to the risk preferences of an individual investor, the harder it is to find another investor willing to trade that exact instrument in the event of a shock to those risk preferences. 32 in other words, the improved matching of risk to an individual ’ s risk profile has given rise to an increase in basis risk within the system. as one illustrative example, any investor wishing to hedge any exposure to the us sub - prime mortgage market over the past year or so would have little alternative but to trade in the standardised abx indices ( which themselves have often been relatively illiquid ) rather than in the specific instrument they held. the developments over the past year have illustrated that hedges have often provided less effective than envisaged, and that there was a significant under - pricing of the inherent basis risk of many innovative structured instruments at the point of origination, given the lack of secondary market liquidity for such specific risk. looking forward, it is quite likely that there will be greater unbundling of complex instruments into standardised components that are likely to be liquid and readily traded with low transactions costs, and bespoke elements that will command a higher risk premium given their inherent illiquidity. strengthening financial infrastructure 33 because of the specificity of the risk, innovative financial products are rarely exchange traded. non - standardised products require the services of a broker - dealer to trade. but over the counter ( otc ) trading is vulnerable to many operational risks. in particular, investors are exposed to the default of the major broker - dealer counterparties. this was a significant concern to counterparties of bear stearns when it was in distress before being taken over by jp morgan. to moderate such concerns in the future, private sector initiatives are being developed to introduce a central clearer to the cds market. such initiatives are very welcome. although the net positions of cds dealers generally represent only a very small fraction of their gross positions, because these gross positions have grown so rapidly in recent years, inter - dealer positions can sometimes be very significant – even after netting. a central clearer that would offset any long bilateral positions that one bank had with another with any short positions that the same bank had with a third bank, could significantly reduce the counterparty risk in the cds market. a leading proposal at present is centred on the clearing corporation, which is jointly owned by eleven major banks and other trading platforms. 34 counterparty risk, as described above, is particularly corrosive for liquidity in financial markets.

of a group may be needed, perhaps using a “ bad bank ” in some cases. planning for that will not be easy, and so for those extreme cases there is a special need somehow to ensure continuity in the provision of absolutely critical services to the economy. in the uk, that is one way that ring - fencing fits into resolution planning. implications for supervision all this has important implications for prudential supervisors. in the first place, supervisors get some allies : debtholders. the prospect of taking losses will incentivise bondholders ( and fellow banks ) to monitor the risks taken by banks – pricing or rationing accordingly. this is market discipline : an extra line of defence. risk being priced into bank bonds will not, as some suggest or threaten, kill the market. it would be uncertainty bis central bankers ’ speeches about the regime governing what happens in the event of distress that would kill the market because that kind of uncertainty could not be priced. supervisors won ’ t be idle though. resolution needs preparation. hence the international agreement that firms should prepare recovery plans and contribute to resolution plans. to be clear, while the firms will own the recovery plans, the authorities will design and own the resolution plans. it has to be that way. to a much greater extent than ever before, supervisors will need to work backwards from the end game, working with resolution authorities. that work is commencing around the world through dedicated crisis management groups. in this context, living wills are effectively, in us parlance, a “ pre - pack ”. what i mean by that is that firms and regulators can do a lot of detailed planning for how they would, for example, execute a bail in of their debtholders. that will focus minds. including on who holds bank paper. this is, therefore, relevant to supervisors of insurance companies – a function that the bank of england prudential regulation authority will combine with bank supervision. but i must stress that none of what i have said entails supervisors diluting efforts to reduce the probability of failure, and to ensure plans are in place to enable recovery. conclusion : the fsb ’ s planned peer reviews the nations of the g20 have signed up to the fsb ’ s standard on resolution regimes. but, of course, we need to keep each other honest. that is why the fsb has proposed a peer review process, involving top officials, to ensure that this is working. the bank of england is 100 % behind this. not only would