the potential for hedge fund leverage to adversely affect market dynamics. perhaps the recent widening of credit spreads will engender increased caution by managers of credit risk. moreover, as in 1999, cooperative private - sector efforts to identify and implement sound risk - management practices have the potential to reinforce the efforts of individual firms and their prudential supervisors. in this regard, a very encouraging development is the recent formation, by leading banks, securities firms, insurance companies, asset managers, and hedge funds, of a new group ( crmpg ii ) to assess improvements in risk management since 1999 and to update the crmpg recommendations to reflect subsequent changes in risk - management practices and in the financial, regulatory, and legal environment. ensuring sound credit - risk management by hedge funds'counterparties remains the most promising approach to addressing concerns about hedge fund leverage. some may believe that government regulation of hedge fund leverage would be more effective. but it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds. a regulatory capital regime that was not extraordinarily risk - sensitive would be ineffective at constraining hedge funds'risk - taking. at the same time, it would impair their capacity to pursue strategies that enhance the efficiency and liquidity of our financial markets and thereby to contribute to the productivity and resilience of our economy. conclusion the rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress. even with sound credit - risk management, a sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds. risk management involves judgment as well as science, and the science is based on the past behavior of markets, which is not an infallible guide to the future. yet the history of the development of these products encourages confidence that many of the newer products will be successfully embraced by counterparty risk management policy group ( 1999 ). " improving counterparty risk management practices ( 348 kb pdf ), " report available through the house committee on financial services. the markets. to be sure, for that favorable record to be extended, both market participants and policymakers must be aware of the risk - management challenges associated with the use of derivatives to transfer risk, both

least three specific concerns. first, market illiquidity may result from a leading dealer's exit and that illiquidity has the potential to adversely affect fannie and freddie and other hedgers of mortgages and mbs. second, meeting the demands for options by mortgage hedgers involves market risk to dealers, a concern that has been heightened by the fact that the notional value of options sold by dealers significantly exceeds the notional value purchased. third, the failure of a leading dealer could result in counterparty credit losses for market participants. the extent to which these concerns are valid depends on how effectively market participants manage market risk and counterparty credit risk. to obtain information on participants'risk - management practices, members of the federal reserve staff last summer interviewed some of the leading market participants, including fannie and freddie and half a dozen leading derivatives dealers. the potential for a dealer's exit to adversely affect mortgage hedgers is dependent upon hedgers'diversification of counterparties, the way in which hedgers use options, and the underlying reason for such an exit. fannie and freddie have about twenty dealers as options counterparties, including investment banks and foreign banks as well as u. s. commercial banks. however, only about five or six of them have direct access to the supply of options from debt issuers ; the others must depend on the interdealer market for a substantial portion of their supply. the exit of one of these five or six may or may not adversely affect market liquidity, depending on the reason for the exit and on the way in which other dealers react. if a dealer is forced to exit because of a credit problem unrelated to its options dealing, other dealers are likely to take its place quickly. if the exit is the result of losses from options dealing, possibly in difficult market conditions, other dealers with similar positions are likely to be pulling back as well, which could leave the options markets quite illiquid. in any event, fannie and freddie and other mortgage hedgers do not rely on continuous liquidity in the options markets. rather, they purchase options periodically and opportunistically. provided that options market illiquidity is not protracted ( say more than a month ), they could postpone transacting in those markets until liquidity returns, without exceeding their internal risk limits. by contrast, mortgage hedgers do rely on continuous liquidity in the swaps market because they currently use swap