In the speech, Yellen stressed the importance of having multiple channels of reform initiatives to enhance systemic stability and cited the Basel Committee as sponsoring a number of initiatives to improve the management of systemic risk. These initiatives include:

• Higher capital standards
• Countercyclical capital buffers
• Liquidity requirements
• Increased capital charges for exposures to large financial institutions
• Large exposure rules
• Deductions from capital for equity investments in banks

In addition to these reforms, regulators have also committed to address weaknesses in OTC derivatives markets. Problems in the functioning and oversight of derivatives markets were exemplified by the widespread effects of losses by American International Group (AIG) on its OTC structured finance and credit derivatives positions. AIG’s failure would have exacerbated the already impaired functioning in important segments of the OTC market.

As a result, in 2009 G-20 regulators committed to require that standardized OTC derivatives be cleared through central counterparties. These regulations are meant to address the gridlock that can occur when each market participant knows its own counterparty exposure but does not have a view of its counterparty’s exposure to others. Given the research cited above, standardizing OTC derivatives to be cleared through central counterparties dramatically simplifies and improves the transparency of the network of counterparty risk exposures. To ensure the viability of central counterparties, Title VII of the Dodd-Frank Act adopted stronger safeguards for central counterparties that clear OTC derivatives. Additionally, Title VIII of Dodd-Frank strengthened the supervision of financial markets utilities, including central counterparties designated as systemically important, by requiring annual examinations as well as ex ante reviews of material rule and operational changes.

To manage risk, central counterparties must value contracts on a frequent basis, or even in real time. However, the G-20 mandate currently requires only standardized OTC derivatives to be centrally cleared. As more non-standardized derivatives migrate to central clearing, regulators will need additional information to manage the risks of non-centrally cleared derivative exposures. An important tool for managing this risk is margin requirements. The International Organization of Securities Commissions has proposed a framework for margin requirements on non-centrally cleared derivatives. The final framework will inform the rulemaking of the Federal Reserve and other regulators. Both financial and non-financial firms might be required to report two types of margin:

1. Variation margin: Requiring the timely payment of variation margin will help prevent an AIG-like event by preventing the buildup of current exposures to unmanageable levels. Reporting variation margin will allow market participants to know that the counterparties with which they deal with will not be carrying large uncollateralized exposures that could impair their ability to perform in the future.
2. Initial margin: Initial margin collateralizes future losses that could occur in the event of a counterparty default. It is a performance bond and is used to replace the position with a new counterparty in case the counterparty does not perform. Global estimates of the opportunity and liquidity cost of initial margin by international swaps and derivatives association are substantial (an estimated $1.7 trillion in liquid assets). Regulation on initial margin is currently under study and the need to reduce systemic risk must be appropriately balanced against the resulting liquidity cost. Nevertheless, Yellen stated that robust and consistent initial margin requirements will help prevent the negative effects of interconnectedness and increase transparency.

Title VII of the Dodd-Frank Act also requires that data on U.S. swaps transactions be reported to swaps data repositories. This data-reporting requirement will be balanced against confidentiality concerns. For this reason, regulators have delayed Dodd-Frank’s real-time reporting requirements for large “block trades” where immediate reporting could reveal and undermine participant positions and discourage market transactions, depth and liquidity.

[Related: "Behind the Lines of the Dodd-Frank Reporting Wars"]

Yellen’s speech laid out the justification for regulatory actions and how they are intended to prevent financial meltdowns like the one in 2008-2009. It is clear that the regulatory response to the great recession in 2008 is as deep and dramatic as the events culminating in the creation of the Federal Reserve System itself. However, given the broad reach and scope of the resulting changes to financial markets, the unintended consequences are likely to be far greater than expected. Financial institutions should be on the lookout for how these regulations are likely to impact the market in unexpected ways. Organizations that correctly anticipate these impacts will be at a significant competitive advantage in the new regime.

Anshuman Sindhar is a Principal Consultant in Capco’s banking practice. He specializes in finance and risk functions.