AI, cybersecurity and digital assets among risks to U.S. economy, Financial Stability Oversight Council says

The Financial Stability Oversight Council identified artificial intelligence, cybersecurity, digital assets, and certain investment funds, including hedge funds, as four of 14 vulnerabilities to the U.S. financial system in its annual report released Dec 6.

“The annual report demonstrates the council’s commitment to monitoring and responding to current and emerging risks to enhance market resilience, efficiency, and stability,” Treasury Secretary Janet Yellen said in a Dec. 6 news release.

In 2023, the council identified AI as a financial vulnerability for the first time, noting that without proper design, testing and controls, it can lead to “disparate outcomes, which may cause direct consumer harm and/or raise consumer compliance risks.”

This year the council warned that “the lack of explainability and the high complexity of AI approaches (in financial services) have the potential to heighten financial instability beyond effects on individual financial actors,” according to the report.

The 2024 report also recommends that FSOC member agencies — which include the Treasury Department, SEC and Federal Reserve — “continue to monitor” the use of AI in financial services and “ensure oversight structures are updated to address emerging risks to the financial system while facilitating efficiency.”

Cybersecurity was named as other vulnerability given that “severe (cyber) incidents at major financial institutions could pose an acute threat to financial stability given the high degree of interconnectedness among global financial institutions and systems,” the report states.

A successful cyber-attack “has the potential to disrupt operations, challenge access to liquidity, increase the likelihood of bank failures and market dysfunction, and generally erode confidence in the financial system, among other outcomes,” according to the report.

Additionally, the council identified digital assets a financial vulnerability, as stablecoins “are acutely vulnerable to runs absent appropriate risk management standards,” according to the report.

The council notes that "the stablecoin market is heavily concentrated, with a single firm (Tether) holding around 70% of the sector’s total market value. Given that firm’s market dominance, if it continues to grow, its failure could disrupt the crypto-asset market and create knock-on effects for the traditional financial system."

The report recommends that Congress pass comprehensive stablecoin legislation “to address run risk, payment system risks, market integrity, and investor and consumer protections,” as well as pass legislation providing federal regulators “with explicit rulemaking authority over the spot market for crypto-assets that are not securities.”

The Financial Innovation and Technology for the 21st Century Act, which the House passed in May, would give the Commodity Futures Trading Commission new oversight of the digital commodities market and designate the SEC as the regulator for the digital securities market, among other things.

The council also identified vulnerabilities in certain investment funds, including hedge funds, open-end funds and collective investment funds.

Open-end funds with “significant liquidity mismatches may face challenges meeting large redemption requests during times of market stress, potentially disrupting market functioning,” and collective investment funds share similar features, according to the Dec. 6 news release.

The council is supportive of an SEC rule, finalized in August, that requires registered investment funds to report their portfolio holdings on a monthly basis rather than a quarterly basis and also increases the frequency of making such data public, the release notes.

FSOC will also continue working “to support better data collection and monitoring to identify risks from highly leveraged hedge funds and the growth in private credit,” according to the news release.

Last December, Sens. Sherrod Brown, D-Ohio and Jack Reed, D-R.I., wrote a letter to federal regulators urging them to monitor the risks private credit may pose to the financial system.