have been selling protection on intermediate tranches of credit portfolios, say on losses between 3 % and 7 %. although they are effectively short an option on portfolio credit risk, they are widely regarded as passive investors who do not dynamically hedge. their counterparts, the dealers, are initially long an option on portfolio credit risk ; as spreads generally widen, the value of the bought - protection position increases non - linearly. over time it became popular amongst short - term leveraged traders to exploit the strong supply of intermediate ( or mezzanine ) protection by holding a bought - protection position on mezzanine tranches as a hedge against selling protection on equity tranches. this was a so - called long credit correlation position, as its value would tend to increase with rises in the implied correlation of default risk among the companies represented in the underlying portfolios. in effect, traders were betting that implied correlation, as modelled, would not fall. as well as being highly convex, the position ’ s popularity no doubt owed something to a straightforward search for yield : the big positive carry from being long high - yielding equity tranches and short lower - yielding mezzanine. this type of position did, though, leave holders exposed to so - called idiosyncratic risk ; that ’ s to say, a deterioration in the credit of a few constituents of the underlying portfolio. this was akin to a short - option position, requiring dynamic hedgers to buy protection as spreads widened on troubled names. when gm and ford spreads rose, these correlation positions unravelled as traders went into the market to cover themselves. in effect, the structured credit market was reminded that credit risk has a major idiosyncratic element ; that even the most sophisticated statistical models can be found wanting when they are detached from fundamentals and / or based on short runs of data ; that hedging can hurt when a trade is ‘ crowded ’ ; and that, in such circumstances, volatility can suddenly spike and spreads move in unplanned - for ways. there are still - more complex variants. in some instances, options are embedded into products where there isn ’ t a liquid market in options with quite the same characteristics or long expiry dates. powerreserve dual currency bonds may be an example, 4 although not one where excess volatility has yet crystallised. while these and other examples suggest that, in certain conditions, volatility can be exacerbated by option - driven

derivative positions, related in part to the growth of hedge fund participation in the structured credit market. if something really bad were to happen, the system would, perhaps, be less robust than otherwise if dealers were not sure about who their counterparties were, etc. this is the type of challenge where collaboration across the industry is needed ; and where individual firms ’ incentives are stronger if they can each be confident that their peers are taking broadly the same actions. what i have in mind is the disincentive a firm faces in being tough with a hedge fund client if they doubt their peers will take the same line. bodies such as isda have a role to play here, and i understand are doing so. collective elements in atomistic markets so, where are the risks? they are all around us all of the time, of course. some will crystallise. but that need not lead to disorder. indeed, in most circumstances, global capital markets are deep and liquid enough – having a sufficiently wide range of participants able to trade with each other, and with different risk appetites and different actual risk exposures – to absorb shocks. but history suggests that strains can appear at times. and as the system develops, we need to be alive to whether cracks might show up in new places or old weaknesses manifest themselves in new ways. the two challenges i have sketched out for today ’ s markets – the incidence, now and then, of structural short option positions amongst short - term traders ; and of controls occasionally lagging behind innovations – have a common feature. they both entail understanding markets as something more than the positions of atomistic agents. in the first case, market participants have an interest in factoring into their risk management an assessment of whether a market has structurally imbalanced option ( or option - like ) positions. in the second case, market participants have an interest in working together to establish robust practices and infrastructure when a particular innovation takes off. many risk managers are, of course, well seized of this. let ’ s hope they are empowered too. as practitioners, you can, and should, play a part in buttressing the system – by continuing to innovate, and by factoring collective outcomes into your private calculus and risk management.