The Squam Lake Report: Fixing the Financial System
18 June 2010
The Squam Lake report provides recommendations with the aim of lowering the risks of systemic failures, as well as increasing transparency in the CDS markets. Additional steps that would help further the goals of the report are moving end-user derivative trades onto CCPs.
The Squam Lake report provides recommendations to, among other things:
(i) protect against a systemic failure arising from a failure in the credit default swap (CDS) market;
(ii) improve transparency in the CDS market; and
(iii) reduce the risk of runs on prime brokers and dealers.
The recommendations focus on the use of central counterparties (CCPs), derivatives trade reporting, stricter regulation of liquidity requirements for dealers, and segregation of customer assets. Additional steps that would help further the goals of the report are moving end user derivatives trades onto CCPs, adoption of standardised exchange traded derivatives for all risk types covered by OTC derivatives and higher regulatory capital requirements for non-standardised contracts; and establishing safety-related registration of all financial products.
Chapter 9 of the report makes recommendations to strengthen the infrastructure of OTC derivatives markets. The proposals are aimed at two goals.
The first goal is to lower the risk of a systemic failure arising from a counterparty failure in the CDS market. Imagine a circle of people in which everyone sells to the person on the left the same OTC derivative. Each person is perfectly hedged because each has bought and sold the same security. But if just one person goes broke, the circle is broken. Likewise, in an OTC market, the failure of one firm can create a chain of failures ending in a complete collapse of the system.
The report recommends that financial firms be encouraged to use clearing houses, which can also ber referred to as central counterparties (CCPs). The encouragement would come in part by requiring additional capital for contracts not cleared through a recognised CCP. If, in the example, , the trading had been through a central clearing house, netting would have eliminated the systemic risk.
Importantly, the report notes that CCPs concentrate risks and so should be "well designed". That is, they should be required to have strong operational controls, appropriate collateral requirements and sufficient capital.
The second goal is to increase transparency in the CDS market. Doing so would improve the ability of market participants and regulators to identify "potential trouble spots". Transparency here is about information collection and dissemination.
To increase transparency, the group would target the index and single-name CDS contracts that are relatively liquid and standardised. In particular, the group suggests introducing trade-reporting similar to that in the TRACE system, which provides post-trade price transparency for US corporate bonds.
Underlying the transparency recommendation is the well-known fact that information asymmetries are often the fuel for financial panics. During the last quarter of 2008, as well as more recently, we saw contagion due to uncertainty over counterparty exposures - that is, not knowing who will bear losses should they occur. It follows that transparency is critical, if panic driven by uncertainty is to be avoided.
Chapter 10 focuses on reducing the risk of runs on prime brokers and dealers. To reduce the risk, the group recommends imposing liquidity requirements on systemically important banks and broker-dealers. And it would exclude from regulatory liquidity any short-term financing based on assets from counterparties or customers. To head-off attempts by prime brokers to avoid the proposed rules on segregation of customer assets, the report recommends that regulation in major financial centres be at least as tight as it in the United States.
