The major dealers and their principal supervisors met at the Federal Reserve Bank of New York about two weeks ago to review progress and discuss next steps. The dealers are now in the process of reaching agreement on a new set of proposals designed to build on the progress to date and produce a more mature, efficient and operationally robust post trade processing infrastructure for the OTC derivatives market. I want to conclude with a few observations about the role of supervision in encouraging progress in both these areas of risk management and the infrastructure for these markets. We live in a system in which nonbank financial institutions play an increasingly important role in a wide range of financial markets, in which the differences between the activities of bank-centered financial institutions and nonbanks has substantially diminished, and in which the largest banks and investment banks in the world compete together in the U.S. market and in other major markets. These changes have many positive implications but they also mean that differences in the incentives faced by institutions with different supervisory and regulatory regimes can have larger competitive effects, and the effects of regulatory arbitrage can reduce the impact of changes applied only to regulated or supervised institutions. They suggest that adverse developments outside the banking system, such as the failure of a major nonbank financial intermediary, can potentially cause greater damage to the core of the financial system than might have been the case in the past.
And I will offer some perspectives on how these challenges should affect the hierarchy of priorities of central banks, and of those who have responsibility for supervision and oversight of the financial system. A characteristic feature of periods of financial innovation is that growth in new instruments and changes in the structure of those markets can outpace the development of the risk management and processing and settlement infrastructure. This gap, the gap between the speed at which markets move to capture the benefits of new opportunities and the pace of development in the supporting control and execution infrastructure, is inevitable. The size and duration of the gap and the risks it presents to the financial system are a function both of will and of ability. They are determined, in part, by the scale of investments that firms make in the infrastructure-investments in people, in technology and in control processes-and they are determined in part by knowledge and experience, which are functions of the environment surrounding innovation. Market discipline exercised by counterparties should create incentives to close these gaps relatively quickly, but competition among financial intermediaries can, at least for some period of time, create offsetting incentives and may make individual institutions less willing to move ahead of the pace of improvement of average practice among market participants. This can take the form of what economists call a collective action problem, leaving individual institutions and the systems as a whole with more risk than would be desirable.