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Regulatory Reform (Basel III (Leverage Ratio Impact (Capital requirements…

- - - - Reduces the amount of balance sheet space required for intermediation
        
        Dealers reducing market making offering of two-way markets (liquidity risk)
        
        Dealers firing or repricing large number of less profitable PB clients
        
        Dealers respond to increases in capital requirements by increasing bid-ask spreads for positions in order to economise on the use of balance sheet space
        
        Dealers abandoning less profitable market-making franchises
      - Example: $100m of additional assets requires $5m additional capital
        
        As capital requirements go up Repo dealers increase bid-ask spread to overcome debt overhang (3 to 16 bp)
        
        Volume of trades in Treasury repos dropped significantly in interdealer repo market
- - - - Dealers will pass on that cost to the client taking into account the length of time clients are expected to keep trades on
        
        Huge risk of basing funding cost on historical behaviour of the client
        
        Example: If a dealer enters into a 20-year swap with a hedge fund and assumes it will only have to fund its IM for 2 years but that hedge fund decides to leave the swap on for a lot longer then the dealer will bleed its profit away
        
        Fast moving hedge fund might unwind withing days, weeks or months, while a corporate hedging a bond issue is more likely to hold the derivative for the full term
      - Another complexity that dealers are facing is the threshold for posting IM whereby counterparties only need to exchange IM once their group exposure breaches $50m
      - Dealers also need to take into account the possibility to rehypothecate client assets collected as IM for the purpose of hedging dealer's derivatives position