As Mr. Knot’s letter observes, despite being buffeted by several severe shocks in recent years, the core of the financial system has largely coped with enormous real-world stress tests in this decade, with limited and temporary support from governments. The implementation of the authorities’ post-2008 crisis reform agenda has gone a long way to reinforce resilience.
Near-record high levels of public and private sector debt, rising debt service costs, and stretched asset valuations in some key markets can pose serious threats to financial stability. As 2023 begins, monitoring and addressing conjunctural and structural vulnerabilities demands overseer vigilance.
Non-bank financial intermediation
The non-bank sector remains vulnerable. As an example, early last year, after Russia’s invasion of Ukraine, some commodities firms found it hard to obtain cash collateral to cover the spike in margin requirements, and this led to some market volatility. This follows previous episodes of liquidity demand in the non-bank sector amplifying market shocks and spilling over to broader financial markets. This explains why the FSB and its members continue to take steps to enhance the resilience of the sector.
At the February 2023 FSB meeting of G20 finance ministers and central bankers, the FSB is delivering a report on the financial stability aspects of commodity markets. It identified numerous weak spots. In contrast to the structure of many other financial markets, a small number of non-financial trading firms play an outsized role. These non-financial firms are connected with core financial market participants through their activities across a range of physical and financial derivatives markets.
Commodities traders are usually highly leveraged and rely on banks for short-term funding. Importantly, many of the vulnerabilities and channels of contagion identified in the report, including leverage, the impact of large margin calls, and opacity, are not unique to commodities markets and are being addressed in the FSB’s work program to enhance the sturdiness of non-bank financial intermediation in its many forms.
Another important piece of this program is the study of forms of leverage that are not always apparent in supervisory and regulatory data. For example, derivatives can be used to take leveraged positions that are not easy to see in typical balance sheet measures. Leverage can be built up in portions of the financial system that are less regulated, such as occurred in the Archegos family office incident.
Some types of open-ended funds have experienced periods of stress, a case in point being the March 2020 market turmoil. The FSB continues its policy work to address liquidity mismatch in open-ended funds. Additional work in this area includes running a pilot program to improve data for financial stability monitoring and coordinating with IOSCO on the development of detailed guidance on liquidity management tools.
The FSB's aim is to enhance market participants’ liquidity preparedness for margin and collateral calls, which were important factors in the March 2020 market turmoil; and to identify data gaps in regulatory reporting.
Finally, in conjunction with IOSCO, the FSB will conduct a peer review of money market mutual fund policy reform measures, to take stock of member countries’ progress in implementation of reforms designed to keep these instruments working under stressful conditions.
Crypto assets and decentralized finance
The events of the past year, not least the collapse of FTX, have highlighted the intrinsic volatility and structural vulnerabilities of crypto assets. The failure of a key intermediary in the crypto asset ecosystem quickly transmitted risks to other parts of that ecosystem. And, if linkages to traditional finance grow, risks from crypto-asset markets could spill over.
The G20 has charged the FSB with coordinating the delivery of an effective and comprehensive regulatory framework for crypto assets in 2023. The recommendations will cover the regulation, supervision, and oversight of crypto assets and markets.
This FSB work program will include the targeting of global stablecoin arrangements, which have characteristics that may make threats to financial stability more acute. The governance frameworks need clarification and strengthening, in particular as regards redemption rights and the need to maintain effective stabilization mechanisms. Importantly, the FSB’s work concludes that many existing stablecoins would not currently meet these high-level recommendations, nor would they meet the international standards and supplementary, more detailed joint guidance provided to national authorities by the Committee on Payments and Market Infrastructures and IOSCO.
Collectively, these recommendations seek to promote the comprehensiveness and international consistency of regulatory and supervisory approaches, recognizing that many crypto-asset activities and markets are currently not compliant with applicable regulations or are unregulated.
Publication of the FSB’s recommendations will only be the beginning of the next phase of work in this area, as the standard-setting bodies will need to derive their own, more detailed views, and member jurisdictions will need to implement this global framework. The FSB will continue to coordinate that work, as necessary, and going forward will monitor implementation. Once that is completed, the appropriate regulation of crypto-assets, based on the principle of ‘same activity, same risk, same regulation’ will provide the beginning of a strong basis for harnessing potential benefits associated with this form of financial innovation while containing its risks.
Within the crypto asset ecosystem, so-called decentralized finance (DeFi) has emerged as a fast-growing segment. The FSB has released a report which points to the need for proactive monitoring, filling data gaps, and exploring to what extent the crypto asset recommendations may need to be enhanced to cover DeFi risks. Additional policy recommendations may be needed.
The FSB continues to assess the implications of crypto assets for financial stability. This year it is analyzing the large crypto asset intermediaries that provide a wide range of services to the ecosystem. It will also undertake an analysis of the increasing trend toward the tokenization of assets.
Enhancing cross-border payments
One factor that has spurred the development of the crypto asset ecosystem is dissatisfaction with the existing system of cross-border payments. In 2020, G20 Leaders endorsed the Roadmap for Enhancing Cross-border Payments, in order to address the frictions that such payments currently face and thereby achieve faster, cheaper, more transparent, and more inclusive cross-border services.
This work is now focused on implementation: the FSB is delivering a report with detailed next steps under the next phase of the Roadmap: the direction is set, the goals are clear, and two new tasks forces are being set up to involve private sector partners.
Cyber and operational resilience
Cyber incidents have grown in frequency and sophistication, and will likely continue to do so as the financial system becomes increasingly digitalized. The growing interconnectedness of the financial system also increases the likelihood of a cyber incident at one financial institution, or an incident at one of its third-party service providers, having spill-over effects across borders and sectors. All of this underlines the importance of continuing to work on strong safeguards.
In April, the FSB will deliver a revised report to the G20 on achieving greater convergence in cyber incident reporting that incorporates public feedback. Information on cyber incidents is crucial for effective response and recovery, and so for promoting financial stability. The consultative document includes recommendations to address impediments to convergence, advances work on establishing common terminologies and proposes the development of a common format for reporting.
This year the FSB will also deliver a consultative document to the G20 aimed at strengthening financial institutions’ ability to manage third-party and outsourcing risk. This will include expectations for financial authorities’ oversight of financial institutions’ reliance on critical service providers, including Big-Tech and FinTech firms.
Climate change
Climate change remains a key priority for financial regulators and supervisors, as set out in the FSB roadmap. A pivotal goal is the finalization of the International Sustainability Standards Board (‘ISSB’) global standards for climate disclosures in financial reporting, in the first half of this year.
The development of climate-related corporate disclosures will provide a unique opportunity to avoid harmful fragmentation and create a global baseline standard at the outset that enables users to compare and aggregate exposures across jurisdictions. Interoperability between the common global baseline and national and regional jurisdiction-specific requirements continues to be crucial to avoid unnecessary costs. Climate disclosures and reporting are being coordinated with the ISSB and IOSCO.
Crucial in the fight against climate change will be gaining a better understanding of how climate change can affect financial stability, so the FSB will continue to monitor possible vulnerabilities in this regard. This includes work being undertaken, in coordination with the Network for Greening the Financial System, on how the information in transition plans can be used for managing transition-related risks to financial stability.
Conclusion
Financial stability is indispensable to robust and sustainable economic growth. The deeply interconnected and globalized nature of the financial system is such that a multilateral, cross-sectoral policy approach is required. The FSB is uniquely responsible for the coordination and policy consistency from one jurisdiction to another.