cds contracts is with five - year maturities, although participants are trying to expand market depth at longer terms. there are also efforts to push demand beyond investment - grade corporate names, for example to high - yield and middle - market sectors. a key question - how much risk is being transferred? - has been difficult to answer due to the participation in the market of many types of regulated and unregulated investors and firms as well as the fact that participants simply reverse or close out one exposure by entering into an additional and offsetting one, as they do with other types of swaps. to be sure, notional amounts substantially overstate the level of risk transfer, but by most accounts, market participants seem to agree that the volume of risk transferred has been material. anecdotally, some of the largest banks indicate they hedge about 15 percent of their investment - grade corporate credit. standard and poor ’ s estimates the banking system globally has used credit derivatives to transfer the risk associated with some $ 300 billion of exposures. but s & p acknowledges that this estimate likely overstates the true level of risk transferred because cds are almost exclusively written on low - risk, investment - grade credits, and because banks issuing cdos typically retain the riskier tranches. even so, it seems to me that such risk management practices are important in governing credit risk in large banking organizations and, in many respects, reducing systemic risk, as well. despite the common practice by banks that issue cdos to retain much or all of the first - loss or “ expected - loss ” tranche, such banks have at least reduced their previous, full credit exposure. moreover, the sale and purchase of cds also allow banks to manage concentrations and to further diversify their portfolios. in the event of highly unexpected defaults among investment - grade firms, a hedged bank ’ s losses will be reduced. the experience with credit derivatives in the enron, world com, and parmalat events, indicate that these new risk products can work effectively. one aspect that we, as bank supervisors, find encouraging about the growth of credit risk transfer activity is the diversification benefit it provides - and its potential for greater economic efficiency. certainly, not all of the risk transferred by banks has left the banking sector. s & p estimates that roughly one - half of this risk remains in the banking sector. the insurance sector, including reinsurance firms, has been a major participant among nonbank firms. among banks, the

. however, as an economist, i also know there is no free lunch ; some of the implications of these developments on the more fundamental elements of risk management must be considered and adequately addressed if the quantitative aspects are to work well. for obvious reasons, i will focus on the practices of large commercial banks. competitive and innovative markets i would like to draw on some observations gathered from the federal reserve ’ s role in banking supervision as we have worked to better understand recent practices by financial institutions to manage and transfer credit risk. i find the preliminary assessment to be informative, interesting, and at least somewhat reassuring ; however, i also feel that it appropriately highlights vulnerabilities in market practices that must be carefully monitored and managed. because much of the innovation in credit risk transfer involves credit derivatives, attention has been focused on transactions using these instruments and on credit default swaps ( cds ), in particular. by way of note, the federal reserve also is participating in work commissioned last year by the financial stability forum to gain a broader understanding of these issues. i look forward to the conclusions and assessment in this regard. as most of you know, credit default swaps involve the sale, or transfer, of credit risk associated with a specific reference entity for a fixed term in exchange for a fee from the other counterparty ( the “ protection buyer ” ). related instruments - synthetic collateralized debt obligations ( cdos ) - entail similar arrangements, but are based on portfolios of exposures and are “ tranched ” in a manner typically seen in securitizations. consequently, through cdos, parties gain even greater flexibility in tailoring and marketing financial transactions to match the risk appetites of ultimate investors, or risk takers. this market has grown rapidly in recent years, attracting increased attention among risk managers and leading to larger operations and higher staffing levels - particularly at dealer firms. the british bankers association, for example, reports that the notional value of credit derivatives has grown from less than $ 200 billion in 1997 to nearly $ 2 trillion in 2002. our own bank call reports indicate that late last year u. s. commercial banks held credit derivatives with notional values of more than $ 800 billion, which may represent one - third of the global market. trading of these instruments occurs mostly among some 1, 200 large investment - grade “ reference entities, ” with more liquidity, of course, among the most active fifty names than among the next several hundred. most liquidity for