The next market disruption probably won’t be a repeat of 2008 — that would be too easy and besides, the Dodd-Frank legislation has reduced some of the big risks that led to the Global Financial Crisis (GFC).
The most pressing threat is cyber, said Michael Bodson, president and CEO of the DTCC. It could be an organized actor, a nation state attack, or something local. On his first day as CEO, Knight Capital blew up because of a software coding error and had to be rescued.
“It doesn’t even have to be malicious,” Bodson said. “The proliferation of technology across the industry and the speed at which transactions occur mean that when something goes bad, it can get big very fast. It’s not a question of if, but when” the next crisis occurs. It could be a big bank, an exchange, or a loss of confidence in the markets.
When it comes to risks, Bodson talks a lot about interconnectedness. One example is exotic ETFs that are made up of illiquid assets, so any dip in the market could lead to a rush for the exits in a thinly traded market.
“The bulk of ETFs are fine,” Bodson said. “The sector is focused, they are very transparent in terms of their holdings and the liquidity of the underlying. But you’ve seen the growth of more esoteric constructs where you may have embedded derivatives or underlying assets that are more illiquid, such as bank loans and emerging market debt.”
Just because risk is chopped up doesn’t mean it goes away, he added.
“We are very careful when we clear. We have to understand the underlyings so we don’t get into a mismatch situation. Like any other product as it moves up the risk curve and the complexity curve, the risk may be chopped up, but the risk remains. The question is, do you know where it is? In 2008 you may have chopped up mortgages, but the risk didn’t disappear.”
Interconnectedness both makes the markets resilient and can be a source of weakness and risk. He credits regulators with reducing risks in the system.
“Obviously we have been hit with a wave of regulations post 2008 which in a lot of ways was needed,” Bodson said. “A lot was thrown into Dodd-Frank which was probably beyond what was connected to the creation of the global financial crisis, but the industry has learned to cope with it. You can’t argue that the financial system is not stronger, but that doesn’t mean it can’t still have problems. It may be stronger in terms of another crisis of 2008 but that probably will not be the crisis of 2018.”
The DTCC provided vital stability through the turmoil of 2008, Bodson said.
“We are very proud of our heritage; we provided stability to the financial marketplace when Lehman collapsed. Our ability to manage their open positions is something we are very proud of.” The the DTCC processes $1.6 quadrillion a year and safeguards $57 trillion in securities, he said.
The firm’s focus in the years ahead will be technology — a combination of cloud, blockchain, artificial intelligence and eventually quantum computing, although that is probably 15 years out.
U.S. regulators have some of the best people he has ever seen in those positions, said Bodson.
“The regulators we deal with have some high quality people. They are very bright, very hardworking and a sense of public service permeates the organizations like the CFTC, the SEC, the Fed and Treasury. There's something about the regulatory world that does attract some very smart, talented people. It’s a tough job and 2008 showed the need for all of us to be vigilant.”
The amount of oversight by financial regulators is multiples of what it was in 2008, he added.
“They are doing this job as well as possible. It may be incremental and not seen by the public, but it is having a massive impact on the financial system.”
Bodson paused to ask himself why he was saying nice things about regulation and regulators, and then moved on to discuss the UK's Financial Conduct Authority (FCA).
Several national financial regulators are experimenting with sandboxes — ways to relax rules while protecting consumers to let fintech firms try out innovations. The FCA is probably the leader in this approach to encouraging innovation.
Bodson said he is more focused on the system rather than individual innovations, so he wants to make sure the fintech firm has appropriate cybersecurity and risk controls. A sandbox can be a useful tool, not least because it helps regulators understand the technology, but he thinks that in the overall risk landscape, sandboxes aren't terribly important.
"The people who will play in the sandbox are probably not the ones you have to worry about.”
