dealers and investors to so - called correlation risk if their models or forecasts of default correlation turn out to be incorrect. correlation risk is challenging to measure and manage, and fairly recently some market participants learned a hard lesson about those challenges. in may 2005, a widening of credit spreads for several automotive companies led to sharp movements in the prices of credit index tranches that seemed to catch market participants by surprise. their models of correlation risk seemed to have lagged behind the development of the new tranched credit products. since then, much energy has been devoted to building better models of correlation risk, but i believe it is fair to say that much work remains to be done before this risk can be considered to be fully understood. these risk - management challenges have not gone unnoticed by market participants themselves. in 2005, a private - sector group, the counterparty risk management policy group ii, or crmpg ii, chaired by e. gerald corrigan, produced a report highlighting many of these issues. 9 that report also made a number of useful recommendations to market participants on how they could address some of the challenges i have mentioned here. it is encouraging to find market participants taking a leading role in making the improvements in risk management that will be needed to fully reap the benefits of innovations in credit markets. the third and final challenge i will discuss is that of infrastructure. the very rapid growth of trading credit derivatives had until recently outpaced the development of the infrastructure necessary to clear and settle those trades. post - trade processes were largely manual, with attendant inefficiencies and risks. by early 2005, credit derivatives dealers had huge backlogs of unconfirmed trades, even though they had greatly increased their back - office resources. unconfirmed trades increase the potential for material inaccuracies in trade records, which can cause mismeasurement and mismanagement of market risks and counterparty credit risks. market infrastructures can be improved only through collective actions by market participants. in 2005, some stimulus for the necessary collective actions was provided by both the private sector and the public sector. crmpg ii called attention to the growing backlogs and the risks that they posed to market participants and called for the convening of an industry roundtable to address them. 10 prudential supervisors then took the lead. in september 2005 they called fourteen leading dealers to the federal reserve bank of new york, where the supervisors collectively made clear their concerns about the risks posed by the

growing backlogs. the supervisors wisely avoided any temptation to design their own improvements to the market infrastructure. instead, they simply insisted that the backlogs be reduced and left it to the dealers who had been at the meeting ( and who became known as the fed 14 ) to figure out with other market participants how best to achieve that objective. the market participants recognized that automation was the key ; manual processes simply are not scalable. both dealers and asset managers embraced use of the depository trust & clearing corporation ’ s deriv / serv electronic confirmation service. the results have been dramatic. between september 2005 and december 2006, aggregate credit derivatives confirmations outstanding thirty days or more at the fourteen dealers declined 92 percent despite continued rapid growth in trading volumes. with the encouragement and support of supervisors, a larger group of dealers and asset managers are now turning their attention to addressing backlogs in the equity derivatives markets. conclusions credit markets undoubtedly will continue to evolve in the years to come. in the short run, rapid change can pose significant challenges to market participants. cooperative initiatives, such as crmpg ii and the fed 14, can contribute greatly to ensuring that those challenges are met successfully by identifying effective risk - management practices and by stimulating collective action when it is necessary, notably in achieving improvements in market infrastructures. the recent success of such initiatives counterparty risk management policy group ii ( 2005 ), toward greater financial stability : a private sector perspective, july 27, www. crmpolicygroup. org. counterparty risk management policy group ii, toward greater financial stability, p. 19. strengthens my confidence that future innovations in the market will serve to enhance market efficiency and stability, notwithstanding the challenges that inevitably accompany change.