Credit risk transfer, hedge funds, and the supply of liquidity

This paper provides a discussion about some recent issues related to the transfer of NEWLINE credit risk (CRT) from the perspective of global liquidity. The CRT market is enormously NEWLINE growing and exhibits major structural shifts in terms of buyers and sellers of NEWLINE protection. I try to address these issues from an options perspective by suggesting NEWLINE that liquidity providing can be understood, in economic terms, as selling put options. NEWLINE The overall conclusion of the paper is that it is not the extent of CRT per se, as often NEWLINE claimed, which causes liquidity related systemic risk, but rather the potential coordination NEWLINE failures of the behavior market participants in adverse market environments. In NEWLINE this context, I critically address the role of investments banks in providing liquidity to NEWLINE hedge funds, and finally, the (limited) access of global banks to central bank liquidity NEWLINE through cross-border collateral trading. Since coordination failures, seen as the major NEWLINE issue of a potential liquidity crisis, is to a large extent a matter of market structure, NEWLINE regulatory actions to improve liquidity should focus on the architecture of the financial NEWLINE system in the first place, not so much on the behavior of individual agents. Market NEWLINE stabilization should therefore be understood as a process of establishing informative NEWLINE markets and adequate infrastructure.