Liquidity 29 These problems of incomplete information, and misaligned incentives have had a major impact on the market liquidity of innovative financial instruments. 30 As described above, misaligned incentives in origination and distribution allowed the provision of sub-prime mortgages to households with very little prospect of repayment and significant vulnerability to modest changes in economic circumstances. So any investor trying to estimate the distribution of likely future delinquency rates amongst sub-prime borrowers would not only have to consider the range of macroeconomic outcomes but also how much this effect would be amplified by poor credit risk screening. This would be an extremely difficult variable to quantify. But because of the sensitivity of complex securities to small changes in loss rates, differing judgements about the quality of risk screening could make a material difference to the value of the instrument. The recognition that risk screening and the availability and quality of information on the performance of complex products was significantly weaker than previously anticipated, as for example investors lost confidence in the quality of credit ratings, led to a substantial increase in the risk premium required to hold such assets. These effects made the valuation of assets extremely uncertain and contributed to the rapid evaporation of secondary market liquidity. 31 There is also an important and fundamental tension between the capability of financial engineering to tailor financial products to meet individual investor demand more effectively and secondary market liquidity.
Section 4 highlights the  1  “Innovation and Integration in Financial Markets and the Implications for Financial Stability”, Rob Hamilton, Nigel Jenkinson and Adrian Penalver, pp. 226-250, The Structure and Resilience of the Financial System, eds Christopher Kent and Jeremy Lawson, Reserve Bank of Australia, November 2007. 2  See for example, the Bank of England Financial Stability Report, October 2007 and the Bank of England Financial Stability Report, April 2008. 3  See for example World Finance and Risk Management, delivered at Lancaster House 25 September 2002. 4  Referring to derivatives in the Berkshire Hathaway Inc. 2002 Annual Report. BIS Review 93/2008  1  obstacles to fulfilment of that vision given the imperfections in financial markets. Lessons for the future and possible policy responses are discussed in Section 5, while Section 6 concludes. Section 2: Trends in financial innovation 5 The pace of change in financial markets in recent years is truly remarkable. A few statistics help to illustrate this point and set the scene: •  The outstanding value of interest rate swaps and other derivatives reached almost $ trillion or some 11 times annual global GDP by the end of 2007, according to the BIS. Ten years ago the value was around $ trillion (2 ½ times GDP) (Chart 1). The global derivatives market expanded almost 50% during 2007.