However, innovations constantly introduce additional layers of sophistication and complexity 13 . In this regard, the system of incentives by which professional asset managers operate should be closely and permanently aligned with the interests of investors. •  One specific type of financial innovation is the emergence of new unregulated players whose default might have implications for systemic risk. One such type of investor are hedge funds. Hedge funds’ activities could clearly be the source of systemic risk since they are now major – often dominant – actors in several market segments accounting for 40% of the turnover of major stock exchanges and 25% of the turnover of credit derivatives markets. They are also the main providers of liquidity in some markets that would dry up very quickly should they withdraw. They often leverage themselves with very high multiples either directly through borrowing or indirectly by intensive use of derivatives. •  The importance of hedge funds and more generally of the already mentioned OFIs illustrates that there may be circumstances in which injecting liquidity into the banking system – a traditional tool of crisis management used by central banks – may not be sufficient to prevent major instability. Three main avenues for mitigating the risks of contagion from hedge fund defaults either through potential losses to their bank creditors or through adverse market dynamics have been proposed 14 .
First, appropriate intervention by supervisors vis-à-vis prime brokers to make sure that they ask for and get broad information from hedge funds and that they put in  12  Angeloni, Kashyap and Mojon, 2003  13  Noyer, 2006a  14  Noyer, 2007  4  BIS Review 42/2007  place comprehensive risk management of all hedge funds-related exposures is essential. Second, there may be scope for policy-makers to encourage appropriate organisation of infrastructure in order to improve the information available on the markets in which hedge funds operate. Third, a specific information system to be triggered in the event of a crisis could be established ex ante in order to ensure that relevant information on exposures and positions could be quickly gathered if necessary. -  At the macroeconomic level •  Increased financial asset holding resulting from financial innovation is likely to result in higher sensitivity of households to asset price booms and busts 15 . On the liabilities side of non-financial agents’ balance sheets, by facilitating the management of risk and easing liquidity constraints, financial innovation stimulates both the supply of and demand for credit, which may lead to higher leveraging and financial fragility. Note that both effects run counter to the result I mentioned at the start, i.e. that financial innovation tends to reduce growth volatility. Although this result may still hold true in normal circumstances, it may thus be reversed in specific ones, especially in stress situations.