An annual report from the Financial Stability Oversight Council (FSOC) recently focused on the risks presented by the burgeoning fintech industry as well as the continuing "pressing concern" of cyber threats and vulnerabilities.

What happened

The 2016 Annual Report found the financial system to be in good shape generally, with members—including the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Comptroller of the Currency, the Director of the Consumer Financial Protection Bureau, the Chairman of the Securities and Exchange Commission, and the Chairperson of the Federal Deposit Insurance Corporation, among others—in agreement that "financial regulatory reforms and a strengthening of market discipline since the global financial crisis have made the U.S. financial system more resilient, as vulnerabilities remained moderate."

That being said, the Council noted that technological developments might pose threats to the current stability, particularly as many new products and services are not covered by regulation.

"New financial products, delivery mechanisms, and business practices, such as marketplace lending and distributed ledger systems, offer opportunities to lower transaction costs and improve the efficiency of financial intermediation," the FSOC wrote. "However, innovations may also embed risks, such as credit risk associated with the use of new and untested underwriting models. Financial regulators will need to continue to be vigilant in monitoring new and rapidly growing financial products and business practices, even if those products and practices are relatively nascent and may not constitute a current risk to financial stability."

For example, marketplace lending is an "emerging way to extend credit" using algorithmic underwriting that has not been tested during a business cycle, the Council wrote, "so there is a risk that marketplace loan investors may prove to be less willing than other types of creditors to fund new lending during times of stress."

In addition, financial regulators will need to keep an eye on "signs of erosion" in lending standards as the industry continues to grow. "In other markets, business models in which intermediaries receive fees for arranging new loans but do not retain an interest in the loans they originate have, at times, led to incentives for intermediaries to evaluate and monitor loans less rigorously," the FSOC cautioned. "Furthermore, given the rapid rise in the number of marketplace lenders who often compete with traditional lenders for the same borrowers, there is a risk that underwriting standards and loan administration standards of these lenders could deteriorate . . . which could spill over into other market segments."

As for distributed ledger systems, they also pose risks and uncertainties that "market participants and financial regulators will need to monitor," according to the report. "Market participants have limited experience working with distributed ledger systems, and it is possible that operational vulnerabilities associated with such systems may not become apparent until they are deployed at scale."

For example, Bitcoin trade confirmation delays have increased dramatically in recent months, the FSOC wrote, and trade failures have occurred "as the speed with which new Bitcoin transactions are submitted has exceeded the speed with which they can be added to the blockchain."

Financial regulators that have previously worked to regulate market activity will need to adapt to the changing market structure as distributed ledger systems reduce the importance of centralized intermediaries, the Council said, and coordination among regulators may be necessary to identify and address risks given that users of such systems span national boundaries and regulatory jurisdictions.

Another worry expressed by the Council: cyber threats and vulnerabilities "continue to be a pressing concern." Cybersecurity-related incidents create significant operational risk, the regulators said, and while investments in cybersecurity by the financial services sector in recent years have been critical to reducing vulnerabilities, continuing these efforts should remain a top priority.

The Council recommended information sharing, having baseline protections in place, and preparations for response to and recovery from cyber incidents.

To read the FSOC's 2016 Annual Report, click here.

Why it matters

The balance between facilitating innovation and integrating constructive regulation remains a high priority for government. The FSOC Annual Report recognized that innovation allows market participants to adapt to changing marketplace demands, exploit the benefits of new technology, and respond creatively to regulatory constraints. However, the regulators noted the flip side of that positive thinking. "Precisely because innovations are new and potentially disruptive, they merit special attention from financial regulators who must be vigilant to ensure that new products and practices do not blunt the effectiveness of existing regulations or pose unanticipated risks to markets or institutions," the report cautioned. While marketplace lending and distributed ledger systems currently play a relatively small role in financial markets, their potential for growth means members of the Council will be keeping a close eye on both. "Financial regulators should continue to monitor and evaluate the implications of how new products and practices affect regulated entities and financial markets and assess whether they could pose risks to financial stability."