to reduce the complexity of the network and enhance netting efficiencies, and to establish robust risk management practices and clear default procedures. since ccps – which interpose themselves between buyer and seller in financial markets – concentrate risk by becoming the counterparty to all transactions, they must have stringent risk - management standards. the use of sufficiently robust ccps is likely to increase the strength of the financial system. it will also reduce the counterparty credit exposures of major participants, which will be reflected in capital requirements for financial institutions. to be safely cleared the contracts that ccps process must, at a minimum, be sufficiently standardized. and the push to standardize otc derivatives contracts will have important ancillary benefits for how these markets function. standardization will create more liquid, transparent and efficient markets for the contracts. it will also help set the stage for shifting trading onto exchanges or electronic trading platforms. the challenges of the g - 20 reforms the g - 20 objectives are necessary and appropriate, but achieving them is going to be challenging, for several reasons. first, they may require the development of new ccp services, a complex and timeconsuming process. we are experiencing this in canada in connection with the work now underway to build a ccp for repos and fixed - income transactions. the canadian industry selected the canadian derivatives clearing corporation ( cdcc ) to develop this facility. the process of creating a ccp for repos in canada, although not yet complete, has been instructive. two fundamental requirements are that the ccp has adequate and robust riskcontrol systems and the capacity to implement them. operational issues, such as developing and testing the relevant software – both for the ccp and its participants – and its interaction with existing systems, also take time to resolve. the challenges of establishing a ccp for repos are considerable. but at least the overall parameters are clear. fulfilling the g - 20 commitments on otc derivatives is a more complex task, requiring coordination among many stakeholders, with a wide range of possible outcomes. the complexity of clearing otc derivatives central clearing of otc derivatives transactions will reduce systemic risk by decreasing the likelihood that one failing institution will bring down others. but, given the globalized nature of the industry, there are several ways to make the transition to ccps. clearing could take place on large international ccps serving the global market ( such as ice clear, cme or lch. clearnet ), or new central clearing

of firms ’ internal processes for controlling risk. this, of course, is the most obvious lesson from several spectacular losses that the press has put under the rubric of “ derivatives debacles. ” supervisors, both here and abroad, are focusing more on reviewing the adequacy of internal controls and management processes, such as enforced risk limits. these are the key to gaining maximum benefit from financial innovation, while at the same time avoiding missteps. the final lesson that i will highlight is the need for supervisory and regulatory polices that are more “ incentive - compatible ” in the sense that they • foster sound risk management within the institution rather than narrow adherence to rules and regulations ; • minimize burden by using internal risk measurement systems ; and • are reinforced by market forces and the performance incentives of bank owners and managers. too often financial engineering is targeted at regulatory arbitrage - - that is, exploiting loopholes in narrowly focused regulatory policies that are based on old, traditional instruments or business lines. also, potential new products may not be introduced because their regulatory treatment is viewed as too burdensome or uncertain. this situation demonstrates all too clearly the differing reaction times of public and private entities. regulatory policies and standards often take a long time to change whereas, in the private sector, market forces can quickly remedy outmoded standards. the resulting distortions of resources that arise when supervisory standards are slow to change is an unfortunate, albeit predictable, outcome. policymakers can reduce this potential for distortion by structuring policies to be more “ incentive - compatible. ” this involves harnessing market forces and market discipline to achieve supervisory objectives. increasingly, supervisors are trying to avoid locking themselves into formulaic, one - size - fits - all approaches to supervision and regulation. the use of internal var models for calculating capital charges for trading activities is an important step in this direction. risk - focused supervision emphasizing sound practices and internal controls is another. a significant effort that could increase supervisory reliance on market discipline in the future is the federal reserve ’ s so - called “ pre - commitment ” approach to determining capital for market risk. it seeks to provide banks with stronger regulatory and market incentives to improve all aspects of market risk management. this approach is currently being studied and tested by a group of u. s. banks organized by the new york clearing house. what will be the eventual outcome of incorporating the lessons learned into banking supervision? i see two themes in the evolution in the supervision of financial institutions : • first