firms a false sense of security. reductions in credit risk may not be as great as perceived. the studies point to ways in which individual firms can make collateral programs more effective. first and foremost, the studies emphasize that collateral is a complement to credit analysis ; it is not a substitute for credit analysis. supervisors observed that some firms accepted counterparties that were unwilling to provide information about their risk profile as long as they were willing to post collateral. the fallacy of that approach was vividly demonstrated. positions may rapidly change in value, creating uncollateralized credit exposures to counterparties of unknown creditworthiness. a main point of these studies was the need for counterparties both to recognize the potential for unsecured exposures to arise in the future and to measure such exposures more carefully. a second theme in the studies was the need for counterparties to recognize that, although collateral programs mitigate credit risk, they also introduce operational, liquidity, and legal risks. to realize the benefits of the collateral program, back office systems must be very robust. that is, counterparties must be able to value portfolios, track collateral posted, call for any deficiencies, and verify the timely receipt of collateral. various studies have noted that firms relying on collateral programs must establish rigorous controls and devote sufficient resources to them. additional liquidity and legal risks also arise with collateral programs. counterparties entering into collateral agreements must ensure that they themselves can deliver collateral in a timely fashion, and the extensive legal documents related to the program must be enforceable in relevant jurisdictions. clearing. a device used to mitigate credit risk among groups of participants in many financial markets is a clearinghouse. a clearinghouse typically substitutes itself as central counterparty to all transactions that its members agree to submit for clearing. the creditworthiness of the clearinghouse is thus substituted for that of its members. the clearinghouse assumes the responsibility for managing credit risk through financial safeguards such as membership standards, capital requirements, and collateral systems. the clearing of otc derivatives is quite limited. some clearing of otc products has been conducted in sweden for several years. last year, the london clearing house ( lch ) began offering such services more broadly, but volumes to date have been limited. in the united states, the clearing of otc derivatives has been hampered by legal uncertainty associated with the possible application of the commodity exchange act. if the recommendations in the report of the president ’ s working group are implemented, this uncertainty will

internal controls and independent external audit. policymakers simply cannot dictate the details of risk management based upon assumed market developments. markets currently are in tremendous flux, and policymakers cannot foresee the needs in future years. thus, the soundest course is to create a clear legal and regulatory environment within which market participants can develop risk management tools as needed. in some instances, rather than mandating certain steps, policymakers might provide proper incentives for risk - reducing steps through capital requirements or disclosure regulations. the recommendations in the working group ’ s report on otc derivatives, in particular, aim to clarify the legal status of electronic communication, trading, and clearing systems. these recommendations, if implemented, offer a variety of enhanced risk management tools to market participants. information flows could be improved, backlogs in the settlement process might be reduced, and the benefits of multilateral netting might be realized. however, it remains for market participants to develop the systems that will best serve markets within the given legal framework. i hope that market participants pursue these opportunities. the risks of trading and settling otc derivatives can and should be reduced. obviously, things that firms can pursue individually are easier to tackle than those requiring collective action. but the potential benefits of new communication, trading, and clearing systems should be evaluated carefully. participants in otc markets have worked together in the past developing standard master agreements, for example, or obtaining legal opinions on netting. those experiences should be useful as these new opportunities for reducing risks are addressed. the challenge for policymakers as these new opportunities are evaluated may well be doing nothing. policymakers no doubt will be tempted to mandate cooperation on the part of market participants in an effort to hasten developments that they believe may reduce risk. in adopting such a course, however, they risk pushing markets and market participants down inefficient and undesirable paths. often market participants are not pursuing steps that, on the surface, appear desirable because the benefits do not seem sufficient. in that event, policymakers ’ efforts would be better spent in helping demonstrate that the benefits have not been appropriately evaluated rather than in dictating market structures.