Credit risk transfer, hedge fundsand the supply of liquidity

This paper provides a discussion about some recent issues related to the transfer ofcredit risk (CRT) from the perspective of global liquidity. The CRT market is enormouslygrowing and exhibits major structural shifts in terms of buyers and sellers ofprotection. I try to address these issues from an options perspective by suggestingthat 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 oftenclaimed, which causes liquidity related systemic risk, but rather the potential coordinationfailures of the behavior market participants in adverse market environments. Inthis context, I critically address the role of investments banks in providing liquidity tohedge funds, and finally, the (limited) access of global banks to central bank liquiditythrough cross-border collateral trading. – Since coordination failures, seen as the majorissue 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 financialsystem in the first place, not so much on the behavior of individual agents. Marketstabilization should therefore be understood as a process of establishing informativemarkets and adequate infrastructure.