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 UScentric, 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 2013. 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 CFTCSEF 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 2014.
“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 12-18 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.