SEC Chair Gensler Warns of "Financial Fires" Spread by Market Interconnectedness
Commentary by Steven Lofchie
In remarks before the Atlanta Federal Reserve Financial Markets Conference, SEC Chair Gary Gensler warned that finance is a "complex, interconnected, global network, with many transmission channels by which financial fires might spread." He likened the SEC efforts on promoting financial resiliency to that of "fire prevention and firefighting equipment," and highlighted steps taken to address regulatory gaps:
- Treasury Markets. Mr. Gensler said the SEC, together with Treasury and the Federal Reserve System - initiated projects to reform Treasury markets, money markets and short term funding markets. He highlighted that "many hedge funds are receiving the vast majority of their repo financing in the non-centrally cleared market," which "might create greater risk in times of stress, particularly when large, interconnected hedge funds achieve high leverage from banks and prime brokers in the Treasury markets." He cited efforts to broaden central clearing, registering dealers, regulating trading platforms, and promoting greater transparency.
- Clearing. Mr. Gensler stated that due to their being situated at the center of capital markets, regulators should "continually look to update rules regarding clearing and clearinghouses themselves." He said that the SEC will be considering a proposal on covered clearing agency’s recovery and wind-down plan at an upcoming meeting.
- Private Funds. Mr. Gensler said that private funds are present in almost every sector of the U.S. capital markets and are interconnected through banking and broker-dealer leverage. He said that the SEC put forth a private-fund-related proposal that would require advisers to identify and report events signaling potential systemic risk or investor harm.
- Money Market Funds. Mr. Gensler warned that money market funds and open-end bond funds have a potential for "liquidity mismatch." He highlighted SEC proposals aimed at addressing structural issues to increase these funds’ liquidity risk management.
- Cyber. Mr. Gensler said that the financial sector increasingly relies on "complex, interconnected, and ever-evolving information systems" while bad actors continue to grow in sophistication. To this end, Mr. Gensler stated that the SEC has proposed several regulations to strengthen cybersecurity practices and incident reporting.
Financial Risks
Mr. Gensler emphasized that if Treasury were to default on debt, then there would be a "raging [financial] fire." He highlighted additional risks to U.S. financial stability, including: (i) certain moral hazards (i.e., when government action - during times of financial stress - incentivizes greater risk taking by the private sector), (ii) "consequential changes" brought about by the digital economy to the deposit and banking landscape and (iii) and "herding, interconnectedness, and regulatory gaps."
Commentary
More regulation does not solve all problems. Recent banking failures do not result from any shortage of rules. They result from high inflation, bad management, and failed supervision, with high inflation being the precipitating cause.
There is no reason to believe that more regulation of central clearing would make markets safer. Based on the reports on the failure of Lehman Brothers, the Trustee blamed DTC and the other central clearing agencies for worsening the crisis because of their unrestrained ability to demand more collateral.
Given Mr. Gensler's emphasis on cyber-risk, it seems odd not to address whether forcing all trading and repo activity in U.S. governments to flow through a single central clearing hub will increase that risk. It seems dangerous to centralize clearing risk for U.S. governments in this way. Should there be a successful cyber attack on the clearing house, the U.S. financial markets would likely shut down.