Comment: Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity? (H. Zimmerman)
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Description
Professor’s 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 derivative 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. Modeling 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 will in ordinary times, may not be well-adapted to cope with 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.
Source Publication
Law and Economics of Risk in Finance: Second International Conference on Law and Economics at the University of St. Gallen, June 29, 2007 St. Gallen, Switzerland
Source Editors/Authors
Peter Nobel, Marina Gets
Publication Date
2007
Recommended Citation
Miller, Geoffrey P., "Comment: Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity? (H. Zimmerman)" (2007). Faculty Chapters. 2020.
https://gretchen.law.nyu.edu/fac-chapt/2020
