Report from the front lines! MIT CENTER FOR FINANCE AND POLICY PANEL DISCUSSION ISSUES IN MICRO-PRUDENTIAL REGULATION CHRIS FERRERI SEPTEMBER 13, 2014

Micro-prudential regulation From the oft-quoted research site Wikipedia: The term micro-prudential regulation or micro-prudential supervision refers to firm-level oversight or financial regulation by regulators of financial institutions, "ensuring the balance sheets of individual institutions are robust to shocks“. The motivation for micro-prudential regulation is rooted in consumer protection: ensuring solvency of financial institutions strengthens consumer confidence in the individual firms and the financial system as a whole. In addition, if a large number of financial firms fail at the same time, this can disrupt the overall financial system. Therefore, micro-prudential regulation also reduces systemic risk. Micro-prudential regulation involves enforcing standards, e.g. the Basel III global regulatory standards for bank capital adequacy, leverage ratios and liquidity.

Dodd-Frank Title VII and the Creation of SEFs A SEF is defined by the Dodd-Frank Act as "a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce.” The CFTC SEF rule is 508 pages with more than 1200 footnotes!

Clearing Mandate and Made Available to Trade (MAT) Following the February 15, 2014 implementation date for the first MAT determinations, SEFs likely became more US- centric, with USD MAT volume increasing and EUR MAT volume declining sharply.

Monthly Interdealer Cleared Euro IRS Activity Notional Volume (EUR bln), 1/1/2013 – 5/31/2014 Source: LCH Clearnet Swap Clear

Market Share Concentration – US Interest Rate Derivatives

Evidence of reduced holdings Source: Oliver Randall, Emory University

Evidence of reduced holdings Source: MarketAxess Research

Footnote 88 Impact ISDA published a survey on the impact of footnote 88 in December Their findings reveal: Liquidity has been fragmented across platform and cross-border lines resulting in separate liquidity pools and prices for similar transactions. Several participants revealed that total derivative trading volume measured as a percentage of notional amount decreased from October 2, particularly in credit and foreign exchange derivatives. 84% of survey participants believe non-US persons are choosing not to trade on SEF platforms as a result of CFTC rules coming into effect in all swap categories: interest rate, credit, foreign exchange, equity and commodity derivatives. 68% of participants believe trading activity with US persons is being reduced or has ceased as a result of the October 2 rule. Over half of the responses indicate the presence of market fragmentation, such as the formation of separate liquidity pools for US persons. 61% of participants believe trading has been redirected from electronic to voice trading as a result of the CFTC- SEF rules coming into force. Roughly half of the participants believe fragmentation resulting from the SEF rule has led to different prices for similar types of derivative transactions.

Liquidity and the decline of the market maker Before 2008, BDs were the heart of the bond market ◦Brought buyers and sellers together ◦Warehoused bonds to meet buy or sell orders themselves ◦Hold inventory of low-risk, easily hedged bonds ◦Trades could be carried out in large volumes with little price impact Since 2008, the market intermediary function has been attacked by regulatory reform which places great pressures on the traditional liquidity providers – the broker dealers. In the US, the Volker rule bans US banks from trading on their own account In Europe, there are several drivers: ◦Basel III requires higher capital to be held as insurance against unexpected losses ◦Basel III also makes it more costly to take on counterparty risks ◦MiFID III aims to increase transparency as BDs must collate and report bond market trades prior to and immediately following execution, increasing trading and IT costs ◦CS told regulators that the new capital adequacy rules would cause risk-weighted assets on its FI trading book to nearly triple from CHF 74 billion to CHF 209 billion.

Principal vs. Agent Trading New York Fed data shows that banks have cut their holdings of corporate bonds by 81% from a peak of $235 billion in 2007 to $45 billion by mid-June “New regulations limiting proprietary trading, such as the Volcker Rule in the US and the Liikanen report in the EU, will severely undermine bank market making operations.” Source – Philippe Morel and Will Rhode, Boston Consulting Group 31 Luly 2014 Niall Cameron, head of markets for Europe, Middle East and Africa at HSBC, said: “HSBC’s role is to act as a facilitator of trades by providing liquidity in standard market size, rather than acting purely as a principal. In the last months, there has been an acceptance from the buyside on the changing nature of the bond market and they are now working out ways to deal with this issue.“ Source – Financial News, Anish Puaar, 20 June 2014 Options available to them include offering low-touch agency execution – although without a change in payment mechanism from spread-based to commission-based FICC execution services, the agency business model may be challenging.