Let me therefore pose another question: has the use of these credit risk transfer mechanism helped to distribute risks, making the financial environment a safer place? On the plus side, credit transfer mechanisms can “redistribute” risks, as default losses would be absorbed by a larger number of investors than otherwise. Some of the losses may be borne by sophisticated players (such as hedge funds or some institutional investors) who are well diversified and can better bear the losses. Credit transfer mechanisms also allow banks (via credit derivatives) to improve their own risk management and enable them to diversify their risk profiles. However, the use or risk transfer mechanisms can contribute to opacity in the distribution of risks, especially once risks are transferred to unregulated entities (i.e. non-banks). This could lead to bunching of risks in particular areas. Additionally, the use and constant innovation of credit risk transfer mechanisms has allowed risk to take on more complex forms, making risk less traceable. My final point will be on the resulting challenges to central banks of small open economies. Central banks need to understand how globalization affects three main objectives: (1) the domestic inflation process, (2) the transmission mechanism of monetary policy, and (3) financial stability. Let me point out at the outset that empirically, there is still some disagreement to the extent of each effect. First of all, it has been argued that the domestic inflation process has been largely changed by trade globalization.
Thirdly, similar investment strategies employed by hedge funds and other funds could  BIS Review 74/2007  1  lead to momentum trading and herd movements, both in terms of inflows and outflows. Any shocks that trigger a change in these strategies could result in large movements of capital. In any case, whether owing to the changes in risk appetite or not, we must remind ourselves that the current pricing of risk is based on the expectation that strong growth and contained inflation will continue to prevail. Any unexpected deterioration of the macroeconomic environment, however, could trigger a rapid turnaround in sentiment. This leads me to my next point, which I had raised earlier, of whether the increase in capital flows to emerging markets was likely to result in an increase in risks? This seems the likely case. For example, local investors do not usually provide counter-trade to hedge funds but rather take similar positions, hence increasing the overall risks. In addition, investment of hedge funds in a particular country is usually only a small fraction of their whole portfolios, and inflows reversals may take place easily. Individual risk management can also collectively induce systemic risks, and central banks may be required to resolve such problems to avoid adverse impacts from sudden reversal of capital flows. This leads us to the question of whether we are underestimating the inherent risks of these capital flows? Let me explain why this may be the case. First of all, net capital flows are small.