Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity

LAW AND ECONOMICS OF RISK IN FINANCE, Peter Nobel and Marina Gets, eds., pp. 41-72, Schulthess, Z├╝rich, 2007

U. of St. Gallen Law & Economics Working Paper No. 2008-14

33 Pages Posted: 27 May 2008 Last revised: 7 Aug 2008

Heinz Zimmermann

University of Basel - Center for Economic Science (WWZ) - Department of Finance

Date Written: June 2007

Abstract

This paper provides a discussion about some recent issues related to the transfer of credit risk (CRT) from the perspective of global liquidity. The CRT market is enormously growing and exhibits major structural shifts in terms of buyers and sellers of protection. I try to address these issues from an options perspective by suggesting that liquidity providing can be understood, in economic terms, as selling put options. The overall conclusion of the paper is that it is not the extent of CRT per se, as often claimed, which causes liquidity related systemic risk, but rather the potential coordination failures of the behavior market participants in adverse market environments. In this context, I critically address the role of investments banks in providing liquidity to hedge funds, and finally, the (limited) access of global banks to central bank liquidity through cross-border collateral trading. Since coordination failures, seen as the major issue of a potential liquidity crisis, is to a large extent a matter of market structure, regulatory actions to improve liquidity should focus on the architecture of the financial system in the first place, not so much on the behavior of individual agents. Market stabilization should therefore be understood as a process of establishing informative markets and adequate infrastructure.

Keywords: transfer of credit risk, hedge funds

JEL Classification: K22, G10, G20

Suggested Citation

Zimmermann, Heinz, Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity (June 2007). U. of St. Gallen Law & Economics Working Paper No. 2008-14; U. of St. Gallen Law & Economics Working Paper No. 2008-14. Available at SSRN: https://ssrn.com/abstract=1137924 or http://dx.doi.org/10.2139/ssrn.1137924

Heinz Zimmermann (Contact Author)

University of Basel - Center for Economic Science (WWZ) - Department of Finance ( email )

Peter Merian Weg 6
Basel, 4002
Switzerland
+41 61 267 33 16 (Phone)
+41 61 267 08 98 (Fax)

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