The Office of Financial Research, within the US Department of the Treasury, was created by the Wall Street Reform and Consumer Protection Act of 2010 (commonly known as the Dodd-Frank act), to provide analysis and data for the Financial Stability Oversight Council, another creation of the same law. It’s Financial Stability Report 2017 discusses some “key vulnerabilities” of the financial system.
Cybersecurity Incidents. “Cybersecurity incidents rank near the top of our threat assessment because of the potential for disruption of operational and financial networks, and the damage such disruptions could cause to financial stability and to the broader economy. Cyber incidents can affect financial stability if defenses fail.”
Resolution Risks at Systemically Important Financial Institutions. The term “resolution risk” refers to what process will begin if a big financial institution becomes insolvent. The regulators are still struggling to address some possible issues. “The treatment of derivatives held by a failing financial firm continues to present a conundrum for policymakers seeking to balance contagion and run risks against moral hazard concerns. Tools for orderly resolution of failing systemic nonbank financial firms remain less developed than for banks, despite the material impact of some nonbank failures in the past and the growing importance of nonbanks, particularly central counterparties (CCPs), in the financial system.”
A Single Bank Deals with all Treasury Securities. The Treasury market will soon be more dependent on a single bank for the settlement of Treasury securities and related repos. A service disruption, such as an operational risk incident or even the bank’s failure, could impair the liquidity and functioning of these markets because some customers will need time to move their operations elsewhere. It could also disrupt other markets that rely on Treasuries for pricing and funding. The 2007-09 financial crisis showed the damage that can be done if activity in short-term funding markets is constrained. Dealers in Treasury securities use clearing banks to settle Treasury cash transactions. Since the 1990s, these services have been provided by two clearing banks, JPMorgan Chase & Co. and Bank of New York Mellon Corp. (BNY Mellon). With JP Morgan Chase’s announcement in July 2016 that it intends to cease provision of government securities settlement services to broker-dealer clients, this business will be concentrated in a single bank. A disruption in BNY Mellon’s Treasury settlement could have broad implications for the Treasury market. It could disrupt trading in Treasuries. If settlement services were interrupted for an extended period, risks could spread further to markets that rely on the Treasury market for hedging and pricing.”
Fragmentation of Stock Markets. In 1996, almost all stock trading happened on the main exchanges of the NYSE or Nasdaq. Now, NYSE and Nasdaq each run a number of separate exchanges, and there are 50 off-exchange stock markets. This fragmentation raises possibilities of playing one market against another, or of liquidity failing in one market with effects cascading across other markets.
