However, those developments do not mean that securitized credit, if structured properly, should not return in size. Reform efforts, to be effective, should foster development of a securitization market that properly aligns incentives and provides adequate transparency about risk transfer. Second, the use of derivatives is integral to the broader functioning of financial markets and the intermediation of credit. Derivatives allow for the redistribution of risks through hedging activities, and they foster improvements in price discovery and market efficiency by facilitating appropriate investments in long and short positions in some types of assets. But while OTC derivatives already provide important benefits, more could be done to enhance the robustness of this market. The measures under consideration promote greater use of central counterparties, increased regulatory and public transparency, wider involvement of exchanges and electronic trading platforms for actively-traded products, and stronger operational and risk management practices. Third, the financial system cannot operate efficiently without leverage. The preferences of businesses and households in their regular economic activities require that intermediation and maturity transformation be conducted somewhere in the financial system. Of course, much of the turmoil we witnessed across financial markets was due to the build-up of excessive leverage in the system, and we cannot miss the chance to learn from this painful  6  BIS Review 40/2010  lesson. But we should also understand that a reduction in leverage to near zero in the financial system is not desirable, as it would significantly reduce the efficiency of credit intermediation.

There were signs of strain in particular segments of these markets, such as dislocations in forward exchange rates and a notable decline in the liquidity of currency swaps. However, market participants were generally able to execute trades and manage currency exposures in these markets on an uninterrupted basis. The resilience of foreign exchange markets owed in part to the availability of CLS Bank for  2  BIS Review 40/2010  eliminating time gaps in the settlement of different currencies, to the efficient collateral exchange achieved through credit support annexes and to the standardization of trade documentation. Credit intermediation and market disruption While those capital markets demonstrated meaningful resilience to financial stress, that was not the case for other parts of the financial system – namely, those involved in more complicated forms of credit intermediation. Many of the most acute problems were driven by a build-up in leverage in which large amounts of opaque, illiquid, long-term assets were financed by short-term liabilities. These activities took place both in traditional financial intermediaries and in what is often referred to as the shadow banking system. The shadow banking system performs a function similar to that carried out by banks and other financial institutions. In particular, it takes the short-term, highly liquid investments that households and other investors want to hold, and it uses them to fund the longer-term, relatively illiquid loans that businesses and households demand to finance their economic activity.