The Financial Stability Oversight Counsel has itemized a number of potential emerging threats and vulnerabilities that could impact the financial stability of the United States in its 2015 annual report to Congress. These threats include the risks of cyber-attacks against financial sector companies and government agencies, as well as the risk that clearinghouses might exacerbate credit and liquidity problems among financial institutions during a period of market stress. (Created under the Dodd-Frank Wall Street Reform and Consumer Protection Act, FSOC consists of representatives of nine federal agencies and one independent member, and is authorized to identify and monitor excessive risks to the US financial system.) FSOC also identified, among other potential concerns, so-called “reach for yield” behaviors of financial services firms whereby they may take on greater risk in the current “historically long, low-yield [interest rate] environment;” changes in market structure caused by the “confluence of factors resulting from technology, regulation and competition” that may be impacting market liquidity; and foreign events that may impact US financial stability. FSOC identified potential cyber attacks on financial sector organizations as a material risk because “[t]he U.S. financial sector is highly dependent upon information technology systems that are often interconnected” and the provision of key services by just a few providers “may create the risk of a cyber incident impacting many organizations simultaneously, with significant impacts on financial sector operations.” FSOC also specifically raised concerns regarding the possibility that “under stressed market conditions [clearinghouses] could transmit significant liquidity or credit problems among financial institutions or markets.” This is because, if multiple clearing members defaulted and pre-funded resources were depleted, the “unexpected timing” for remaining members to replenish CCP resources “could increase market uncertainty during a time of overall market stress,” FSOC wrote. FSOC also raised concerns regarding the potential failure of a global clearinghouse active in multiple jurisdictions. “The failure of such an interconnected financial infrastructure potentially could disrupt financial markets and transmit unpredictable financial stress,” said FSOC.
My View: FSOC’s concerns regarding clearinghouses raises the bar in the debate as to whether US for-profit clearinghouses should be mandated to post at least some level of their own capital in default waterfalls, and what level. Currently, the European Securities and Markets Authority requires European clearinghouses to include at least 25 percent of their own capital in default waterfalls, which represent a compromise from ESMA’s originally proposed 50 percent requirement. It is also important to consider whether clearinghouses should be strongly encouraged (let alone required) to include non-pro-cyclical funding sources (e.g., insurance) in their default waterfall to mitigate reliance on sources of funding that, if used, would likely exacerbate any financial crisis. Regarding threats caused by potential cyber-attacks, Katten Muchin Rosenman LLP will be hosting a seminar on cybersecurity, entitled “The Weakest Link: Where Is The Achilles Heel Of Your Cybersecurity Program,” co-sponsored by the Managed Futures Association, on June 10, 2015. (Click here for details.)