Wednesday, May 17, 2023

Amid U.S. debt ceiling logjam, Gensler warns of possible Treasury market risk

By Suzanne Cosgrove

Tracing the history of fires – real ones, like the Great Chicago Fire of 1871, and figurative flare-ups, like the global crisis of 2008, SEC Chairman Gary Gensler noted the past “is replete with times when fires in one corner of the financial system or at one financial institution spread to the broader economy.”

Current near-term risks include “a rise in interest rates more significant than in decades … With such a transition of inflation and rates, it’s appropriate to stay alert to financial stability issues,” Gensler said in a speech delivered Monday at the Atlanta Federal Reserve Financial Markets Conference.

The rise in rates fuels “vulnerabilities related to valuation pressures, borrowing by businesses and households, financial-sector leverage, and funding risks,” said Gensler, citing a recent Financial Stability Report by the Federal Reserve.

Repo financing in the non-centrally cleared market also creates risk in times of stress, Gensler said, “particularly when large, interconnected hedge funds achieve high leverage from banks and prime brokers in the Treasury markets.”

Filling in the gaps. Arguing in favor of more dynamic financial reform, Gensler said the SEC has several projects in the works designed to help ensure U.S. capital markets’ resiliency.

Along with the Department of the Treasury and the Federal Reserve System, the SEC is working to broaden central clearing, register dealers, regulate trading platforms, and promote greater transparency, he said.

He cautioned regulators to watch for gaps when technologies provide new ways of intermediating, transforming, or creating risk and money. “In these instances, regulators often fail to keep pace,” Gensler said.

Watching for risks. Looking further out on the horizon, Gensler noted three additional areas to monitor for their economic and financial impact: moral hazard, the digital economy and artificial intelligence.

“There are tradeoffs of governmental interventions in the markets to forestall the spread of a financial fire,” he said. Moral hazard arises in times of stress when sector support incentivizes greater risk-taking by individuals in the private sector.

Further, the costs of an individual market participant’s failure may not fall on that market participant. “Thus, risk appetites and management may change in a way that’s adverse to financial stability,” he said.

Looking at the digital economy, even excluding the “generally noncompliant crypto markets,” Gensler said, we’ve already seen the effects of fintech and social media on significant parts of consumer finance and investing. “It’s possible, particularly in light of the higher rate environment, that we might see consequential changes to the deposit and banking landscape,” he added.

AI looms large. “Looking further out, the use of predictive data analytics and artificial intelligence might be the most transformative technology of our time,” Gensler said. “This transformation is happening throughout our economy, and finance is no exception.”

AI already is being used in call centers, account openings, compliance programs, trading algorithms, sentiment analysis, robo-advisers and brokerage apps, Gensler noted.

“Such applications can bring benefits in market access, efficiency, and returns. It also has the potential to heighten financial fragility as it could increase herding, interconnectedness and expose regulatory gaps,” he said.