US regulator warns against operational vulnerabilities in Blockchain applications and cyberattacks

The Financial Stability Oversight Council (Council) has published its 2016 annual report. The Council reports annually to Congress on a range of issues, including significant financial market and regulatory developments, potential emerging threats to the financial stability of the United States, and the activities of the Council. The report also makes recommendations to promote market discipline; maintain investor confidence; and enhance the integrity, efficiency, competitiveness, and stability of U.S. financial markets.

“The Council’s annual report is a vital vehicle to publicly highlight potential threats to financial stability and is another example of how Wall Street Reform has improved coordination among financial regulators,” said Treasury Secretary Jacob J. Lew. “In this year’s annual report, the Council outlines potential threats on the horizon and offers an important roadmap to help guide the Council’s focus in the coming years. I look forward to continued collaboration with members of the Council as we carry forward this work.”

The Council’s findings are organized around the following 12 themes that warrant continued attention and, in many cases, further action from the Council’s members or member agencies:

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  • Cybersecurity: Government agencies and the private sector should continue to work to improve and enhance information sharing, baseline protections such as security controls and network monitoring, and response and recovery planning.
  • Risks Associated with Asset Management Products and Activities: The asset management industry’s increasing significance to financial markets and to the broader economy underscores the Council’s ongoing consideration of potential risks to U.S. financial stability from products and activities in this sector, including further analysis of the activities of hedge funds.
  • Capital, Liquidity, and Resolution: Regulators should continue working to ensure that there is enough capital and liquidity at financial institutions to reduce systemic risk, including finalizing rules setting standards for the minimum levels of total loss-absorbing capacity and long-term debt maintained by certain large banking organizations operating in the United States.
  • Central Counterparties (CCPs): Member agencies should continue to evaluate whether existing rules and standards for CCPs and their clearing members are sufficiently robust to mitigate potential threats to financial stability, and should also continue working with international standard-setting bodies to implement more granular guidance with respect to international risk management standards in order to enhance the safety and soundness of CCPs.
  • Reforms of Wholesale Funding Markets: Counterparty risk exposure has been significantly reduced in the tri-party repurchase agreement, or repo, market, though the potential for fire sales of collateral by creditors of a defaulted broker-dealer remains an important risk. Better data are needed to assist policymakers’ understanding of how the aggregate repo market operates. Furthermore, regulators should continue to monitor and evaluate the effectiveness of structural reforms of money market mutual funds.
  • Reforms Relating to Reference Rates: Regulators and market participants should continue their efforts to develop alternative benchmark interest rates and implementation plans to achieve a smooth transition to these new rates.
  • Data Quality, Collection, and Sharing: While Council members have made progress in filling gaps in the scope, quality, and accessibility of data available to regulators, regulators and market participants should continue to work together to improve the scope, quality, and accessibility of financial data.
  • Housing Finance Reform: While regulators and supervisors have taken great strides to work within the constraints of conservatorship to promote greater investment of private capital and improve operational efficiencies with lower costs, federal and state regulators are approaching the limits of their ability to enact wholesale reforms that are likely to foster a vibrant, resilient housing finance system. Housing finance reform legislation is needed to create a more sustainable system that enhances financial stability.
  • Risk Management in an Environment of Low Interest Rates and Rising Asset Price Volatility: Depressed energy and metals commodities prices, large swings in equity valuations, and upward movement in high-yield debt spreads underscore the need for supervisors, regulators, and managers to remain vigilant in ensuring that firms and funds maintain robust risk management standards.
  • Changes in Financial Market Structure and Implications for Financial Stability: The growing importance in certain markets of propriety trading firms and automated trading systems may introduce new vulnerabilities, including operational risks associated with the very high speed and volume of trading activity. Increased coordination among regulators is needed to evaluate and address these risks.
  • Financial Innovation and Migration of Activities: 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.
  • Global Economic and Financial Developments: Market participants and regulators should be vigilant to potential foreign shocks that could disrupt financial stability in the United States.

With regard to blockchain technology, the FSOC report points out that like most new technologies, distributed ledger systems also pose certain risks and uncertainties which market participants and financial regulators will need to monitor. 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, in recent months, Bitcoin trade confirmation delays have increased dramatically and some 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. Similarly, although distributed ledger systems are designed to prevent reporting errors or fraud by a single party, some systems may be vulnerable to fraud executed through collusion among a significant fraction of participants in the system. Distributed ledger systems have the potential to change the way some asset classes are traded and settled. Financial regulators have often worked with those market infrastructures and firms which facilitate trading and settlement, such as exchanges, dealers, and clearinghouses, to monitor markets and, in some cases, regulate market activity. To the extent that distributed ledger systems ultimately reduce the importance of these types of more centralized intermediaries, regulators will need to adapt to the changing market structure.

Furthermore, since the set of market participants which makes use of a distributed ledger system may well span regulatory jurisdictions or national boundaries, a considerable degree of coordination among regulators may be required to effectively identify and address risks associated with distributed ledger systems.

The FSOC also highlighted that Cybersecurity threats and vulnerabilities continue to be pressing concerns for companies and governments in the United States and around the world. In the U.S. financial system, cybersecurity remains an area of significant focus for both firms and the government sector.

This attention is appropriate, as cybersecurity-related incidents create significant operational risk, impacting critical services in the financial system, and ultimately affecting financial stability and economic health. Financial services sector companies and industry groups, executive branch agencies, financial regulators, and others have made notable progress in improving cybersecurity and resilience throughout the system. This progress includes developing and testing of system-wide plans for responding to major incidents, the expansion of information sharing programs through organizations like the Financial Services Information Sharing and Analysis Center (FS-ISAC), and the continued development of regulatory and non-regulatory structures for assessing and addressing firms’ cybersecurity risk levels. Continuing to advance these and other efforts should remain a top priority for business and government leaders, and the Council makes several recommendations for doing so which build on recommendations made in last year’s annual report.

The full FSOC report is available here via the website of the U.S. Department of the Treasury.

Lavanya Rathnam

Lavanya Rathnam is an experienced technology, finance, and compliance writer. She combines her keen understanding of regulatory frameworks and industry best practices with exemplary writing skills to communicate complex concepts of Governance, Risk, and Compliance (GRC) in clear and accessible language. Lavanya specializes in creating informative and engaging content that educates and empowers readers to make informed decisions. She also works with different companies in the Web 3.0, blockchain, fintech, and EV industries to assess their products’ compliance with evolving regulations and standards.

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