contract would be netted out and B’s contractual obligations would be extinguished. If B

went bankrupt, neither A nor C could suffer a default loss (as long as the CCP remains

solvent) (Pirrong).”

Second, bilateral OTC derivative trades do not require collateral to be posted by either party. In the case

of default, either party cannot reduce its respective loss. In contrast, CCPs require clearing members to

post initial margin at the initiation of a trade (Pirrong). CCPs also require clearing members to post

variation margin if the intra-day price of the respective security fluctuates past a certain threshold

(Pirrong). The initial margin and variation margin can be utilized to reduce or even offset losses in the

case of default by a clearing member (Pirrong).

CCPs also introduce the concept of risk mutualization. In order for a firm to become a member of a CCP,

the respective institution has to contribute to a default fund (Pirrong). Losses that exceed the posted

collateral can be further absorbed by the money pool within the default fund (Pirrong).

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CCPs may also utilize insurance and equity to absorb losses and ultimately mitigate systemic risk.

Insurance has historically provided additional protection when losses exceeded the defaulter’s margin

(Pirrong). Equity can supply for-profit CCPs with supplementary buffers to absorb default losses

(Pirrong).

Market Transparency

The EE mandate further reduces systemic risk. The increased transparency of a SEF provides regulators

with an increased ability to measure and mitigate risk. Under the present infrastructure, regulators are

only able to elicit price information by interacting with dealers and do not possess the ability to

immediately determine the counterparties of a financial institution approaching default (ISDA Research

Staff). Upon the implementation of the EE mandate, SEFs will provide information – for example, size of

the transaction, prices, type of derivative within the transaction - to regulators on a pre-trade basis (ISDA

Research Staff). The utilization of technology also provides regulators with the ability to accurately

measure the price of swaps. In regards to the simpler version of swaps – plain vanilla swaps – the current

value of future transactions can be easily observed in the market (Hull). If the price of plain vanilla swaps

cannot be measured, other inputs such as interest rates and credit spreads can be utilized to calculate their

value (Hull).

Reduction of Operational Risk

The introduction of the EE mandate provides an opportunity to reduce the operational risk associated with

swap execution. Present OTC derivative trading and execution requires a series of daily actions that are

often manual and onerous. These processes include, but are not limited to, manually setting up OTC

trades in a trade capture system, utilizing labor hours that are time consuming, exposing the daily

workflow to human error, performing trade confirmations by hand, and inaccurately determining market

values (Oracle Financial Services). As ISDA points out,

“A different type of safety and soundness concern with OTC derivatives has always been

present as a result of the infrastructure of the marketplace. Unlike exchanges,

clearinghouses and other organized trading venues, the OTC derivatives market is what

its name implies – over the counter. Each dealer and each user must construct its own

infrastructure to manage its positions. The infrastructure ranges from accounting and

payment systems to valuation models, collateral processes, portfolio reconciliations, etc.

Regulators naturally believe one centralized family of systems is better than dozens, if

not hundreds of independent families, any one of which could potentially create financial

havoc if it failed.”

Institutions have identified this opportunity and are currently utilizing their economies of scope and

technological know-how to become a SEF to further reduce operational risk for their respective clients.

Reducing operational risk can be performed by automating the life cycle of a transaction as much as

possible. For example, State Street announced the launch of its respective SEF, SwapEx (Business Wire).

SwapEx will reduce operational risk through the automation of the many stages of derivatives processing

by including execution, clearing, collateral management, cash and securities flows between the middle

and back offices, transaction cost and risk reporting, valuations, and the reconciliation of positions

(Business Wire). Streamlining the aforementioned processes through technology not only complies with

the mandate of SEC, but can potentially reduce errors in trade processing.

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Legal Entity Identifiers (LEIs) also create an additional step in further reducing the operational risk

associated with OTC derivative trading and clearing. As Marsh points out,

“The introduction of a global and standardised Legal Entity Identifier is primarily

intended to provide regulators with the tools to monitor systemic risk. However, the new

identifier, which will straddle all of the existing identifiers, can be used to support

financial institutions with the enormous process of aggregating information from various

sources and across the entire enterprise. The LEI as standalone code doesn’t provide

much benefit. Where the code could become very useful is when it is packaged with

additional content, such as the underlying reference data and is used as a tool to aggregate

different identifiers to support a firm’s business requirements. Specifically, the fact that

this code can be freely passed between firms, as well as firms and regulators, and can

include all of the essential underlying information means that financial institutions can

use it for aggregating information across the enterprise to achieve greater operational

efficiency.”

Marsh has identified the following nine ways that LEIs can enhance operational efficiency.

1- “There is the possibility to reduce the amount of reconciliation required across the internal databases

and provide more interoperability across systems that run off of different identification schemes.”

2- Increase the ability to accurately identify counterparties for clearing and settlements.

3- LEIs could discontinue the need for firms to support complicated cross-referencing of data for

corporate actions.

4- LEIs reduce the need to utilize multiple reference identification codes for organizing data.

5- The identification codes could help improve data flow, data timeliness, and risk management.

6- LEIs could minimize the time required to aggregate data across business divisions within a single

organization.

7- Improved data aggregation increases the ability to utilize business intelligence for future business

projections.

8- Improved data aggregation techniques increase the ability to access more amounts of information at a

finite point in time.

9- Improved data aggregation techniques increase the ability of an organization to identify, assess, and

proactively minimize risk exposures.

Two additional identifiers – unique swap identifier (USI) and unique product identifier (UPI) – will be

utilized in conjunction with the LEI (Acworth). The USI will bring together all data reporting for a given

swap; and “the UPI will identify the asset or assets on which the swap is based (Acworth).” Together, the

three identifiers will link data across counterparties, asset classes, swap data repositories, and transactions

(Acworth).

B. Negative Consequences

Central Counterparty Clearing House (CCPs)

As previously stated, CCPs do not eliminate risk; they reallocate it. CCPs were introduced within the

DFA to reduce risk. However, CCPs can also exacerbate systemic risk and threaten the global financial

system.

CCPs rely on a “waterfall” – collateral, default fund, insurance, and equity – to absorb losses for clearing

members that default (Pirrong). The resources to absorb the losses are extensive; however, they have

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limits (Pirrong). In the case of CCP default, the scenario can send shockwaves throughout the capital

markets and further decrease the general public’s confidence in the financial system.

CCPs request variation margin when the price of an OTC contract fluctuates past a specified threshold.

The reasoning is to ensure that the CCP can absorb losses when the clearing member defaults. During

times of market volatility, the probability of a CCP to request variation margin from a clearing member

diminishes. “Firms that must meet large margin calls may respond by selling assets and reducing

positions in ways that exacerbate the price changes that caused the initial margin calls. The margin

dynamic can lead to exaggerated, systemically destabilizing price movements (Pirrong).”

CCPs introduce elements of moral hazard even though their conception under the DFA is altruistic in

nature. CCP collateral depends solely on the product risk characteristics instead of the creditworthiness

of the clearing member (Pirrong). Counterparty risk depends on both product risk and creditworthiness in

reality (Pirrong). Under this regime, uncreditworthy firms will tend to trade beyond their actual

characteristics and creditworthy firms will tend to trade below their actual characteristics (Pirrong).

Adverse selection also occurs through the advent of CCPs. Since CCPs specialize in clearing derivatives,

they do not have the same capabilities as clearing members to price derivatives (Pirrong). As a result,

CCPs have asymmetric information measuring the risk of the respective derivatives. Firms will tend to

overtrade products in which the CCP underestimates risk, and eventually increase the probability of

default within the CCP itself (Pirrong).

The advent of the DFA will lead to more OTC derivatives being cleared by CCPs. In contrast, there are

financial and non-financial institutions that will need the tailored characteristics of bespoke derivatives.

As a result, the issue of pricing cleared and uncleared derivatives of similar terms has come up.

In the case of cleared and uncleared derivatives, end users are required to post initial margin. However,

differences arise when variation margin needs to be posted. When an end party posts variation margin for

a cleared derivative, the variation margin becomes the property of the recipient (Cont). When an end

party posts variation margin for an uncleared derivative of similar terms, the variation margin and the

associated coupon payments remains the property of the end user (Cont). Due to the different treatment

of variation margin, the pricing of cleared and uncleared derivatives is affected by the convexity and NPV

effect (Cont).

The “convexity effect appears in futures contracts when there is a significant correlation between the

price of the future and the term rate (Cont).” For example, if an investor takes a short position in a

Eurodollar future contract based on interest rates and interest rates decline, the investor with the short

position will receive variation margin (Cont). This same investor can utilize the variation margin to

purchase other securities such as a zero coupon bond (Cont). If the interest rates increase at a later time,

the investor has at least mitigated any losses with the purchase of securities (Cont). Due to the convexity

effect, Eurodollar futures are priced lower than their unclear counterparts, forward rate agreements

(Cont).

The NPV effect also leads to different prices between cleared and uncleared derivatives. For example,

assume that an investor purchases a natural gas swap and the natural gas forward curve appreciates after

purchase. In the case of the uncleared natural gas swap, the investor will receive variation margin that is

equal to the additional discounted future cash flows. In the case of a cleared natural gas forward, the

investor can demand to unwind the position at a price that is equal to the additional future cash flows, not

the additional discounted future cash flows (Cont).

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Increased Liquidity Risk

The higher levels of Tier I Capital under Basel III and the collateral requirements associated with OTC

derivative central clearing reduces the probability of systemic risk. In contrast, the aforementioned

regulations increase the expectations of liquidity risk. The assets allocated to capital buffers and

collateral cannot be utilized by the respective organization to generate returns for shareholders. This issue

produces four potential negative results. First, there could be an elevated cost of capital for future

investments and higher prices for end consumers of OTC derivatives (PWC). Second, end users would

have to post more collateral if their credit rating was downgraded or there was a large price change

against its current positions. Third, shareholders could vent their frustration by seeking higher returns at

non-financial institutions. Fourth, financial institutions could migrate to other jurisdictions to take

advantage of less stringent regulations. The accumulation of financial institutions in the aforementioned

locales could ultimately heighten the expectation of systemic risk, which is the unintended effect of Basel

III and posting collateral for OTC derivative central clearing.

Financial Costs

The financial costs to understand the snafu of new regulations and perform implementation upon

comprehension will continue to be burdensome for financial institutions. An example is adherence to the

EE mandate for executing interest rate swaps. Currently, interest rate swaps, one type of OTC derivative,

is executed bilaterally between a client, a buy-side financial institution, and a dealer. ISDA research staff

explored these incremental financial costs by conducting a survey of buy-side financial institutions. They

found out that these same institutions expect to spend approximately $2.1 million on technological

infrastructure, $1.3 million to amend client/counterparty documentation, and $200,000 on an annual basis

for additional regulatory reporting.

Dealers will face increasing expenditures in respect to the EE Mandate. ISDA research staff surveyed the

16 largest derivative dealers and found out that they “are expected to invest approximately $725 million”

to prepare for the EE mandate. These expenditures include $400 million for technological infrastructure

improvements, $17 million for hardware, and $66 million for legal (ISDA Research Staff).

The CFTC will require funds for its increased supervisory role of interest rate swaps. The US

organization has requested an additional $139.2 million for its 2012 fiscal year budget (ISDA Research

Staff). Gary Gensler, Chariman of the Commodity Futures Trading Commission, has acknowledged that

the agency does not have sufficient funding to fulfill its supplemental responsibilities (Steinberg). At the

Futures Industry Association Conference in Boca Raton, Florida, he stated, “the agency currently employs

700 people, about 10% more than in the 1990s, but the market has grown 30% (Steinberg).”

Finally, there are costs associated with building and operating the SEFs themselves. The required

expenditures for establishing and operating a SEF on an annual basis are approximately $7.3 million and

$11.9 million (ISDA Research Staff). The tasks associated with constructing a SEF will require

registration with the CFTC, building hardware and software infrastructure, product development, drafting

client documentation and operating policies, and developing disaster recovery plans (ISDA Research

Staff). The demands that are necessary for operating a SEF on an annual basis are employing personnel,

leasing and maintaining offices, upgrading technological infrastructure, maintaining financial resources,

and updating business continuity plans (ISDA Research Staff).

Reputational Risk

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The increased transparency associated with Title VII in the DFA presents the potential for reputational

risk to SEFs. SEFs such as State Street’s SwapEx are able to leverage their decades of experience in the

financial industry. However, utilizing technology to automate the business processes associated with SEF

operations is new. Furthermore, Title VII can undergo new changes in the near future. Future changes to

Title VII could require a SEF to further alter its technological infrastructure and/or connectivity to market

participants. If a SEF is not able to handle the technological requirements and fails to deliver on its

obligations, the institution’s brand equity as a SEF not only suffers, but the reputation for the respective

company’s business divisions and the firm as a whole could potentially suffer as well.

IT Risk

Over-the-counter service providers are preparing for the eventual implementation of Title VII by

establishing connectivity to related parties. For example, Trade Web, a leading provider of competitive

electronic interest rate swap markets for the institutional marketplace, has completed electronic links to

major derivative clearing houses such as the International Derivatives Clearing Group,

IntercontinentalExchange (ICE) Europe, and ICE Europe. As the different players in the OTC derivative

space become interconnected, each respective firm exponentially subjects itself to certain defects,

failures, or interruptions, including, but not limited to, those caused by computer “worms” and viruses,

from its interconnected institutions. Companies in the OTC derivative space will have to invest more in

business continuity programs and backup systems as the connectivity between different parties increase.

Otherwise, the failure of one party’s IT system could potentially corrupt the entire value chain of swap

execution and settlement.

Financial institutions and non-financial institutions will also have to eliminate workarounds (Hodgson).

A workaround is booking a complex derivative as a bundle of more simple vanilla products in an IT

system (Hodgson). In the past, booking a workaround is helpful in expediting the execution and settling

processes of the derivative transaction. However, booking future transactions will need to be

standardized as they are centrally cleared. Sending information on a workaround to a CCP can lead to

unbalanced positions and the incorrect amount of collateral for the respective trade (Hodgson). New

systems and processes will need to be created in order to create harmonization between the booking entity

and CCP (Hodgson).

Who / What it affects?

A. CCPs

Pricing of Cleared vs. Uncleared Interest Rate Swaps

Problems arise when pricing cleared interest rate swaps due to the convexity and NPV effect. The

International Derivatives Clearinghouse (IDCG) has derived valuations to ensure that its futures contracts

are the equivalent of uncleared swaps with similar terms. However, IDCG’s valuation process for futures

contracts differs from the price of uncleared swaps.

The cash flows for IDCG futures contracts can be calculated. (Zero volatility can be initially assumed to

arrive at an equation for calculating the cash flows.) There are three components of the cash flows. The

first part is the cash flows generated from the daily variation margin based on the change in the NPV of

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an uncleared interest rate swap (Cont). (Note: The following variables represent the variables utilized for

the equations within the IDCG Swap Future Section)

Ft = NPV of a unit notional

C = semi-annual coupon rate

TN = time period for receiving semi-annual coupon payments

T1(fl)

= time period for receiving quarterly floating coupon payments

∆i = time between fixed payments

гj = accrual periods of each floating payment

Et = expectation conditional on the information up to time t

Bt = reference to money market account

The first component is denoted by the equation below.

Equation 1

∑

∑

“Ft can be thought of as the price of an asset that pays discrete dividends. On the day of

coupon payment, Ft has an instantaneous jump equal to the amount of the coupon. Ft - Ft- =

-C∆i, if t corresponds to a fixed payment Ti and Ft - Ft- =

, if t corresponds to a

floating payment time Tj(fl)

(Cont).”

The second component in the cash flows is generated by the net of fixed and floating coupon payment

(Cont). Cont states that

“….each time of the fixed coupon payment Ti, the amount is equal to C∆i, and at each

time of the floating coupon payment Tj(fl)

, the amount is equal to -

. The present

value of this component is equal to F0 (Cont).”

The third part of the IDCG futures cash flows occurs when the trade is consummated (Cont).

“If the coupon of the swap does not coincide with the swap rate on the settlement curve, a

positive or negative cash flow equal to the initial settlement price, F0, applies through the

variation margin (Cont).”

Combining the equations for the three components of the IDCG futures contract’s cash flows gives rise to

the following equation (Cont).

Equation 2

∑

{

}

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In the equation above, V0 is calculated by adding all of the cash flows over each trading day until the

expiration of the swap (Cont). When the same equation is transformed into a continuous-time analogue,

the following equation is the result (Cont).

Equation 3

{∫

}

Since dBt = rtBtdt is the derivative of Bt (rt is the short rate at time t and Ft = 0), integration can be utilized

to calculate the following equation (Cont).

Equation 4

{∫

}

If Equation 4 is simplified, the following formula results (Cont).

Equation 5

∫

Valuation under Hull-White model

Quantifying the different features of an IDCG futures contract is more complicated than Equation 5 that

was derived in the previous section (Cont). The Hull-White model incorporates “time-dependent

parameters which assume the following dynamics for the spot rate under the following pricing measure

(Cont).”

drt = (Ɵ(t) – art)dt + σdWt

Ɵ(t) = long-term mean of the short rate (allowing exact calibration to the initial yield curve)

a = short-rate mean-reversion speed

σ = volatility

Even though the Hull-White model does not perfectly replicate market observations, the model can be

utilized to describe interest rate fluctuations (Cont). Let’s start by stating that the equation for the fixed

coupon payments is the following

Equation 6

∫

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Incorporating the Hull-White model into Equation 6 gives rise to the following equation (Cont).

Equation 7

When a → 0, Equation 7 results in the following expression (Cont).

Equation 8

The Hull model can also be utilized to create an equation for the floating side of the IDCG futures

contract (Cont). Let’s start by stating that the equation for the fixed coupon payments is the following.

Equation 9

{∫

}

If the Hull-White model is incorporated into equation 9, the following equation results (Cont).

Equation 10

When a → 0, Equation 10 results in the following expression (Cont).

Equation 11

(

)

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Equations 8 and 11 correspond to the fixed and floating payments of a stylized IDCG-type contract,

respectively (Cont). The fair coupon of an IDCG futures contract can be calculated from the

aforementioned equations (Cont). The fair coupon “is the coupon rate C in Equation 8 that equates the

initial fair value V0 = -

to zero (Cont).” Upon calculating the convexity correction of the IDCG

futures contract, the convexity correction, the correction for the convexity effect and NPV effect, for an

IDCG futures contract can be calculated (Cont). The convexity correction is the difference between the

fair coupon and the par coupon of an equivalent uncleared interest rate swap (Cont).

The total fair value V0 of a standard IDCG futures contract is calculated by adding all of the fixed and

floating payments (Cont). The fixed and floating payments are calculated from Equation 7 and 10,

respectively (Cont).

Cont applied the IDCG convexity correction – the difference between the fair rate of an IDCG futures

contract and the par coupon of an uncleared swap with same payment structure – by utilizing a Hull-

White model calibrated to the market data as of December 2010. Cont found differences between the

swap rates of the IDCG future and corresponding uncleared swap rate. For a 10-year contract, the

difference was 18 basis points (Cont). For a 30-year contract, the difference was 60 basis points (Cont).

In conclusion, the IDCG pricing mechanism leads to differences between the cleared swap future and

uncleared interest rate swap of similar terms.

Portability and Segregation Model

CCPs are one of the main keys and bastions of safety for solving the puzzle for global systemic risk. As

stated previously in the text, CCPs do not absolve systemic risk from the global system; they reallocate it.

Going forward, CCPs need to carry a portability attribute to ensure that the CCP itself does not pose a

danger to OTC derivative trading or the financial system.

Portability is an essential characteristic to invigorate potential clearing members with confidence and

ensure that the CCP system continue to run in times of distressed environments. Portability allows

clearing members to transfer collateral and positions from one CCP to another. As Medero states,

“Portability refers to the ability to transfer swap positions (and related collateral) of a

non-defaulting customer from one FCM to another FCM, without liquidating and re-

establishing such swaps. It is important that cleared swaps customers be able to “port”

their positions and related collateral without delay from one FCM to another FCM. This

will allow customers to continue to participate in the market with minimum business

disruption in case there is a concern about their FCM. Closing out positions with one

FCM and re-establishing the positions with another FCM is costly, an unnecessary

expense and time-consuming. Facilitating immediate portability also produces systemic

benefits by providing an orderly framework to allow customers of an insolvent FCM to

move positions to another FCM where the porting of positions is based on each

customer’s risk profile and not linked to the insolvent FCM. (Medero)

After the Lehman collapse, the lack of portability is one of the reasons investors and the general public

lost confidence in the financial markets. On one side of the Lehman trade, the client assets were frozen.

On the offsetting side, the party was exposed to the volatility of the markets (Dudley). The “asymmetry

contributed to the sharp increase in market volatility, the dramatic reduction in market liquidity, and the

impairment in market function following the Lehman failure (Dudley).” The bankruptcy instilled fear in

other dealers and induced them to flee from market participants that were even perceived to be weak

(Dudley).

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Portability needs to be established across international regimes. Clearing members will continue to

purchase and sell swaps that are located in different geographic regions after CCPs are established.

International portability will ensure that systemic risk is minimized, arbitrage opportunities are reduced,

and promote liquidity on a global basis (Goebel).

CCPs also need to elect an operational model that further enhances the reallocation of global systemic risk

in a practical manner. Presently, there are three operational models – Physical Segregation Model, Legal

Segregation Model, and Futures Model.

Physical Segregation Model

Under this model, the Futures Commission Merchant (FCM) would maintain individual accounts for each

customer and the respective customer’s collateral (Medero). Separating collateral on a customer basis

ensures that the collateral is not utilized to support the obligations of another customer (Medero). In the

case of default, the FCM and Derivatives Clearing Organization (DCO) would segregate the books,

records, and cleared swaps of each client and the respective client’s collateral (Medero).

Legal Segregation Model

The FCM and the DCO would separate the cleared swaps and collateral of each client within their books

and records. In reality, the collateral of each client would be commingled (Medero). Within the Legal

Segregation Model, there are two further models – Complete Legal Segregation Model and Segregation

with Recourse Model.

Complete Legal Segregation Model

The DCO is able “to access the collateral of the defaulting cleared swaps customers, but not the collateral

of the non-defaulting cleared swaps customers” (Medero).

Legal Segregation with Recourse Model

The DCO is able to access the collateral of the non-defaulting cleared swaps customers after the DCO

utilizes its capital to ameliorate the default (Medero).

Futures Model

The Futures Model is the clearing system being utilized for the US futures markets. Under this model,

“……each FCM and DCO would be permitted to commingle all cleared swaps collateral

for all cleared swaps collateral for all customers of an FCM in one account and when an

FCM default, due to a default by a customer, following the depletion of the FCM funds,

the DCO would be permitted to access the collateral of the non-defaulting cleared swaps

customers before applying its own capital or the guaranty fund contributions of other

non-defaulting clearing members. In other words, the funds of non-defaulting customers

of an FCM are at the top of the waterfall to cure any losses to the DCO after the funds of

the defaulting customer and the defaulting FCM are depleted (Medero).”

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B. Regulators / Governments

Governments have consistently attempted to tackle the systemic risk and associated issues with the

financial crisis by proposing and passing innumerable legislation, and increasing their own powers.

Regulators will have to be cognizant of foreign governments in regards to the legislation that they pass

and how it affects financial transactions and proposed regulations within their own shores.

However, the ability to predict the outcomes of future regulations is hindered because the infrastructure to

share data between governments is limited. The 2008 financial crisis has forced regulatory bodies to

think about how to identify global systemic risk, perceive how international banks are connected, and

determine how economic shocks can propagate across borders (Cerutti). Without the global viewpoint,

vulnerabilities in the international banking system can go undetected. There are three areas that have

been identified need to be strengthened in order to prevent another financial crisis.

First, there are weak institutional infrastructures that promote coordination between different countries

(Cerutti). Presently, national policy makers tend to focus solely on national policies due to the insular

mindset of the policy makers (Cerutti). Often, national policy makers will promote policies on the

country scale without weighing the benefits or disadvantages. There are international bodies that have a

global regulatory purview; however, these organizations are usually fragmented and lacking coordination

themselves (Cerutti).

Second, business has become increasingly complex in regards to the international context. Banks can

have different organizational structures, legal statuses, numerous subsidiaries and branches spread across

the globe (Cerutti). When an analysis is conducted on a bank’s operational structure, a group-level

consolidated data approach is utilized (Cerutti). In other words, the analysis assumes that the bank

resources are easily transferable between the different subsidiaries and branches (Cerutti).

Third, there is a lack of comprehensive data that captures the international dimensions of systemic risk

(Cerutti). Governments have different procedures for collecting data within their walls. Furthermore,

there are security restrictions that prevent the complete sharing of data between countries (Cerutti).

Basel III

Since the G20 meeting in 2009, the same group has been in charge of establishing the regulatory agenda

and ensuring that governments comply. However, there has been minimal progress to date. There is

more communication than coordination, cultural differences, regulatory overlap between countries,

sovereign protectionism, and different analytical approaches. Time is essential for the different country

regulators to become accustomed and know each other. However, time is also not a luxury because

financial institutions are currently in limbo and need to know the finality of the proposed regulations to

change operational and legal procedures.

For example, the purpose of Basel III is to raise the capital buffers of financial institutions with liquid

assets on a global scale. However, there has been minimal progress in regards to the regulation. Only

two nations, Japan and Saudi Arabia, have published their final implementing law for the regulation

(Brunsden). Furthermore, Basel 2.5, the precursor to Basel III, has not been fully implemented. Six of

the Basel 2.5 committee members – Argentina, Indonesia, Mexico, Russia, Turkey, and US – have not

been fully implemented (Brunsden). China and Saudi Arabia – two members of the Basel 2.5 committee

– have made limited progress (Brunsden). The European Union, United Kingdom, and US authorities

have accused each other of “watering down or delaying the tougher standards” of Basel III (Masters).

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Volcker Rule

There are multiple proposals that are becoming laws, and they could result in unintended consequences.

For example, the Volcker rule limits proprietary trading of SIFIs. As a consequence, the Volcker rule

could potentially push proprietary trading into the shadow banking system, cause US governmental

backlash, restrict efficient funding of private firms, and result in exploitation of the rule itself.

As more financial transactions are shifted to the shadow banking system, the ability to measure the

growth in nominal GDP becomes more difficult for outsiders – for example, regulators and government

officials. Abel, Bernanke, and Crouse stated that money is traditionally categorized into the following

groups:

M0 – the total of all physical currency, plus accounts at the central bank that can be exchanged for

physical currency

M1 – the total of all physical currency, plus bank reserves and checking accounts

M2 – M1 plus most savings accounts, money market accounts, retail money market mutual funds, and

small denomination time

M3 – M2 plus all other CDs, deposits of Eurodollars, and repurchase agreements

At the onset of a bubble, the difficulty in properly measuring nominal GDP begins to arise. Utilizing the

equation of exchange, MV = PY = GDP (M = money supply, V = velocity of money, P = price, Y = real

output), money demand is proportional to nominal GDP (Wilmont). However, only the aforementioned

classifications of money are plugged into the equation of exchange to calculate GDP.

Institutions and other optimistic investors begin to utilize substitutes for money – for example, financial

assets – to purchase the overpriced security at the time. The overpriced security becomes more inflated

and traditional forms of money, along with financial assets, are utilized to purchase more of the

overpriced security. During this time, outsiders cannot properly measure the value of nominal GDP or the

security itself due to the use of financial assets. The boom and the potential bubble continue to be fueled

until the market realizes that the security in question in overvalued. The market eventually reaches a

peak, the “pop” occurs, and the market descends into freefall.

The aforementioned phenomenon occurred with the collapse of Lehman Brothers. The European arm of

Lehman Brothers rehypothecated the client collateral of its clients for its own funding purposes. This

included the purchase of mortgage backed securities and similar financial instruments.

Institutions suddenly seek to deleverage and find safety within cash or other liquid assets (Wilmont).

Unfortunately, the demand for cash or other liquid assets causes these same securities to be priced at a

premium (Wilmont). At this point, the government is forced to intervene through a series of programs to

inject liquidity into the market.

Under the Volcker Rule, US government securities can undergo proprietary trading. However, foreign

securities cannot undergo proprietary trading. Foreign governments have voiced their concern over this

matter. If the Volcker Rule is implemented by the July 21st deadline in its current form, the inability will

raise the cost of capital for foreign governments in the United States. These same foreign governments

will seek other capital markets to raise funds for their respective liquidity needs and market making

activities. This shift in capital raising activities outside of the United States will make the US itself less

attractive to FDI and potentially lead to a decrease in American GDP in the future.

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The US could face a backlash in regards to the sole exemption of US government securities under the

Volcker rule. On the political front, the US could suffer a loss of political capital at future international

meetings such as the G20. The US government securities exemption could also result in exclusion from

future trading blocs and/or decrease in future bilateral trade agreements with foreign governments. The

aforementioned exclusion would not only result in a loss of future GDP, but the promotion of the

American economy decoupling from the rest of the world.

The federal government has restricted the benefit of efficient funding to private firms focused on raising

capital through the issuance of corporate debt and equities. This double standard whereby the federal

government is able to preserve liquidity for the trading markets related to its securities, but other private

or public entities securities will be subject to greater transactions costs seems problematic. This is

particularly the case in an environment in which the federal government should be looking to facilitate

and encourage greater capital formation as the US economy is still recovering from the Great Recession.

There are also opportunities for financial institutions to exploit the Volcker Rule. These opportunities

stem from its origin in Congress. Congressional leaders who wrote the rule specifically stated that the

firm could utilize proprietary funds for micro-hedging, not macro-hedging (Eisinger). However, federal

regulators interpreted the Volcker rule after it was handed to them from Congress (Eisinger). The

regulators decided that a hedge was legitimate if the hedge had a reasonable correlation with the security

being hedged (Eisinger).

In its present form, there are so many exceptions that implementation of the rule has become complex.

“Former FDIC Chairman Sheila Blair has told lawmakers that the Volcker Rule is so complicated that

regulators should consider starting over.” (Sloan). If the present form of the Volcker Rule is finalized by

its scheduled date on July 21st, financial institutions could exploit these exemptions and transform them

into loopholes. Exploiting these loopholes will require a legal team to extensively study, review, and

provide practical advisory in regards to providing circumventing the Volcker Rule. The largest financial

institutions will probably be the only party to afford the expense of hiring such a robust legal team.

Instead of reducing risk within the capital markets, these large financial institutions are further

concentrating systemic risk within their walls pending the exploitation of potential opportunities. Future

financial crises will only make it more difficult for regulators to contain systemic risk within the financial

system.

Exploitation would further catalyze another financial crisis. In this scenario, the US would be forced to

intervene in the private sector and overall economy with federal programs similar to TARP, secret federal

loans to banks, quantitative easing, and/or “Operations Twist”. The federal government would have to

pay for the federal programs through an alteration of fiscal policy – reduction in taxes, decrease in

government expenditures, and/or government borrowing. The immediate result would be a diversion of

resources from other aspects of the American economy, aid to American citizens, and/or much needed

state infrastructure projects.

Based on past history, regulation within US borders has rippled overseas to the European neighbors.

European financial institutions, along with US banks, took advantage of the US regulatory changes in

2004 (Nishimura). European banks took advantage of securitization within the US to boost profitability

due to the minimal prospects in Europe itself. This obviously fueled the run-up to the 2008 financial

crisis. The European purchase of credit products, coupled with the euro experimentation and weak

balance sheets of sovereign governments within the Eurozone, triggered the present Eurozone crisis. The

Volcker rule could cause similar ripple effects to overseas markets.

C. Financial institutions / Non-Financial Institutions

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Upcoming regulations have adversely affected and will continue to target financial institutions and non-

financial institutions in the future. The results include, but not limited to, decrease in global risk-free

assets, limited opportunities to utilize bespoke derivatives in the near future, increased regulations

towards shadow banking, and excision of swap businesses under the swap push-out rule.

Banks, especially SIFIs, will have to utilize their resources – in particular, time, personnel, and costs - to

understand the myriad of pending future legislation. Upon comprehension, the same financial institutions

will have to create, but not limited to, new operational procedures, technological infrastructures, corporate

governance standards, and employment positions to handle the financial regulations. Financial research

has not calculated the total costs for the aforementioned endeavors because the imminent laws are not

final, and they are also subject to change. In other words, there is a large element of uncertainty in the

current environment. Further research will be needed to capture the time and financial costs that are

needed by financial institutions to seek further comprehension.

Financial regulations have potentially limited their investment opportunities for institutional investors and

individuals. Financial institutions have to employ more financial resources for capital buffers and

collateral. Even though some global financial institutions – for example, Goldman Sachs, UBS, Morgan

Stanley, and Citi – have vast resources, they are still limited. This limits the amount of capital they have

for seeking returns through investments. Furthermore, they are limited or restricted to take on certain risk

taking activities such as proprietary trading. From the shareholder perspective, investors are less likely to

directly or indirectly invest in financial institutions. Investors could seek opportunities in other attractive

and dynamic industries.

Institutional investors are also looking for havens of safety in this uncertain environment. Even though it

is five years since the financial crisis, an IMF study has confirmed that there are fewer risk-free financial

assets available (O’Brien). O’Brien further points out the reasons for the decline in fewer risk-free assets

are the following:

1 – Demand for risk-free assets has increased due to market uncertainty

2 – Supply of safe assets by highly rated governments has decreased due to credit downgrades

3 – Failure of securitization of low-quality mortgages in the US

Recent history provides evidence of fewer risk-free financial assets in the world. Investors fled to the

security of the Swiss franc due to Switzerland’s notoriety of economic stability and the worsening of the

Eurozone crisis. In August 2010, 1.35 Swiss France was worth approximately one euro (Teevs). In

August 2011, the Swiss franc appreciated until it was on par with the euro (Teevs).

The sudden global demand for Swiss Francs hurt Swiss exporters and threatened the stability of its

economy. As a result, the Swiss government and the Swiss National Bank (SNB) intervened. First, the

SNB lowered the target range of the London Interbank offered rate (LIBOR) from 0% - 0.75% to 0% -

0.25% (Hawkes). Second, the SNB injected liquidity into the banking system by expanding banks’ sight

deposits from CHF 5 billion during the pre-crisis years to CHF 200 billion in August 2011 (Kong).

Third, the SNB established a minimum exchange rate of 1.20 Swiss francs per euro (Kong).

Global markets are still persistent in their search for risk-free assets even though a year has almost passed

since August 2011. The SNB still maintains the exchange around 1.20 Swiss francs per euro and the

three month LIBOR hovers between 0.00% - 0.25% (Danthine). The SNB will probably have to continue

the aforementioned policies due to the dire state of the global economy and the strength of the Swiss

economy.

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Gold has received renewed interest. The precious metal has historically served as protection against

economic uncertainty and inflation. In August 2011, gold prices soared to new highs and hovered around

$1,900 per ounce (Dyson). Gold prices presently circulate around $1,700 per ounce. However, gold

prices could rise again since the Eurozone crisis has not been solved. Some investors expect gold prices

to rise to new highs and peak around $2,000 per ounce this year (Dyson).

The difference in margin requirements for cleared and uncleared derivatives will also lead to different

costs incurred by financial and non-financial institutions. This will result in a further distortion of costs

between purchasers of cleared and uncleared derivatives. Furthermore, the Prudential Regulators –

Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, the Office of

the Comptroller of the Currency, the Farm Credit Administration, and the Federal Housing Finance

Agency – and the CFTC have proposed regulations for establishing margin requirements for uncleared

swaps (Skadden). Skadden points out that the proposals include, but not limited to, the following:

1 – Restricting margin to cash and US Treasuries

2 – Requiring significantly larger amounts of margin than for cleared contracts

3 – Requiring initial margin posted by most dealers and major participants to be held by independent,

third-party custodians with restrictions on rehypothecation and reinvestment

Entities that rely on bespoke swaps are faced with two options. First, they can begin to utilize

standardized, cleared swaps in order to minimize their costs through lower price and collateral

requirements. Second, they can continue to choose bespoke swaps and absorb the associated costs

through higher prices and collateral requirements.

The aforementioned scenarios potentially increase business risk and systemic risk. In the first scenario,

businesses are not able to fully hedge their risks in comparison to utilizing tailored derivatives. If the

business is a financial institution itself, a standardized swap diminishes the firm’s ability to hedge risk.

Bankruptcy and/or distress of the firm in question can cause ripple effects within the financial system.

In the second scenario, absorbing the higher prices and collateral requirements for utilizing tailored

derivatives leads to reduced profitability. In times of financial stress, the business loses its ability to build

and fortify its capital buffers and balance sheet. If the business is a financial institution, the diminished

capital buffers and balance sheet increases the probability of bankruptcy and/or distress, which can cause

pose market risk if it is systematically important.

Third, the different links between the shadow banking sector and regulated financial system pose

systemic risk to the global economy (Constancio). Shadow banking largely refers to banking activities

that occur outside of the regulatory purview of its respective government. In regards to the lead up to the

financial crisis, these unregulated banking activities commonly referred to the securitization process and

special purpose vehicles.

A special characteristic of shadow banking is that a main component is the secured lending markets,

particularly the repo market (Constancio). “In the U.S., the money market funds are usually included in

the shadow banking sector and were an important source of funding for other shadow financial

institutions, like securitization vehicles, via the purchases of their short-term debt (Constancio).” Money

market funds are not as important for funding shadow financial institutions. However, the intermediation

activity of money market funds is more closely tied to banks in the EU (Constancio). As a result, money

market funds provide links between shadow banking and the regulated banking sector (Constancio).

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Before the financial crisis, shadow banking entities utilized asset-backed securities as collateral in the US

(Constancio). When the financial crisis started in 2008, the value of the asset-backed securities declined

rapidly. The shadow banking entities could not access the Federal Reserve since they do not fall under

the regulatory purview of the US government. These same entities were forced to sell their holdings, the

housing bubble burst, the prices of securitized products entered free fall, and liquidity froze (Constancio).

Constancio points out that

“Secured financing provides benefits over unsecured lending, especially during turbulent

market times. At the same time, however, the reliance on secured financing provides a

powerful channel of transmission of shocks in the financial system. The decline in

collateral values translates in additional collateral calls possibly compounded with higher

haircuts and margin requirements. A system in which financial institutions rely

substantially on secured lending tends to be more pro-cyclical than otherwise.”

The value of shadow banking assets relative to the assets of the banking system differs among the United

States and euro area. In the US, shadow banking assets are approximately equal to banking system assets.

In the euro area, shadow banking assets are about one-half of banking system assets. However, the level

of systemic risk posed by the links between the shadow banking sector and regulated banking is still high

because “some segments of the shadow banking provide funding to the regulated banks and the liabilities

of financial vehicles set up outside the balance sheet of banks may actually be guaranteed in some form

by the originator banks (Constancio).” The links between the shadow banking sector and regulated

financial system need to be strategically assessed in order to tackle global systemic risk and inspire

investor confidence.

Finally, the Lincoln provision, or the swap-push out rule will force banks to excise the swap-side of their

business at the end of 2013. Recently, US regulators announced a concrete definition of a swap dealer.

Any financial institution that does more than $8 billion dollars in swap trades annually will be slapped

with a heavy price tag (Protess). This price tag includes, but not limited regulatory reporting

requirements, capital buffers, and additional capital.

The combination of the swap-push out rule and the recent definition is possibly a blessing in disguise for

the large financial institutions that are capable of handling these annual amounts of swap trades. The

additional price tag of conducting swap trades will obviously lead to lower profitability, but the level of

profitability could eventually be lower than the overall profitability of the bank itself. Under this

scenario, the respective financial institution would desire to excise the swap business regardless of the

swap-push out rule.

Basel III

Basel III requires more liquid assets to comprise bank capital buffers in comparison to Basel II.

According to many estimates, the equivalent amount of RWA under Basel III versus Basel II for a typical

banking portfolio is approximately 2:1. This ratio can be higher for heavily credit-sensitive portfolios. In

response, dozens of banks have announced significant targeted reductions of the credit sensitive portions

of their portfolios. For example, UBS is planning $150 billion of reductions, Credit Suisse announced

$100 billion of RWA reductions, BNP Paribas and Societe Generale have been reducing close to $100

billion in RWA each. In total, banks have planned over $1 trillion in RWA reductions across global

capital markets over the near-term. Assuming that the approximately $1.2 trillion in announced Basel III

RWA reductions were converted into Basel II equivalent RWA, we are still looking at $500 - $600 billion

of risk capital removed from capital markets over the coming quarters as most banks are anticipating

coming compliance with Basel III recommendations well ahead of the published deadlines of 2019.

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It is important to note that these reductions in RWA across the global financial industry represent

significant reductions in risk capacity across global capital markets that could materially impact the

ability of markets to absorb substantial macroeconomic shocks over the coming quarters. How the global

capital markets adjust to this wide-scale reduction in risk capacity over the coming months will have

major implications for bank portfolio asset allocations and relative risk reward for bonds versus equities.

In particular, we can project that due to a substantial bias against debt and structured debt products that

over-the-counter (OTC) bonds to include asset-backed securities, high yield bonds, and emerging market

debt will be particularly prejudiced during this global adjustment process towards Basel III. Of course,

less bank leverage in our financial system may be desirable, buy by penalizing one asset class versus

another in terms of capital requirements may have detrimental effects upon global levels of debt

financing.

If we combine this adjustment process with the reduced liquidity resulting from the Volcker Rule, we can

see that regulatory risks like many other risks can have undesired interactive effects. Just at the time

when many global economies are in need of capital formation, increased capital requirements resulting

from Basel III and reduced liquidity in secondary trading markets induced by the Volcker Rule may

conspire to significantly reduce the level of capital formation well below what is desirable.

The lack of global harmonization with Basel III could also lead to undesired effects and induce a future

financial crisis. The world would be divided into Basel III and non-Basel III regimes. Financial

institutions would have a propensity to relocate to non Basel III countries due to the lower capital buffers.

The institutions within these non Basel III countries would have more capital to engage in risk taking

activities. The additional risk taking would increase the growth of the financial sector and overall GDP of

the non-Basel III regime in relation to Basel III regimes. This would attract foreign direct investment and

encourage more risk taking by the same financial institutions. The end result would be a negative

feedback loop and increased GDP in the near future for non-Basel III regimes.

The financial institutions domiciled in Basel III countries would have to raise more equity capital to

comply with Basel III itself. The higher levels of equity capital would raise the Weighted Average Cost

of Capital for these same financial institutions (Mahapatra). The banks would offset the new

requirements by lending at higher rates to borrowers. The end result would be less profitability for the

financial institutions (Mahapatra). “McKinsey & Company suggest that all other things being equal,

Basel III would reduce return on equity (ROE) for the average bank by about 4 percentage points in

Europe and about 3 percentage points in the United States (Mahapatra).” There would also be less

liquidity and lower GDP within the Basel III countries, and a flight of investment capital to non-Basel III

countries (Mahapatra).

Furthermore, there would be a higher concentration of these financial institutions within the country’s

borders. The failure of one bank would pose additional stress on other banks and cause a domino effect to

occur within the borders of the non-Basel III country.

The systemic failure within the borders of the non Basel III country could pose risk on a global scale if it

was an important financial center such as Hong Kong or Singapore. In this scenario, foreign governments

would have to aid the non-Basel III country in order to curtail systemic risk. The foreign government

support would drain resources that are attributed to its respective citizens. This could result in lower

GDP, less governmental programs, and/or higher taxes. Government support provided by multiple

foreign governments would eventually result in lower GDP growth on a global scale. This would also

promote the generational imbalances that commonly exist among developed nations.

Within the United States, the leading financial institutions are losing business as prime brokers. As Basel

III is being phased into the regulatory environment, prime brokers cannot provide the same level of

finance and leverage that they did in the past. As a result, they are gradually increasing their margin

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requirements and fees for non-financial institutions such as hedge funds and asset managers (Jones). The

smaller clients that are not able to pay the additional costs are forced to leave the respective prime broker

(Jones). The larger hedge funds and asset managers will end up paying the additional costs (Jones).

These upcoming costs will have ripple effects for the financial industry and American society. The hedge

funds will pass the costs on to their clients. Since hedge-fund clients are high-net worth clients, they will

be able to afford the new expenses. In contrast, asset managers count pension funds and mutual funds as

their clients. These different funds will pass on the new expenses to their customers, the working citizen.

As time passes, the returns for the working citizen’s retirement fund will decrease. US government could

compensate for a potential shortfall in retirement; however, government resources are diminishing due to

state programs such as social security and aging population.

EE Mandate / SEFs

There are entrepreneurial opportunities that exist during this climate of uncertainty. Multiple financial

institutions and financial related institutions are registering with the CFTC to become SEFs. Some of the

aforementioned institutions include TradeWeb, ICAP, Bloomberg, State Street, and the Odex Group.

They will differ in regards to the institutions they serve, the OTC derivatives that will be available to be

cleared on their respective SEF, and the execution time.

Unfortunately, the opportunity to register and become a SEF will primarily be dominated by industry

insiders and incumbents such as inter-dealer brokers, multi-dealer platforms, exempt boards of trade

(EBOTs) and designated commission merchants (DCMs) (Easthope). There is potential for

approximately 40 companies to become SEFs in the OTC swaps marketplace (Easthope). “However,

regulatory delay and market conditions have reduced the likelihood of even half that number ultimately

being achieved as registrants (Easthope).

The barriers to entry for registering and becoming a SEF are highlighted by the experiences of Fritz

Charles, an MBA graduate from the University of Pennsylvania Wharton School of Business and co-

founder of Diamond OTC, a SEF financial start-up. Fritz Charles, along with the other co-founders,

attempted to register Diamond OTC as a SEF for equity swaps (Burne). Charles focused solely on equity

swaps because the credit derivatives market overshadows the equity swap market. However, Diamond

OTC failed to secure additional financial backing because “competing execution platforms were making

significant progress and it was unclear if theirs could get off the ground……(Burne). Furthermore, there

were between 30 to 50 competing firms also vying to compete in the equity swap space at the time of the

article (Burne). During summer 2011, Charles stated,

“I don’t think the winners in this game will be start-ups…….It’ll be existing players like

the voice brokers, who already have the eyes and ears of the customers and don’t need

funding.”

Volcker Rule

Short-term foreign exchange swaps could be subject to the Volcker Rule under its current form

(Nishimura). The “dollar liquidity that has been provided through foreign exchange swaps could be

curtailed (Nishimura).” This lack of dollar liquidity could pose two challenges.

First, the lack of dollar liquidity could be “a concern for many financial institutions, especially when the

global condition of foreign-currency funding is tightened. For example, financial institutions need to

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boost the capital buffers on their balance sheets with more liquid assets under Basel III. As Brunsden

stated,

“The largest global banks would have needed an extra $639.5 billion, or 485.6 billion

euros in their core reserves to meet Basel capital rules had the standards been enforced

last June.”

Even though the different measures of Basel III are scheduled to be fully implemented by 2019, the

regulatory purview of short-term foreign exchange swaps under the Volcker rule would create a

roadblock for banks to meet their designated goals.

Second, and more importantly, the lack of dollar liquidity, coupled with Western sanctions of Iranian oil

on the global market, could cause the dollar to appreciate. Dollar appreciation is a factor that could lower

global GDP. Furthermore, dollar appreciation could reignite the debate to switch from dollars as the

global currency to alternatives such as special drawing rights (SDRs), gold, euros, or a basket of global

currencies. The heightened uncertainty would create a more difficult environment for financial

institutions to meet their funding needs, and non-financial institutions to procure assets that meet their

investment objectives.

Another bubble can be exacerbated by the exemption of US government securities under the Volcker rule.

Proprietary traders can use the market freefall as an opportunity to sell US government securities at a

premium and speculate while other parties require the US government securities to fortify their balance

sheets. The US government has secured a market for Treasuries within American borders; but, the

exemption has promoted market volatility.

D. Taxpayer / General Public

The general public has come to resent the largest global banks and the financial industry as a whole.

These same banks engaged in risky activities leading up to the financial crisis, but also received financial

assistance under the Troubled Asset Relief Program (TARP). Even though individuals accepted loans

with variable interest rates from these same banks, they did not receive assistance when their mortgage

payments increased and eventually forced into bankruptcy.

Going forward, the angered general public will have to foot the bill for upcoming financial regulations

and their enforcement. An example is the additional responsibilities and financial request of the CFTC.

Taxpayers will ultimately pay for the increased funding to supervisory of OTC derivatives since the

CFTC is a public agency. Increased legislation could potentially infuriate the general public even further.

Volcker Rule

A potential result of SIFIs exploiting the Volcker Rule is a crowding-out effect. Pending the buildup of

systemic risk within SIFIs and the induction of another financial crisis, governments would have to

allocate resources to pacify the capital markets. The larger budget deficits induced by government

borrowing would decrease the quantity of savings, which would increase the real interest rate (Kaplan

Schweser). The higher real interest rate would lead firms to reduce their borrowings of financial capital

and their investment in physical capital (Kaplan Schweser).

This crowding-out effect could be countered by citizens pending they are able to anticipate the increase in

taxes and increase private savings. Examining the current economic environment, this scenario is highly

unlikely. First, American citizens have amassed vast amounts of credit card debt. Credit card debt has

recently declined between the fourth quarter of 2010 and fourth quarter of 2011; however, “American

26

households still owe more than $800 billion just in credit card debt (Atlanta Business Chronicle).”

Student loan debt is also becoming a looming problem for the country because it is strapping down future

taxpayers and preventing them from saving to desired levels. “Student loan debt has reached about $870

billion, exceeding credit cards and auto loans, and balances are expected to continue climbing (Yerak).”

As Lisa Madigan, the Illinois Attorney General has stated,

“Just as the housing crisis has trapped millions of borrowers in mortgages that are

underwater, student debt could very well prevent millions of Americans from fully

participating in the economy or ever achieving financial security (Yerak).”

In general, the general public’s resources to positively affect the economy are diminishing with the

increase of private household debt.

What to do about it?

A. CCPs

Pricing of Cleared vs. Uncleared Interest Rate Swaps

One solution that can be utilized to correct the mispricing of interest rate swaps is based on swap futures

contracts. The Eris Exchange “uses an original methodology to address both the convexity effect and the

NPV effect by incorporating an adjustment to the terminal value of its futures contract (Cont).” In

regards to the Eris Exchange, terminal value is the difference between the “accumulated value of

payments made pursuant the terms of the swap” and “the accumulated value of interest earned on

variation margin over the life of the futures contract (Cont)”. The daily settlement value of an Eris swap

futures contract can be represented by the following equation (Cont). (St will represent the daily

settlement value of an Eris swap future contract.)

Equation 1

∑

∑

∫

If the variables Ci and Ti are used to represent the amount of the coupon payments (for fixed and floating)

and time, respectively, the terms in Equation 1 can be rearranged to yield the following equation (Cont).

Equation 2

∫

∑

Recall that Ft refers to the NPV of an interest rate swap (Cont). As a result, “the initial futures price is

equal to the NPV of the interest rate swap (Cont).”

Further derivation of Equation 2 can be used to calculate the futures price at any time t (Cont). The

resulting equation is the following.

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Equation 3

∫

∑

∑

If integration is applied to both sides and multiplied by Bt, the following can be calculated (Cont).

Equation 4

∑

∫

Equation 4 can be utilized to calculate the daily settlement value of the interest rate swap (Cont).

“The first term is the accumulated value of all realized coupon payments up to time t.

The second term is the NPV (of the remaining cash flows of the interest rate swap). The

last term, so called “total return on modified variation margin”, represents the adjustment

of all the interest earned on the variation margin cash flows to date (Cont).”

The final step is to determine whether or not an Eris future has the same profit and loss as its uncleared

version (Cont). If the terms in Equation 3 are rearranged, the following equation results.

∫

∑

{∑

} ∑

“The left hand side is the present value of the profit (or loss) of a party who enters the

Eris swap future a time 0 and closes the position at time t. The right hand side represents

the present value of the coupon payments of the interest rate swap up to time t, plus the

NPV at time t discounted to time 0, minus the initial value of the swap. Therefore, the

right hand side is the present value of the profit (or loss) of a party who enters the

uncleared interest rate swap at time 0 and liquidates the trade at time t (Cont).”

LCH Clearnet, an independent clearing house serving major international exchanges and platforms, has

properly addressed the convexity and NPV effect through the “Price Alignment Interest” (PAI) (Cont).

LCH utilizes PAI in the following manner:

“LCH credits or debits each open position on a daily basis to offset the benefit of being

able to invest the variation margin……LCH uses PAI to replicate the interest payment

and generates the same cash flows as an uncleared swap. The PAI rate is set at the

Effective Federal Funds rate for US dollar denominated interest rate swaps (Cont).”

CME, the dominant exchange holding company in the United States, offers PAI for its cleared interest

rate swap facility (Cont). The only difference between LCH and CME is that CME provides a separate

OTC segregated account type (Cont).

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Portability and Segregation Model

Which CCP Model is Best? The Complete Legal Segregation Model is the best model for CCPs to utilize

based upon an analysis of the different characteristics. First, the Physical segregation model enables a

CCP to segregate the collateral for each client on an individual basis. While this ideal for recordkeeping,

individually segregating collateral incurs additional operational costs during the life of the CCP itself.

The start-up costs for initializing the CCP will be more significant than other clearing models (Medero).

Handling the collateral from becomes more convoluted as the number of clearing members increases over

time (Medero). In the case of default, porting non-defaulting customers to another CCP becomes more

complex and inefficient.

Second, LCH.Clearnet currently uses the Complete Legal Segregation Model. Furthermore,

LCH.Clearnet employs

“……..a collateral protection model that ensures that non-defaulting clients can be

protected from the risks of other defaulting clients and is structured so as to enable the

clearinghouse to identify and cover the risks associated with an individual customer’s

portfolio as if the clearinghouse were required to take on its management in isolation, as

could happen in the event of a FCM member default (Medero).”

Best clearing practices can be extrapolated from LCH.Clearnet’s experiences and expertise, and

disseminated to current and future CCPs.

Third, CCPs would not have the ability to attribute investment losses of collateral to the specific clients.

While clients would like to reap the benefits of an investment gain on an individual basis, they would not

be enthusiastic to suffer losses on an individual basis either (Medero).

Fourth, the Futures Model is not ideal for current and future CCPs. The DCO is unable to access the

collateral of non-defaulting members under the Complete Legal Segregation Model. However, the DCO

can tap the collateral of non-defaulting members before enlisting its own capital or the capital fund of the

default fund (Medero). Even though the Futures Model can be assessed for best clearing practices, future

clearing members would be reluctant to use a CCP that could easily use its capital in distressed

environments. Clearing members that utilize a CCP with a Futures Model are more likely to port their

positions to another CCP at the initial onset of a distressed environment (Medero). This movement would

worsen the capital structure of the CCP and lead to an eventual bankruptcy.

Fifth, the Legal Segregation with Recourse Model shares most of the same traits as the Complete Legal

Segregation Model; however, this is not the optimal model. The Legal Segregation with Recourse Model

does not facilitate portability to the same degree as the Complete Legal Segregation Model because “a

DCO may be unable to release the collateral of non-defaulting customers until it has completed the

process of liquidating the portfolio of the defaulting FCM and its customers (Medero).”

Choosing the correct CCP clearing model for OTC derivatives is not a luxury; it is essential. Why?

There are potential and actual scenarios that display that the default waterfall is insufficient to curtail

systemic risk. CFTC and other regulatory bodies want to voluntarily induce potential clearing members

to become vocal proponents for CCP use. Widespread of CCPs utilization would instill a loss of

confidence in the framework and clearing system. Furthermore, it would cause a widespread retraction to

trading OTC derivatives on a bilateral basis.

CCP failure would at least temporarily halt the ability of financial institutions to hedge risky positions.

Volatility and economic losses would result. In addition, CCPs would refrain from trading derivatives of

29

a certain asset class that pertains to the failed CCP or CCPs with similar characteristics. The bid/ask

spread of the aforementioned derivatives would widen and liquidity would erode within the financial

system of the failed CCP’s geographic area and beyond its borders.

B. Regulators / Governments

Regulators and governments are currently taking steps to increase international coordination. The

Financial Crisis and Information Gaps, a joint group formed between the IMF and G20, has proposed 20

recommendations on reducing and closing the financial data gaps. Cerutti has highlighted some of the

aforementioned recommendations below:

1 – “Development of measures of system-wide, macro-prudential risk, such as aggregate leverage and

maturity mismatches

2 – “Development of a common data template for systemically important global financial institutions for

the purpose of better understanding the exposures of these institutions to different financial sectors and

national markets

3 – “Enhancement of Bank of International Settlements consolidated banking statistics, including the

separate identification of non-bank financial institutions in the sectoral breakdown, and the tracking of

funding patterns of international financial systems

4 – “Development of a standardized template covering the international exposure of large non-bank

financial institutions.”

The international working group is utilizing the recommendations to create a template for capturing bank-

level data (Cerutti). The completed template “would provide information on banks’ exposures and

funding positions with breakdowns by counterparty country and sector, instrument, currency, and

remaining maturity (Cerutti).”

In addition, the Financial Stability Board (FSB) is currently preparing policy recommendations that

address shadow banking (Constancio). The work involved in preparing the policy recommendations is

divided into five different workstreams (Constancio). Two of the workstreams include regulatory

treatment for money market funds and securitization (Constancio). The remaining workstreams cover

“banks’ interactions with shadow banking entities, the need for new regulation on shadow banking

entities, and systemic risks stemming from practices in securities financing and repo markets

(Constancio).”

Constancio takes a step further by making considerations for the following three policy issues:

1 – Pro-cyclical nature of margin requirements used in securities financing transactions

2 – Utilization of CCPs in repo markets

3 – Financial instability associated with some repo and securities lending market practices

Recent studies show that margin requirements and haircuts in repo markets are pro-cyclical (Constancio).

Regulators have proposed that minimum haircuts could be applied permanently to curtail system leverage

or used temporarily for overheated market conditions (Constancio). Constancio suggests that the proposal

to administer minimum haircuts and similar proposals need to be carefully assessed in regards to their

impact on money markets and potential effects on monetary policy implementation because the pro-

cyclical factor may be attributed to the level of market prices for collateral can be high during bubbles and

low during crises.

30

In regards to the second policy issue, the volume of repos generally declined at the onset of the financial

crisis in 2008. In contrast, several Eurozone CCPs saw an increase of volumes. Constancio states that

“This happened because CCPs provide effective protection against counterparty risk by

interposing themselves between the original repo parties. From a financial stability

perspective, properly supervised and overseen CCPs act as a firewall against the

propagation of default shocks an can mitigate counterparty credit risk, enhance market

transparency, facilitate collateral liquidation, and foster standardization of repo terms and

eligible collateral. There is also the advantage that policy makers can monitor the cleared

repo markets since CCPs are regulated institutions.”

Increase utilization of CCPs can potentially reduce the systemic risk associated with repo clearing.

Several repo and market lending practices – for example, cash collateral reinvestments in securities

lending and rehypothecation of securities collateral – create and/or exacerbate financial stability

(Constancio). Constancio suggests that further study needs to be conducted in order to constrain negative

incentives and increase disclosure.

Due to the significance of the European repo markets to the shadow banking sector, Constancio has put

forth the idea of creating a EU Central Database on Euro Repos. Constancio has identified that the

market data for repos are not timely, there are significant limitations in regards to data availability, and

there are no statistical sources for the repo and securities financing markets. Creating an infrastructure to

obtain detailed information on repo market activity in a timely manner and identifying potential risks as

they soon arise would increase the ECB’s ability to enhance monetary policy implementation and

measure financial stability (Constancio).

Volcker Rule

The federal government would have limited authority to supervise the aforementioned trading activities.

The federal government could respond by passing legislation over proprietary trading within the shadow

banking system. Parties that still engage in proprietary trading could counteract by moving trading

activities to less restrictive overseas jurisdictions. Proprietary would become virtually nonexistent within

American borders. However, the pockets of global systemic risk would not be reduced; it would be

reallocated.

The federal government has already taken the initial steps to increase supervisory activity over the

shadow banking system and other non-bank financial institutions. On April 1st, 2012, the Financial

Stability Oversight Council (FSOC), voted unanimously to adopt a rule that will increase oversight over

hedge funds, private equity firms, and insurers if they meet certain criteria (Lowrey). Lowrey has cited

the three-step criteria that the FSOC will utilize to designate these non-bank financial institutions as

SIFIs.

1 – Determine whether or not the firm in question has over $50 billion in assets

2 – If the firm has over $50 billion in assets, regulators will compile public and regulatory data and

perform analyses to determine its systemic importance and riskiness

3 – The FSOC will vote to decide whether or not the firm is systemically important after requesting

additional information

31

The three-step process is not absolute. The FSOC can still deem a non-bank financial institution as

systemically important if it does not pass the three-step criteria.

The current legislation of the Volcker Rule should be revisited. Representative Barney Frank requested

that a simplified version of the Volcker Rule be drafted by September 3rd

(Sloan). This could potentially

minimize the legal arbitrage opportunities that larger financial institutions could exploit after the rule

finally becomes law. In addition, regulators have provided relief to American banks by allowing them

until July 21, 2014 to comply with the Volcker rule (Alper). This extension will also give the regulators

more time to make the necessary changes to the rule.

C. Financial Institutions / Non-Financial Institutions

There are many avenues that financial institutions can take in regards to present and upcoming financial

regulations. First, they can start by learning about present and future regulations, and altering their

organizational structures to comply with the laws. This will require multiple resources, including time

and capital, to conform to the laws.

Financial institutions can take a wait-and-see approach. Banks that choose this course of action are

relinquishing first-mover advantage to their competitors. However, they are able to position themselves

to reap the benefits from observing and learning how their competitors comply with the financial

regulations and make mistakes. In the near future, the banks that take the wait-and see approach can

change the external and internal workings of its organization in a more timely and cost-efficient manner

in comparison to competitors. More importantly, the backseat approach enables these same banks to

generate new ideas for complying or even circumventing upcoming legislation.

Circumventing present and upcoming legislation is an option available to banks. Deutsche Bank has

become a vanguard for this option by reorganizing “its Taunus subsidiary so it is no longer considered a

bank holding company…..(Orol)” Employing this course of action prevents Deutsche Bank from

infusing $20 billion into the US subsidiary under the DFA (Orol). Other non-US financial institutions

such as Barclays and UBS could employ the same tactics on American shores.

Financial institutions have also utilized lobbying as a tool to change the regulatory landscape. Since the

financial crisis, banks have increased funding to remove stipulations or weaken certain aspects of the

DFA. As time progresses, observers expect this activity to only increase.

Financial institutions could also take advantage of the Lincoln provision by investing in spun-off swap

businesses. The financial markets should expect swap industry to undergo mergers and acquisitions after

the banks have excised the mandated swap trading businesses. Swap businesses would be required to

increase their capital buffers in order to reduce systemic failure. Swap businesses could achieve

economies of scale by acquiring smaller players and/or merging with other swap business with similar

characteristics. Swap businesses could also achieve economies of scale by providing services to clients in

different swaps such as credit-default and interest rate swaps.

Unfortunately, the swap-push out rule, legislation that was passed to reduce systemic risk, could

eventually lead to an unintended consequence. The larger swap business would further concentrate

systemic risk within their walls as consolidation within this space increases over time.

In regards to non-financial institutions, Institutional investors are not so quick to invest in the same

organizations that engaged in risky activities such as securitization. The 2008 financial crisis ruptured the

integrity of the financial markets due to moral hazard and lack of corporate governance associated with

the industry. Investors have employed their resources – in particular, time – to conduct further due

diligence of future investments and seek opportunities that are “safer” than mortgage back securities.

32

Investors have also utilized their increased buyer power to request that these institutions be more

transparent in future transactions. If their demands are not met, they can explore other investment

opportunities.

EE Mandate / SEFs

The SEF registration and creation processes are presently at the nascent stages of the product life cycle.

Since there are multiple companies making efforts to enter the SEF space, liquidity will be fragmented

(Acworth). When the aforementioned phenomenon is coupled with the Volcker rule, the bid/ask spread

of securities will widen further, market volatility will increase, and liquidity will decrease even further.

The number of participants in the SEF space should decrease as competition continues. Presently, the

number of swap trades that are executed on a daily basis falls below the level of executed trades on listed

derivatives exchanges (Acworth). In addition, the liquidity of swaps is less than futures. Swaps can trade

as infrequently as one time per week (Acworth).

The end users of OTC derivatives ultimately want the best execution. Best execution includes the highest

bid for sellers, lowest ask for buyers, and timely execution. As the SEF product life cycle becomes

mature, the differences between the SEFs – for example, focus on executing specific classes of swaps,

links with specific clearing houses, price points, in-house technological and trading expertise - will erode

and the competition between them will become fierce. Some of the original SEFs will cease to exist and

consolidation in this space will occur through mergers and acquisitions. Finally, the SEF, a product in

itself, will become commoditized in a similar manner to Sales and Trading.

SEFs can avoid the present fate of Sales and Trading by elongating the product life cycle through

consistent innovation. The goal is to provide clients with best execution, but there are hidden features

that OTC derivatives users could potentially value. SEFs could survey clients and the marketplace on the

attributes that they desire for a SEF. Potential SEF players such as Bloomberg and Thomson Reuters

have already established these relationships by consistently interviewing market participants and

customers about their requirements.

Volcker Rule

Investment banks such as JP Morgan, UBS, and Citi are displaying their flexibility by reallocating

proprietary traders into their asset management divisions. The traders will not be able to continue with

their previous activities pending implementation of the Volcker rule, but they can sell their strategies to

clients and other third parties.

There is also a possibility that the expected widening of bid/ask spreads and decrease in liquidity

associated with implementation of the Volcker Rule will not persist. Non-bank entities such as regional

dealers, hedge funds, and private equity firms could take advantage of the new spreads (Owens).

Increased and persistent participation by these non-bank entities could lower the bid/ask spreads to pre-

Volcker rule levels (Owens). Regulators have also presume that hedge funds or some other unidentified

institution would enter the markets to help provide liquidity given the increased bid-ask spreads in the

absence of significant global banking participation.

However, the assumption that was pontificated by Owens from Woodbine Opinion and regulators has not

become a reality. There are important structural features of the marketplace that provide the large global

banks with funding advantages and other economy of scale benefits that are not easily replicable by non-

financial institutions. As a result, the market has exhibited higher levels of systemic risk as measured by

33

volatility levels (median volatility in 2011 now exceeds the median level in 2008), and correlation levels

(have been at higher levels longer across the top S&P 500 names than in 2008).

If the federal government is concerned with systemic risks here, why would they attempt to push risk

taking inherent in market-making activities to institutions that are less well-funded, less capitalized

(institutions not adhering to the Basel III capital regime) and over which there is significantly less

supervision? The aforementioned assumption and observations in regards to volatility and correlation

levels need to be reexamined so that non-financial institutions or other entities could possibly increase

their participation in the marketplace and increase liquidity through the minimization of bid/ask spreads.

D. Taxpayer / General Public

General public anger has already begun to materialize and will continue to coalesce if they have to

continuously pay for future financial regulations and economic assistance to the private sector.

Observers can expect the general public to utilize the same tactics as the financial industry – for example,

lobbying – to influence policymakers. Members of the general public are more numerous than financial

institutions and do not necessarily have the same financial resources as these banks; however, this is an

avenue that the general public can explore and vent their frustrations.

Second, individuals localized in democratic regimes can vote for policymakers that favor their respective

interests.

Third, the general public can organize themselves into political parties or factions. An example of this is

the Tea Party movement within the United States. The populist movement originally formed as a conduit

for the anger and frustration towards TARP. Even though the Tea Party is a confederate collective of

smaller groups, the movement as a whole has become an entrenched group within the Republican Party

and influenced the domestic political discourse.

E. Summary

The effort that is required to prevent a future financial crisis is far from over. Domestic regulators will

have to consistently work with sovereign governments to ensure that their laws are in harmony with the

regulations of foreign governments. Government will also need to be cognizant of the unintended

consequences of potential and actual legislation in the future. More importantly, financial institutions

need to ensure that they comply not only with the letter of the law, but the spirit of the law as well.

Future toxic behavior will not only to the global economy and citizens of the world, but it will also render

irreparable damage to the banks themselves.

34

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