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Systemic Risk Mitigation Should Be Front of Mind in Technological Innovation

By Michael Leibrock, DTCC Chief Systemic Risk Officer and Head of Counterparty Credit Risk | 5 minute read | March 6, 2023

Emerging technologies hold considerable promise and benefits for the global financial system. Distributed ledgers, for example, could be used to validate and track transactions on a distributed and decentralized platform, providing a compelling alternative to today’s centralised payment infrastructures. More specifically blockchain, a type of distributed ledger technology (DLT), could improve efficiency in existing international payments systems and infrastructures. The payments sector is a great example of how technology has helped increase client access to the financial system while enhancing the user experience leveraging innovative payment tools.

After all, new technologies are significantly changing the way society and the financial services industry conduct business. Initially, many fintech developments focused on enhancing existing capabilities through innovative technologies, such as the cloud, Application Programming Interfaces (APIs) and machine learning. Today, fintech applications are looking to fundamentally transform the way counterparties interact with one another, for example by using distributed ledgers, smart contracts and digital assets.

Addressing New Risks
Despite the multiple current and potential use cases, no new technology application comes without risks. First and foremost, the interdependency or interconnectedness of the global financial marketplace should be front of mind when considering new technology implementations. Recent events in the crypto industry highlighted the increased risk of contagion to the financial sector and the real economy.

Indeed, a recent report by the Financial Stability Board (FSB) has shown that correlations between crypto asset prices and mainstream equity indices have been steadily increasing. Meanwhile, the use of DLT, while minimizing some risks and providing efficiencies, simultaneously increases the number of points of potential failure, as well as the risk of data breaches, hacking and other types of third-party risk. According to DTCC’s most recent Systemic Risk Barometer survey, the threat posed by cyber risk is considered one of the top three risks in financial services. Consistently ranked as one of the top risks since the survey first launched in 2013, against the backdrop of increasing adoption of new technology solutions and the related risks to the industry, this trend is only likely to accelerate in coming years.

There are also a number of other influential factors that should be addressed. For example, models, including AI-based models, have contributed to faster and often better decision-making. However, an over-reliance on models that are calibrated largely on historical data and events can be less effective when unprecedented, exogenous shocks occur. For example, the Covid-19 pandemic led to widespread deficiencies in credit rating models, as the dislocation of historically stable fundamental credit risk factors and macro-economic variables produced unreliable probability of default estimates.

Additionally, the overreliance on high-speed processing and output decision making can lead to errors, lack of transparency, and underpin unintended biases. Furthermore, conflicting national priorities can also impede cross-border data sharing, compromising efforts around tackling cyber terrorism and financial crimes – both of which are on the rise. Finally, the use of social media platforms and online forums has the potential to negatively impact market volatility and risk, enabling frictionless retail financial participation on low-cost digital platforms and brokerages which, for example, contributed to the 2021 meme stock event.

Increasing Regulatory Focus
Regulators and policymakers globally are increasingly cognizant of the technology-driven risks to market resilience and have been implementing measures to enhance the industry’s focus on model risk management and to encourage industry collaboration. In the U.S. for example, the White House executive order on responsible development of digital assets issued in March 2022 focused on consumer and investor protection and ensuring financial stability. This was followed by multiple related reports issued by the U.S. Department of the Treasury, including the digital asset, financial stability, risk and regulation report published by the Financial Stability Oversight Council (FSOC) which focused on crypto asset risk and outlined regulatory gaps and market risks that could pose threats to stability. Given significant risk events in the crypto markets of late, it is likely that legislative activity will accelerate this year.

Ensuring Thoughtful Innovation
As we look ahead, the risks that come with any new technology implementation should not deter innovation strategies of global financial services firms. Instead, firms should be encouraged to adhere to three guiding principles as they embark on their innovation journeys, in order to ensure that their services continue to provide optimal value and maximum benefit to clients.

First and foremost, any development of digital solutions, including those covering digital assets, must begin with a strong client and industry-centric approach. Client benefits must be clear and tangible, backed by customer engagement, industry support and proven hypotheses. New or enhanced solutions should allow the industry to optimize the full value chain, or key components of it, to achieve cost and operational efficiency. Second, any new technology initiative should provide equal or greater resilience than existing infrastructures and solutions. And finally, given that the financial markets ecosystem will continue to change at a rapid pace, all participants and market providers must be prepared to adjust early and often, and focus on creating the most flexible long-term solution, not the only short-term solution.

Without doubt, emerging technologies offer many benefits, leading to greater access to products and services along with lower costs of participation and other efficiencies for both consumers and institutions. However, today, many of these benefits have yet to be fully realized despite great promise, and we have already seen some significant, unexpected risks arise as a result of new technology implementation.

Evidence to date indicates that the balance between prudent innovation and systemic risk considerations has not yet been achieved. Policymakers and regulators should act swiftly to promote the implementation of appropriate guardrails and best practices globally, and to ensure that any new technology initiative provides equal or greater resilience than existing infrastructures. The industry, market participants and regulators should continue to work together to avoid a scenario whereby in the pursuit of rapid innovation, and the desire for speed and convenience, we undermine the progress in systemic risk mitigation achieved since the last financial crisis.

This article was originally published to PRMIA’s Intelligent Risk in February 2023.

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