To begin, let me acknowledge that the events of 1998, and the resulting recommendations of the private-sector Counterparty Risk Management Policy Group (CRMPG), and other groups, were followed by very significant improvements in risk management practices, including those related to hedge fund counterparty exposures. At a general level, these changes were significant because they offered the promise of limiting the overall hedge funds could take on, as well as the direct credit exposure of firms to hedge funds. Specifically, firms put in place stronger internal due diligence regimes to manage hedge fund exposures. They imposed stricter credit terms, required more collateral, adopted daily margining and more conservative practices for valuing collateral. They put greater emphasis on measuring potential future credit exposures, while adopting more sophisticated ways of measuring and stress testing those exposures. Firms have also sought to obtain more information from hedge funds about the risks the funds are taking on, although more often than not this seems to have taken the form of periodic onsite visits and informal discussions rather than through a regular and frequent flow of detailed risk reports. These improvements are notable, but a few qualifications are in order. First, progress has been uneven across the major dealers. Second, there are signs of some erosion in standards in response to competitive pressures, reflected in some lowering of initial margin requirements and a relaxation in other credit terms.
Those reforms have played an important role in reducing risk in the system, alongside the overall improvements in capital, risk  4  BIS Review 70/2004  management, and the financial infrastructure. Further progress in strengthening risk management practices is an investment worth making, particularly at a time when the markets appear to be pricing in a relatively benign view of risk in the financial system and in the economy overall. BIS Review 70/2004  5