But over the counter (OTC) trading is vulnerable to many operational risks. In particular, investors are exposed to the default of the major broker-dealer counterparties. This was a significant concern to counterparties of Bear Stearns when it was in distress before being taken over by JP Morgan. To moderate such concerns in the future, private sector initiatives are being developed to introduce a central clearer to the CDS market. Such initiatives are very welcome. Although the net positions of CDS dealers generally represent only a very small fraction of their gross positions, because these gross positions have grown so rapidly in recent years, inter-dealer positions can sometimes be very significant – even after netting. A central clearer that would offset any long bilateral positions that one bank had with another with any short positions that the same bank had with a third bank, could significantly reduce the counterparty risk in the CDS market. A leading proposal at present is centred on the Clearing Corporation, which is jointly owned by eleven major banks and other trading platforms. 34 Counterparty risk, as described above, is particularly corrosive for liquidity in financial markets. Investors become concerned not only with the soundness of their immediate counterparties but their counterparties’ counterparties, and so on. When risk crystallises it can be unclear which financial institutions have been adversely affected. As a result of limited disclosure and transparency, investors may limit the supply of funds to a much broader array of counterparties than necessary.

An investor wanting to make an inter-temporal transfer without taking on any credit risk, for example, could then buy a bond and purchase credit default swap protection, thus retaining exposure to the cash flows on the risk free component of the underlying instrument. Synthetically, this expands the volume of low risk investment portfolios. On the other side, a market is created for those who specifically want to trade default risk which allows cleaner pricing of this dimension of risk. Efficient markets for each element should raise the efficiency of the corporate bond market as a whole, with attendant benefits for both borrowers and investors. •  Furthermore, because credit default swaps have different maturities, investors could, for example, buy the corporate bond and retain the resulting exposure to default risk in the near term. But they could also buy protection against default at longer horizons, about which they may be more uncertain. •  Moreover, nominal corporate bonds can also be separated into a nominal and inflation-linked risk component if the corporate also issues inflation-indexed bonds. BIS Review 93/2008  3  Investors can utilise these instruments to buy or sell protection against exposure to inflation risk. As noted above, the markets for single-name corporate credit default swaps have become more liquid than the underlying bonds given the flexibility and specificity they provide to endinvestors. 9 The underlying components of risk can, of course, also be recombined by financial engineering to create new financial products with different risk characteristics.