Regulatory Reactions to the Crisis and Moving Forward

As the second anniversary of the financial crisis came and went on Sept. 15, many of us likely recalled the shock of the Lehman Brothers collapse, the unprecedented government bailouts of banks and the controversial rescue of A.I.G., whose toxic derivatives nearly toppled the global financial system.

Today, a new Wall Street is reemerging. But it is one that will be heavily regulated by the recently passed Dodd-Frank Financial Reform Bill. The far-reaching changes include moves to bring the shadowy world of OTC derivatives under more government scrutiny and the Volcker Rule, which bans banks from speculating with their own capital (see, "The New Wall Street," page 24). But even in this new era of financial services, risk remains.

Big banks that have dominated the OTC derivatives business will be forced to submit trades to central clearinghouses and post margin to reduce counterparty risk. Some experts, however, question whether the new clearinghouses are safe enough, pointing to the possibility that the reserve fund might not have enough margins in the event that a member's trade blows up.

On the other hand, many industry observers predict that the restrictions on big banks trading for their own accounts will actually cause a renaissance in proprietary trading, as the banks are forced to spin off their desks, restructure them, and raise outside money (or seed them with capital) to form hedge funds. In fact, independent proprietary trading firms are salivating at the prospect of luring some of the star traders from the bulge-bracket firms. And technology suppliers also are tracking the trend, as they stand to profit from outfitting the start-ups - for example, with data, execution platforms, connectivity and colocation services .

As regulators strive to prevent another financial crisis, they are proposing new information systems and audit trails to track the substantial trading activity of high-frequency and other large traders. But imposing these behemoth and duplicative projects on the industry is expected to cost billions of dollars and could drain IT resources, so opposition is brewing.

And while it seems as if enough regulations already have been proposed, we may not be done yet. Contributing editor Larry Tabb assesses the damage caused by the May 6 Flash Crash and analyzes Sen. Ted Kaufman's plan for tweaking U.S. equity market structure. On the list are new incentives for liquidity provisioning, a cap on new exchange and ATS licenses, and capital allocations for high-frequency traders tied to how many messages they put out.

Clearly the industry is going through a period of introspection and, some might say, regulatory overreaction. With the SEC and CFTC preparing their final report on the Flash Crash, the next few months should be very interesting.