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Banks are exposed to credit risk in all areas of business: loans, letters of credit, guarantees and foreign exchange settlement to name a few. The arrival of credit default swaps in the mid 1990s transformed bank credit portfolio management by allowing banks to lay off the credit risk that, in its raw form, was virtually unsellable.

The very nature of illiquid non-standard credit instruments (and most credit risk fits this definition) means that the instrument itself often cannot be hedged or even sold: it is the credit risk of the instrument that is being hedged. The “liquidity” that is brought by credit derivatives is risk liquidity, not cash liquidity.

Banks tend to specialise in regions, industries and products, and the bulk of their business is often done with a small percentage of their clients. Over time this can produce very lumpy credit portfolios that, before the arrival of credit derivatives, could only be managed (not hedged) by imposing limits and by striving for diversification.

To ban CDS altogether would virtually remove a bank’s ability to manage credit risk; to ban naked shorts would completely remove the ability to find proxy hedges for the huge array of credit risk that cannot be sold or directly hedged. More
Ban will restrict ability to manage credit risk, Financial Times, Letter, Robert Reoch, New College Capital, London