Limited ability to hedge illiquid exposures

Credit derivatives can effectively hedge credit exposures when an underlying borrower
has publicly traded debt (loans or bonds) outstanding that can serve as a reference
asset. However, most banks have virtually all their exposures to firms that do not
have public debt outstanding. Because banks lend to a large number of firms without
public debt, they currently find it difficult to use credit derivatives to hedge these
illiquid exposures. As a practical matter, banks are able to hedge exposures only for
their largest borrowers. Therefore, the potential benefits of credit derivatives largely
remain at this time beyond the reach of community banks, where credit concentrations
tend to be largest.