financial institutions hold against risk, which is in part a function of the strength of risk management systems. in both of these areas, market practice has made significant progress over the past decade, and further improvements are underway. a few quick points about two areas in which we believe further progress offers the highest possible return in terms of improving the overall resilience of the financial system. in the broad area of market infrastructure, we think the greatest near - term imperative is to strengthen the post - trade processing systems that underpin the rapidly growing over - the - counter derivatives market. the major dealers and the buy - side investors are making substantial investments in improving the process around the credit derivatives market. the overall strategy outlined in the public letter signed by the 14 major market participants on march 10, 2006, offers the prospect of a more automated confirmation and settlement process, with significantly less operational risk than has existed in these markets since their inception. looking beyond the specific objectives for reducing confirmation times and backlogs, we hope to see agreement over the next several months on a new isda® protocol for net physical settlement in the event of default and progress toward adoption of emerging utilities for centralizing certain processing and information functions that can facilitate netting and matching of payments and collateral. alongside these improvements in what we call infrastructure, this is a moment where it is important to see more care and attention and greater conservatism applied to the discipline of risk management. this is most critical in the areas that are hardest to do well. the challenges seem most exacting in the firms ’ abilities to capture the exposure of the institution to stress scenarios that lie outside the range of recent experience, and to set exposure limits and calibrate margin and credit terms accordingly. the challenges here are magnified by the changes i described earlier, including the rapid growth in complex structure products with imbedded leverage, uncertainty about liquidity in many instruments in less - benign financial conditions and other features of the present environment. a credible stress - testing process has to try to account for not just the effects of a discrete change to some dimension of market risk or some constellation of asset prices, but the effects of those changes on, for example, the behavior of financial market participants and on the broader macroeconomic conditions that might affect credit. it is also critical that firms assess their concentrations not only under current conditions, but also determine how firmwide credit concentrations to names, sectors or counterparties could build up under more stressful economic and financial market conditions.

, but uncertainty is greater because much of the recent innovation has occurred against the backdrop of general economic stability and a sustained period of low credit losses, low risk premia and low implied volatility across many asset classes. this means that some aspects of the financial system today have not yet been subjected to the more exacting tests of macroeconomic or financial stress. this makes it harder for the conventional array of risk management tools to capture the actual risk faced by financial institutions today. the challenge we face is not simply in determining whether we are better off today than we were at past periods of considerable stress in the financial system, but also in assessing how well positioned the current system is to deal with prospective sources of stress. that assessment is harder to make today because of the changes now underway in the nature of financial intermediation and the overall conditions in which these changes have occurred. several examples of these changes are worth noting : the more critical role played by hedge funds and other nonbank financial institutions in credit and other markets has the potential to magnify the impact of distress in those institutions on market dynamics and liquidity if counterparty risks are not managed appropriately. the proliferation of new forms of derivatives and structured financial products has changed the nature of leverage in the financial system. the addition of leverage imbedded in financial instruments to balance sheet leverage has made this source of potential risk harder to assess. new players, new products and more dynamic ways of intermediating and managing credit may increase the sensitivity of balance sheets and income - to - market volatility and potentially amplify the impact of a sharp change in perceptions about macroeconomic risk or credit on asset prices and liquidity. the increased international integration of both capital and goods markets has brought a huge increase in the scale of cross - border financial activity. the largest global financial institutions now play significant roles in a large number of financial systems outside of their home market. these changes are likely to affect the manner in which financial shocks in one region are propagated to other regions. finally, we have witnessed an increase in the degree of concentration in some markets, a development that has the potential to make the system more vulnerable to the deterioration in conditions at one of the major bank or nonbank financial intermediaries. the degree of systemic risk presented by these changes depends importantly on two things. it depends on the robustness of the infrastructure that supports these markets. and it depends on the level of reserves, capital, margin and collateral that the major