These concerns are based in part on uncertainty - a candid acknowledgment that there is a lot we do not yet know about how these instruments and the increased role of nonbank institutions in these markets will affect how the financial markets are likely to function in conditions of stress. Or to put it a bit differently: this concern comes from an awareness of the formidable complexity of measuring the scale of potential exposure in many of these instruments, and it comes from an awareness of the difficulty in anticipating how changes in credit market structure are likely to affect the behavior of financial market participants and market liquidity across a wide spectrum of financial and macroeconomic conditions. The velocity of change itself would not be particularly interesting if the scale of exposures involved were still small, but this is not the case today. Credit derivatives, although still only 7 percent of estimated total notional over-the-counter (OTC) derivatives contracts, generate a significant fraction of total counterparty credit exposure. The direct counterparty credit exposure in OTC derivatives is quite large relative to the capital cushions of the major banks and investment banks, and relative to more traditional forms of credit exposure. Further, these exposures merit more attention because they may be harder to measure than those in the more mature interest rate and exchange rate derivatives.
And the increase in the diversity of nonbank financial institutions that hold risk may also serve as a stabilizing force in credit markets. But the greater relative importance of nonbank financial institutions also means that distress among these institutions has the potential to have a substantial impact on market behavior and liquidity. Understanding these relationships is an important part of the risk management challenge for banks, even in a world where derivatives have helped spread risk more broadly. The innovations that have taken place in the credit derivatives market were driven to a significant degree by the losses experienced in past crises, but most of the growth in this market has occurred in relatively favorable overall economic and financial conditions. This wave of innovation in credit markets has occurred in an environment in which: •  the price of insurance against credit risk has fallen substantially as realized losses have declined and perceptions about corporate credit fundamentals have improved;  •  volatility has declined in many different types of asset prices, as have expectations of future volatility  •  the number of bank failures in the United States have fallen to levels not seen in a generation or more, and the price of protection against default by the largest financial institutions has fallen to levels that suggest a very low probability of failure; and  •  overall liquidity in markets has been high.