Credit Risk Transfer + Hedge Funds + Liquidity

[Sapphire Capital]

Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity

HEINZ ZIMMERMANN
University of Basel - Center for Economic Science (WWZ) - Department of Finance; WHU Otto Beisheim Graduate School of Management
--------------------------------------------------------------------------------
June 2007

U. of St. Gallen Law & Economics Working Paper No. 2008-14


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

papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1158246_code720524.pdf?abstractid=1137924&mirid=3

[Sapphire Capital]

Comment on H. Zimmermann: Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity?

GEOFFREY P. MILLER
New York University - School of Law
--------------------------------------------------------------------------------
June 2007

U. of St. Gallen Law & Economics Working Paper No. 2008-15


Abstract:
Professor Zimmerman's paper is a rich source of insights about the important and burgeoning market in credit risk transfer (CRT) instruments, and in particular the spectacular growth of credit derivatives and the rise of hedge funds as sellers of these instruments. Professor Zimmerman astutely observes that CRT instruments can enhance social wealth by distributing credit risk to more efficient risk bearers. ing CRT as a sale of an out-of-the-money put option, he observes that CRT improves the liquidity of the financial system. While recognizing these benefits, Professor Zimmerman is concerned about the potential risks. The CRT market, at present, is anything but transparent. This opacity in the market creates a risk that the CRT market, which has operated well in ordinary times, may not be well-adapted to cope with a crisis.

More specifically, Professor Zimmerman is concerned that due to their highly leveraged capital positions the sellers of these puts may themselves lack the liquidity to satisfy their commitments under unusual market conditions. The actual providers of liquidity then may be the hedge fund's creditors. In a financial crisis that triggers many claims on CRT instruments, those creditors (mostly investment banks) may themselves lack the liquidity to satisfy their obligations - especially because, in addition to lending to hedge funds, these institutions are increasingly competing with hedge funds by offering their own CRT products. If the investment banks lack liquidity in such circumstances, central banks will be called on to supply liquidity in order to prevent a fundamental breakdown in the financial system. But central banks themselves may not operate as effective liquidity providers of last resort, given the lack of transparency in the system and the cross border feature of many CRT contracts. Moreover, because in a crisis these events will happen quickly, there is a risk that the coordination function of the market will break down as contracts are not settled in an orderly fashion. Any breakdown in the orderly process of settlement may greatly exacerbate the problems as market participants lose confidence in the effective functioning of the system.

Professor Zimmerman offers no simple solution to this frightening scenario of a global financial meltdown triggered by unanticipated and correlated calls on CRT contracts. The basic regulatory problem is how to deal with a serious risk that we can perceive but cannot quantify and do not fully understand, in the context of a highly dynamic and rapidly evolving market which is likely to have outgrown any by the time policymakers get around to constructing one. Some degree of confidence can be gained from the fact that the world's financial system has proven to be remarkably robust, and that crises, when they happen, are more often the result of ill-considered attempts at regulation than the result of defective market design. The CRT market has developed as a result of private contractual decisions by many sophisticated parties. There are no looming externalities that cry out for regulation. The function of CRT is not new: it is simply insurance in a different guise; nor is the concern about liquidity and market disruption new: reinsurance markets, for example, have long provided backup sources of liquidity for insurance contracts in case of unanticipated claims on an insurer‘s capital.

In light of these considerations, Professor Zimmerman wisely refrains from calling for enhanced substantive regulation of the CRT market. His more comprehensive
suggestion is that regulators should strive for more transparency in the system, and should conceptualize liquidity issues in a broad but unified context, including all financial intermediaries (central banks, insurance and reinsurance firms, hedge funds, pension funds, clearing organizations, etc.). The advice is eminently sound, although, as Professor Zimmerman recognizes, it is easier to call for a comprehensive of liquidity provision in financial markets than to actually construct one.

papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1158493_code720524.pdf?abstractid=1137927&mirid=1