to achieve very high levels of leverage because some regulated counterparties had not appropriately managed their counterparty risk exposures. subsequently, both banks and supervisors had to reassess what such management entailed. clearly, supervisors should strongly encourage institutions to know their risk posture and to be able to control it and react appropriately as circumstances change. policymakers should insist on similarly high risk - management standards for regulated financial institutions that provide retail products. as a case in point, bank supervisors in the united states recently issued guidance about the management of risks related to home - equity lines of credit. this guidance did not involve new regulation of these instruments but rather reminded institutions offering such products that they have an obligation to manage the resulting risks appropriately. a pervasive lack of awareness about the risks embedded in new financial products certainly increases the likelihood that users of those products may face difficulties and that those difficulties may become systemic. one way policymakers can help prevent this possibility from happening is by supporting increased transparency and disclosure. although counterparties in wholesale markets should generally be expected to demand and obtain the information they need to evaluate their risks, policymakers can no doubt help establish high standards. in the case of retail transactions, support for efforts to foster the basic financial literacy of households is a useful complement to efforts to promote appropriate disclosure. the more consumers are equipped to interpret disclosures, the more effective those disclosures are likely to be. a third feature of the moderate approach i am trying to chart is an active dialogue between policymakers and market participants. in my view, policymakers should serve as a voice for the development of infrastructure and sensible standards and practices. ideally such steps would be taken by market participants of their own volition, but sometimes informal interventions by policymakers can help foster cooperative efforts by market participants. for example, partly in reaction to the report of the second counterparty risk management policy group, the federal reserve bank of new york recently hosted a meeting with representatives of major participants in the credit default swap market, as well as with their domestic and international supervisors, to discuss a range of issues, including market practices with regard to assignments of trades and operational issues associated with confirmation backlogs. the result was an industry commitment to take concrete steps to address issues of concern. a fourth dimension of my proposed middle path is the ongoing monitoring of key markets and institutions. policymakers should be aware of any emerging stresses in the financial system, including those related to new instruments and institutions. indeed, some central banks have created

welfare. for example, new products and markets can open the door to new investment opportunities for a variety of market participants. and improved risk - measurement and risk - management technologies can contribute to an improved allocation of risk as risk is shifted to those more willing and able to bear it. financial innovations also have the potential to boost financial stability. risk - transfer mechanisms can not only better allocate risk but also reduce its concentration. improved efficiencies and increased competition may result in substantially lower trading costs and may consequently improve liquidity in many markets. better liquidity, which is instrumental to faster and more accurate price discovery and therefore to more - informative prices, can also be brought about by an increased presence of new institutions in new or existing markets. the entry of those new institutions into new markets can, so long as the institutions prove resilient, increase the availability of funds to borrowers in times of stress and may thus reduce the likelihood of credit crunches. although financial innovations have the capacity to improve economic welfare overall, it is natural for policymakers to worry that innovations may have unexpected and undesirable side effects and may even represent new sources of systemic risk. for example, policymakers may be concerned about unexpected price dynamics or problems in infrastructure or operations. market participants estimate how prices and investment flows are likely to behave for new instruments, but their understanding becomes more detailed and more accurate only as behavior under a variety of economic conditions is observed, and the development of that understanding obviously takes time. under turbulent conditions, or when new information causes market participants to question their own investment strategies, their behavior may change rapidly, leading to rapid price changes that may seem outsized relative to changes in economic fundamentals. that was briefly the case recently in the market for synthetic collateralized debt obligations. market participants did not anticipate the sharp decline in implied default correlations that followed the downgrades of ford and general motors debt. prices moved quite a bit for a short time as portfolios were rebalanced, but spillovers to other markets were limited, and market volatility subsequently eased. problems with the infrastructure or operations that support an innovation - - including the underlying legal documentation and accounting - - are also likely to be revealed only over time, as exemplified by the technical difficulties with restructuring clauses in credit default swaps that became apparent a few years ago. in that case, default events and related payoffs sometimes did not occur as expected, and so actual exposures differed from