Potential Economic Knock-on Effects of Financial Regulations

Sol Steinberg 5/15/2012

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 2

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

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 (GSIBs), 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 firms 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 4

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 NSFRs objective is to limit a banks 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 institutions 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 5

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, Bs 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, Bs contract would be netted out and Bs 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). 6

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 defaulters 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.

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 doesnt 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 firms 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

limits (Pirrong). In the case of CCP default, the scenario can send shockwaves throughout the capital markets and further decrease the general publics 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 s ignificant 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).

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 10

The increased transparency associated with Title VII in the DFA presents the potential for reputational risk to SEFs. SEFs such as State Streets 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 institutions brand equity as a SEF not only suffers, but the reputation for the respecti ve companys 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 partys 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, IDCGs 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

11

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 j = 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- = -Ci, 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 Ci, 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 contracts cash flows gives rise to the following equation (Cont). Equation 2 { }

12

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 = ((t) art)dt + dWt (t) = long-term mean of the short rate (allowing exact calibration to the initial yield curve) a = short-rate mean-reversion speed = volatility Even though the Hull-White model does not perfectly replicate market observations, the model can be utilized to describe interest rate fluctuations (Cont). Lets start by stating that the equation for the fixed coupon payments is the following Equation 6

13

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). Lets 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 ( )

14

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 HullWhite 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 reestablishing 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 customers 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). 15

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 customers 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 clients 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). 16

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 banks 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). 17

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. 18

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

19

Upcoming regulations have adversely affected and will continue to target financial institutions and nonfinancial 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 (OBrien). OBrien 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 Switzerlands 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.

20

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 firms 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).

21

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. 22

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 countrys 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 23

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 citizens 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 cofounder 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 platf orms were making significant progress and it was unclear if theirs could get off the gro und(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 dont think the winners in this game will be start -ups.Itll be existing players like the voice brokers, who already have the eyes and ears of the customers and dont 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 coul d 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 24

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 25

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 publics 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. 26

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 marginLCH 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).

27

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. LCH.Clearnet employs Furthermore,

..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 customers 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.Clearnets 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 28

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 CCPs 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 banklevel 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 procyclical factor may be attributed to the level of market prices for collateral can be high during bubbles and low during crises. 29

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 ECBs 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

30

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. 31

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 preVolcker 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 nonfinancial institutions. As a result, the market has exhibited higher levels of systemic risk as measured by 32

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.

33

References

Abel, Andrew B., Ben S. Bernanke, and Dean Croushore. Macroeconomics. Sixth Edition. Boston: Pearson Education, 2008. Print. Actworth, Will. The Coming Boom in Swap Trading Volume. Web. http://www.futuresindustry.org/fimagazine-home.asp?a=1363&iss=202. Accessed April 12th, 2012 Actworth, Will and Joanne Morrison. CFTC Moves Forward on Dodd-Frank Rulemaking. Web. http://www.futuresindustry.org/fi-magazine-home.asp?a=1370&iss=202. Accessed April 13th, 2012 Alper, Alexandra. Fed Clarifies When Volcker Rule Kicks In. Web. http://www.reuters.com/article/2012/04/19/us-financial-regulation-volcker-idUSBRE83I1DS20120419. Accessed April 19th, 2012 Alper, Alexandra. U.S. Swaps Pushout Rule to Kick in July 2013. Web. http://www.reuters.com/article/2012/03/30/us-financialregulation-swaps-idUSBRE82T1BS20120330. Accessed April 4th, 2012 Atlanta Business Chronicle. Consumer Credit Card Debt Falls More. Web. http://www.bizjournals.com/atlanta/news/2012/02/21/consumer-credit-card-debt-falls-more.html. Accessed April 13th, 2012 Brunsden, Jim. Big Banks Needed 485.6 Billion Euros for Basel Capital Rule. Web. http://www.bloomberg.com/news/2012-04-12/big-banks-had-485-6-billion-euro-capital-shortfall-at-june2011.html. Accessed April 13th, 2012 Brunsden, Jim. US Alongside China in Roll Call of Basel Bank-Rule Laggards. Web. http://www.bloomberg.com/news/2012-04-03/u-s-alongside-china-in-roll-call-of-basel-bank-rulelaggards.html. Accessed April 7th, 2012 Business Wire. State Street Launches SwapEx Initiative, Significantly Expanding End-o-End Derivatives Solution. Web. http://www.businesswire.com/news/home/20120215005050/en/State-StreetLaunches-SwapEx-Initiative-Significantly-Expanding. Accessed March 29th, 2012 Burne, Katy. Swap-Trading Venture Folds, Unable to Get Funding. Web. http://www.marketwatch.com/story/swap-trading-venture-folds-unable-to-get-funding-2011-07-21. Accessed July 21, 2012 Cerutti, Eugenio, Stijn Claessens and Patrick McGruire. Systemic Risks in Global Banking: What Can Available Data Tell Us and What More Data are Needed? Web. http://www.bis.org/publ/work376.pdf. Accessed April 13th, 2012 Constancio, Vitor. Shadow Banking the ECB Perspective. Web. http://www.bis.org/review/r120430d.pdf. Accessed April 30th, 2012 Cont, Rama, Radu Mondescu, and Yuhua Yu. Central Clearing of Interest Rate Swaps: A Comparison of Offerings. Web. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1783798. Accessed April 19th, 2012 Danthine, Jean-Pierre. A World of Low Interest Rates. Member of the Governing Board of the Swiss National Bank, at the Money Market Event, Zurich. 22 March 2012. Address.

34

Dudley, William C. Reforming the OTC derivatives market. Harvard Law Schools Symposium on Building the Financial System of the 21st Century, Armonk, New York. 19 March 2012. Address. Dyson, Richard. Savers Rush for Gold as Eurozone Debt Fears Drive Up Price. Web. http://www.thisismoney.co.uk/money/saving/article-2129714/Savers-rush-gold-eurozone-debt-fearsdrive-price.html?ito=feeds-newsxml. Accessed April 14th, 2012 Easthope, David. The Road Ahead for SEFs: If you Build it, will they Come? http://derivsource.dancingmammoth.com/articles/road-ahead-sefs-if-you-build-it-will-they-come. Accessed April 7th, 2012 Eisinger, Jesse. Volcker Rule Gets Murky Treatment. http://dealbook.nytimes.com/2012/04/18/interpretation-of-volcker-rule-that-muddies-the-intent-ofcongress/. Accessed April 18th, 2012 Faux, Zeke. Moodys Says Governments Should Create New Ratings Firm. Web. http://www.businessweek.com/news/2012-03-22/moody-s-says-governments-that-criticize-should-doown-ratings. Accessed March 25th, 2012 Goebel, Scott. Reply to Protection of Cleared Swaps Customer Contracts and Collateral; Confirming Amendments to the Commodity Broker Bankruptcy Provisions. Fidelity Publications. August 2011. Print. Hawkes, Alex. Switzerland moves to contain franc appreciation. Web. http://www.guardian.co.uk/business/2011/aug/03/switzerland-franc-overvalued-intervention. Accessed April 14th, 2012 Hodgson, Bill and Kevin Samborn. CCP Conversion: An Implementation Battle Looms. Web. http://edge.sapient.com/assets/imagedownloader/283/trm_journal_edition. Accessed April 19th, 2012 Holman Fenwick Willan (HFW). Regulatory Bulletin April 2011 Introduction to the European Market Infrastructure Regulation. Web. http://www.hfw.com/publications/bulletins/regulatory-bulletin-april2011/regulatory-bulletin-april-2011-introduction-to-the-european-market-infrastructure-regulation. Accessed March 30th, 2012 Hull, John. OTC Derivatives and Clearing: Can All Transactions be Cleared? April 2010. Print. ISDA. Swap Execution Facilities: Can They Improve the Structure of OTC Derivatives Markets? March 2011. Print. ISDA Research Staff. Costs and Benefits of Mandatory Electronic Execution Requirements for Interest Rate Products. ISDA Discussion Paper Series Number Two November 2011: Print. Jones, Sam. Hedge Funds Feel Pinch from New Banking Rules. Web. http://www.ft.com/intl/cms/s/8ff2dcce-8898-11e1-a52600144feab49a,Authorised=false.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2 F8ff2dcce-8898-11e1-a526-00144feab49a.html&_i_referer=#axzz1spTM3n00. Accessed April 17th, 2012 Kaplan Schweser. SchweserNotes 2011 CFA Level 1 Book 2: Economics. United States: Kaplan, 2010. Print. Kong, Fernand. Switzerland Sets Currency Ceiling as the Swiss Franc Becomes a Victim of its Own Success. Web. http://www.svb.com/blogs/fkong/switzerland-currency-ceiling/. Accessed April 14th, 2012 35

Lowrey, Annie. Regulators Move Closer to Oversight of Nonbanks. Web. http://www.nytimes.com/2012/04/04/business/economy/regulators-move-closer-to-scrutinizingnonbanks.html. Accessed April 4th, 2012 Mahapatra, B. Implications of Basel III for capital, liquidity, and profitability of banks. National Conference on Emerging Macro Environment, Regulatory Changes, and Bank Competitiveness, Pune, India. 3 March 2012. Address. Marsh, Darren. LEI Usability the Benefits of this New Standardised Code Comes Down to Aggregation. Web. http://www.derivsource.com/content/lei-usability-%E2%80%93-benefits-newstandardised-code-comes-down-aggregation. Accessed March 15th, 2012 Masters, Brooke. Global Finance: Conflicting Signals. Web. http://www.ft.com/intl/cms/s/0/57646ada798e-11e1-b87e-00144feab49a.html. Accessed April 3rd, 2012 Nishimura, Kiyohiko G. What should we learn from the Eurozone Crisis? A regulatory-reform perspective. Institute of International Bankers 2012 Annual Washington Conference, Washington DC. 7 March 2012. Address. Norton Rose. European Market Infrastructure Regulation: What you need to know. Web. http://www.nortonrose.com/knowledge/publications/62449/european-market-infrastructure-regulationwhat-you-need-to-know. Accessed March 30th, 2012 OBrien, Dan. Fewer risk-free financial assets available, says IMF. Web. http://www.irishtimes.com/newspaper/finance/2012/0412/1224314639617.html. Accessed April 12th, 2012 Oracle Financial Services. Automating OTC Derivatives Processing and Risk Management. Web. http://www.oracle.com/us/industries/financial-services/045343.pdf. Accessed March 30th, 2012. Orol, Ronald D. Fed will respond to Deutsches change: Tarullo. Web. http://articles.marketwatch.com/2012-03-22/economy/31223583_1_deutsche-bank-bank-rules-volckerrule. Accessed March 25th, 2012 Owens, Sean. Beyond Volcker: Seeing the Forest through the Trees. Web. http://www.advancedtrading.com/regulations/232800354. Accessed April 7th, 2012 Pirrong, C. The Economics of Central Clearing: Theory and Practice. ISDA Discussion Paper Series Number One May 2011: Print. Pricewaterhouse Coopers (PWC). OTC Derivatives: Should all customized derivatives be standardized? Web. http://www.pwc.com/us/en/point-of-view/otc-derivitives.jhtml. Accessed March 30th, 2012 Protess, Ben. Regulators Defend Derivatives Rule. Web. http://dealbook.nytimes.com/2012/04/18/regulators-defend-derivatives-rule/. Accessed April 18th, 2012 Protess, Ben. Barney Frank Wants Simpler Volcker Rule by Labor Day. Web. http://dealbook.nytimes.com/2012/03/22/barney-frank-wants-simpler-volcker-rule-by-labor-day/. Accessed March 25th, 2012 Skadden, Arps, Slate, Meagher, & Flom. Proposed Margin Requirements for Uncleared Swaps. Web. http://www.skadden.com/newsletters/Proposed_Margin_Requirements_for_Uncleared_Swaps.pdf. Accessed April 20th, 2012 36

Skadden, Arps, Slate, Meagher, & Flom. The Volcker Rule. Web. http://www.skadden.com/newsletters/FSR_The_Volcker_Rule.pdf. Accessed March 29th, 2012 Spicer, Jonathan. Update 1-Feds Dudley Back global push for more swaps oversight. Web. http://www.reuters.com/article/2012/03/23/usa-fed-dudley-idUSL1E8EMAXT20120323. Accessed March 25th, 2012 Medero, Joanne, Richard Prager, and Supurna BedBrat. Reply to Protection of Cleared Swaps Customer Contracts and Collateral; Confirming Amendments to the Commodity Broker Bankruptcy Provisions. Blackrock Publication. August 2011. Print. Sloan, Steven. Regulators Should Propose New Volcker Rule, Paredes Says. Web. http://www.bloomberg.com/news/2012-04-02/regulators-should-propose-new-volcker-rule-sec-s-paredessays.html. Accessed April 7th, 2012 Steinberg, Julie. CFTC Needs More Staff, Money, Gensler Says. Web. http://www.fins.com/Finance/Articles/SBB0001424052702304459804577281661682517538/CFTCNeeds-More-Staff-Money-Gensler-Says. Accessed March 25th, 2012 Tarullo, Daniel T. Regulatory Reform. Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC. 22 March 2012. Address Teevs, Christian. Swiss Fear the End of Economic Paradise. Web. http://abcnews.go.com/International/swiss-fear-end-economicparadise/story?id=14382093#.T4pLLVHWY98. Accessed April 14th, 2012 Weidmann, Jens. Lessons from the crisis for monetary policy and financial market regulation. Frankfurt Finance Summit, Frankfurt am Main. 20 March 2012. Address. Wilmont, Jonathan. Long Shadows: Collateral Money, Asset Bubbles, and Inflation. Credit Suisse Publication. May 2009. Print Yerak, Becky. Student Loan Debt a Growing Threat to the Economy. Web. http://www.baltimoresun.com/business/money/ct-biz-0413-student-debt-20120416,0,4520796.story. Accessed April 13th, 2012 Basel III. http://en.wikipedia.org/wiki/Basel_III. Accessed March 29th, 2012 Dodd-Frank Wall Street Reform and Consumer Protection Act. http://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_ Act#Title_VII_.E2.80.93_Wall_Street_Transparency_and_Accountability. Accessed March 29th, 2012 Volcker Rule. http://en.wikipedia.org/wiki/Volcker_Rule. Accessed March 29th, 2012

37