With the growth of instruments such as credit default swaps and collateralized debt obligations, the marketplace for financial products has become rather complicated. “It has put some significant strains on systems that were built in the late 80s and early 90s,” says Gregg Berman, head of institutional business at RiskMetrics Group (New York).
Credit default swaps (CDS) provide lenders with a technique for off-loading the risk that a specific borrower enters when in financial distress. As with commodities traders who rarely lay hands on a barrel of wheat or a pork belly, CDS traders get involved in the financial instrument without having a stake in the underlying asset. “The CDS market is even more liquid than the bonds that they’re trading,” Berman says. “Now, you can have one entity buy credit protection and another sell credit protection for a name that they have nothing to do with.”
These 21st-century financial instruments pose a new risk management challenge. Credit default swaps are exposed to both market risk and credit risk, but banks had typically measured their credit risk exposures on one system and market risk exposures on another.
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