60 n the trade derivatives n issue 4 n Q3 2013 n www.thetradenews.com Systemic risk n The TRADE Derivatives forum

While this will make banks safer, it will reduce banks’ ability to step in and take risk, increasing market volatility during periods of market dislocation and shock.

It will also mean that when interest rates rise as quantitative easing ends, price volatility will have to be more significant to draw in non-bank actors, such as hedge funds and proprietary trading firms to absorb this liquidity.

The introduction of CCPs is welcome and should reduce systemic risk, however there is also a downside to concentrating assets within clearing houses. If competitive pressures force CCPs to lower margin requirements to too low a level, it could lead to a default which would in turn result in the spreading of contagion witnessed in 2008.

But just because banks are systemically less risky, it doesn’t mean that risk disappears. The risk just gets spread from banks to hedge funds, proprietary trading firms and corporations. Stringent attention must be applied to ensure that bank deleveraging and de-risking does not concentrate outside of regulated entities and create a series of hidden risks that won’t be known until something goes horribly wrong.

Dodd-Frank and European market infrastructure regulation have concentrated on limiting the contagion and bilateral linkages that exacerbated the crisis. The products that sparked the crisis, such as collateralised debt obligations and mortgage syndication products, have largely evaded regulatory reform, but have become less popular.

Regulatory frameworks in the US and Europe have placed the industry in a stronger position than before 2008, but it’s not clear whether risk is actually better managed now, despite being more visible.

Greater transparency of participants’ exposures is beneficial to the market and in conjunction with greater bank capitalisation, means assets are more accurately valued and supported by collateral should an adverse event take place.

The large-scale change witnessed since 2008 has increased the industry’s capacity to handle risk, but avoiding another crisis will depend on the industry understanding banks’ new limitations, capital requirements, and the risk practices of clearing houses.” n