SENATOR BAYH: My final question, here, as my time expires, there's been a recent increase in the price of credit default swaps on U.S. Treasuries.  What do you think accounts for that? And should be a matter of some concern in the message the market seems to be sending about their confidence?

BERNANKE: It could well -- there's been a lot of movement in a variety of spreads; for example, the spreads between the newly issued and previously issued bonds and so on.

I wouldn't read too much into that. It's a very small change. I think it has more to do with liquidity in markets and other risk aversion, other types of behavior, rather than any sense that there's a default risk.

From the Q&A session

A CCP has the potential to reduce counterparty risks to OTC derivatives market participants and risks to the financial system by achieving multilateral netting of trades and by imposing more-robust risk controls on market participants.  However, a CCP concentrates risks and responsibility for risk management in the CCP.  Consequently, the effectiveness of a CCP's risk controls and the adequacy of its financial resources are critical.  If its controls are weak or it lacks adequate financial resources, introduction of its services to the credit derivatives market could actually increase systemic risk.

A CCP that seeks to offer its services in the United States would need to obtain regulatory approval.  The Commodity Futures Modernization Act of 2000 included provisions that permit CCP clearing of OTC derivatives and require that a CCP be supervised by an appropriate authority, such as a federal banking agency, the Commodity Futures Trading Commission, the SEC, or a foreign financial regulator that one of the U.S. authorities has determined to satisfy appropriate standards.  A CCP for credit derivatives with standardized terms that was not regulated by the SEC might need an exemption from securities clearing agency registration requirements.

The New York Fed and other supervisors are working with market participants to fundamentally change how CDS and other OTC derivatives are processed by applying increasingly stringent targets and performance standards. They are also emphasizing that dealers must demonstrate their capability to adequately manage the failure of a major counterparty, including calculating exposures rapidly, having clear management procedures, and conducting internal stress exercises. Finally, they are encouraging the development of well-regulated and prudently managed central counterparty clearing arrangements for CDS trades.

"Credit default swaps are a good example of a market that has huge potential for helping people manage risks," said Kohn, but he added that those who use the swaps "need to be aware of the risks they're taking."

Kohn said "good progress" has been made in improving the infrastructure of the credit default swaps market, so that "counterparties are not assigned arbitrarily." But he said swaps purchasers still need to "be very careful about where their exposures are in that market."

From Q&A as reported by Market News International

There are good reasons to think that these developments have made the financial system more resilient to shocks originating in the real economy and have made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years. From the 1970s through the early 1990s, we seemed to be in almost continuous crisis mode. These crises were centered on depository institutions, and because borrowers were so dependent on depository institutions for credit availability, problems at depository institutions meant problems for the financial system and for the economy more generally.

...

But we certainly should not read this experience as meaning that we are free of systemic risk--the risk of financial-sector problems spilling into the real sector or aggravating already difficult economic circumstances. Indeed, I see several reasons for carefully considering the potential for such problems to emerge.

New players and new instruments have become important since 2002, when the last adverse credit cycle peaked. New and already existing market participants are maneuvering for greater shares in a rapidly evolving market structure. Although leverage has declined in the nonfinancial businesses whose credit is being priced and traded, it may well have increased in the structure of intermediary finance. In any event, the growth of tranched CDOs and other structured credit products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.

In addition, the extraordinarily rapid growth of credit derivatives markets in the past few years has occurred against the backdrop of relatively benign macroeconomic performance--good global growth, low inflation, historically high corporate profits and low business failures, and reasonably predictable monetary policies. Partly as a consequence, the prices of financial assets seem to embody relatively low expected volatilities and relatively little reward for taking credit risk or for extending the duration of investor portfolios.

In thinking about how, or whether, to regulate innovative financial institutions (such as hedge funds) or instruments (such as credit derivatives), we should be wary of drawing artificial distinctions. Are the characteristics of hedge funds or credit derivatives that arouse concern peculiar to these institutions and instruments, or are they associated with others as well? If the characteristics in question are in fact a feature of the broader financial landscape, then a narrowly focused approach to regulation will be undermined by the incentives such an approach creates for regulatory arbitrage.

For example, while the complexity of new financial instruments and trading strategies is potentially a concern for policy, as I will discuss, not all credit derivatives are complex and--to state the obvious--not all complex financial instruments are linked to credit risk. Single-name credit default swaps and credit default swap indexes are relatively simple instruments, whereas derivatives based on other asset classes--such as exotic interest-rate and foreign-exchange options--can, by contrast, be quite complex. Moreover, derivatives in general are not necessarily more complex than some types of structured securities. In short, if complexity per se is the concern, we cannot address that concern by focusing on a single class of financial instruments. Similarly, hedge funds are hardly a homogeneous group of institutions, nor can their trading strategies be unambiguously distinguished from those of large global banks or of some traditional asset managers. A consistent regulatory strategy needs to be tailored to the essential characteristics of institutions or instruments that pose risks for policy objectives, not to arbitrary categories.

The hedge funds' share of this market increased from 3 percent to 28 percent between 2000 and 2006.  If credit experience gets rocky, will these participants stay in the market? And could they affect liquidity if they leave?

As reported by Bloomberg News

A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets. The sheer number of financial contracts that would have to be unraveled in the context of a default, the challenge that a former colleague of mine likes to refer to as "unscrambling the eggs," could exacerbate and prolong uncertainty, and complicate the process of resolution.

As is typical during periods of rapid innovation, these markets grew much more quickly than did the supporting infrastructure. Take credit derivatives, for example. For most of the early years of this market, much of the post-trade processing system was not automated and required substantial manual intervention. Positions were assigned without the knowledge of counterparties. Confirmations backlogs rose to very high levels. As Alan Greenspan put it, the market was using 19th century methods of dealing with 21st century financial instruments.

For example, some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk.  But those unregulated or less regulated entities should in principle be subject to more-effective market discipline than banks because, without a safety net supporting them, their creditors have stronger incentives to monitor and limit their risk-taking.  In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred to institutional investors that are far less leveraged than banks. 

These risk-management challenges have not gone unnoticed by market participants themselves.  In 2005, a private-sector group, the Counterparty Risk Management Policy Group II, or CRMPG II, chaired by E. Gerald Corrigan, produced a report highlighting many of these issues.⁹  

...CRMPG II called attention to the growing backlogs and the risks that they posed to market participants and called for the convening of an industry roundtable to address them.¹⁰  Prudential supervisors then took the lead.  In September 2005 they called fourteen leading dealers to the Federal Reserve Bank of New York, where the supervisors collectively made clear their concerns about the risks posed by the growing backlogs.

The supervisors wisely avoided any temptation to design their own improvements to the market infrastructure.  Instead, they simply insisted that the backlogs be reduced and left it to the dealers who had been at the meeting (and who became known as the Fed 14) to figure out with other market participants how best to achieve that objective.  The market participants recognized that automation was the key; manual processes simply are not scalable.  Both dealers and asset managers embraced use of the Depository Trust & Clearing Corporation’s Deriv/Serv electronic confirmation service.

A forward-looking view of the credit risks associated with subprime mortgages can be obtained from a new financial instrument related to these mortgages. These instruments {CDS} suggest a big increase in the risk associated with loans made to the lowest-rated borrowers, but little change in risk for other higher-rated borrowers. Based on these results, it appears that investors in these instruments expect the losses to be fairly well contained. Of course, a shift in market sentiment about the risk of some of these securities is always possible. Such a shift would have ramifications for mortgage financing and housing, likely through tighter credit standards and higher mortgage rates for certain borrowers. In fact, we already have seen some tightening among commercial banks in recent months.

Hedge funds, private equity funds and other leveraged financial institutions control increasingly large shares of aggregate financial capital and play very active roles in many asset markets and in credit markets. Although assets under management in hedge funds still represent a relatively small share of total financial assets, their relative share has increased significantly and their ability to take on substantial leverage magnifies their potential impact on financial market conditions. These private leveraged funds have become an important source of protection to regulated institutions by being large sellers of credit insurance in the rapidly growing market for credit default swaps.