Starting with the collapse of the European exchange rate mechanism (ERM) in 1992–93, intensified during the Asian crises and the financial market disruptions associated with the Russian sovereign default and the collapse of LTCM, and in light of their tremendous growth over the past several years, hedge funds came to be seen by many, correctly or incorrectly, as potentially giving rise to systemic risk concerns. Others believed that the attention paid to hedge funds as posing systemic risks was misplaced and should have been focused on the over-thecounter derivatives markets instead (Schinasi et al. 2000). As the recent global crisis demonstrated, hedge funds did not play a (major) role in the virulent market dynamics and dysfunctioning whereas the over-the-counter markets did play a major role.

Transnational financial markets (global and pan-European markets for example)—a third source of systemic risk identified in the second column of Table 1—fall between being and not being regulated and supervised. What is meant by transnational markets? Examples are the foreign exchange markets and their associated derivatives markets (both exchange traded and over the counter) and the G-3 (dollar, euro, and yen) fixed-income markets as well as other markets associated with international financial centers (pound, Swiss franc, etc.) and their associated derivatives markets. Dollar, euro, and yen government bonds are traded more or less in a continuous (24/7) global market and the associated derivatives activities are also global. The European euro repo markets are also transnational and are a primary source of liquidity for the major European wholesale banks and their nationally-oriented counterparty banks in European countries. The primary line of defense against systemic risk in these markets is market discipline.

Transnational markets are only indirectly regulated. They are subject to surveillance of one form or another through private international networks and business-cooperation agreements; information sharing by central banks and supervisory and regulatory authorities; official channels, committees, and working groups; and less directly through IMF multilateral surveillance of global markets. Parts of these markets are linked to national clearance, settlement, and payments infrastructures, so they are also subject to surveillance through these channels. The risks they potentially pose are less of a concern to the extent that the major players in them—the large internationally active banks—are supervised and market disciplined by financial stakeholders. Nevertheless, if there is poor oversight of the major institutions, then these global markets are subject to considerable risks, including a greater likelihood of systemic risk. One obvious example is the global over-the-counter derivatives markets, which are unregulated and which were prior to the crisis (and still now are) subject to little formal oversight except through the regulation and supervision of the institutions that engage in the bulk of these markets‘ activities. European financial institutions play a major role in these global markets. For example, according to the BIS latest triennial survey of global OTC derivatives markets, the Euro was the currency of denomination in 40 percent of the daily transactions (turnover) in the global OTC interest-rate derivatives markets.<sup>21</sup> The fourth and final source of systemic risks identified in Table 1 is the policy framework itself, which includes both macroeconomic policies as well as the financial-stability architecture. As will be discussed later, there were mistakes made in many policy areas which either encouraged the behavior that led to systemic risks or directly posed systemic risks as with some aspects of the financial-stability architecture itself.

> 21 See Table 8 in Bank for International Settlements (2010).

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