MIL-OSI USA: Assessing the Unknown


Source: Securities and Exchange Commission

Sept. 24, 2021

Thank you Professor Scott for that introduction. I am thankful for the opportunity to virtually speak with you today here at the Harvard Law School and Program on International Financial Systems Symposium on Building the Financial System of the 21st Century. Before I begin my remarks, I need to mention that the views I express today are my own and do not necessarily reflect the views of the Commission or its staff.

Twelve years into a historic bull run, with the 2008 financial crisis increasingly just a memory, some might assume the stability of our markets has become self-sustaining.[1] Since the last major economic downturn, our financial markets have experienced unprecedented growth, even as sectors of the real economy have not always kept pace, as in the early stages of the global pandemic.[2] Our markets are cyclical and increasingly complex and interconnected.[3] As some observers have noted, even in a year in which the U.S. stock market notched dozens of record high closes,[4] at some uncertain point in the future, the bull run will end.[5]

This has compelled me to think broadly about market risks. In times of consistent and positive stock market returns, we should not be lulled into complacency. SEC Chair Gensler recently stated that the reforms enacted after the 2008 crisis have better positioned our markets to absorb shocks.[6] I agree. But all of us, regulators and market participants alike, have a role to play in the stability of markets. Given the increasing market complexity and interconnectedness, which can increase and amplify risks, we must all remain vigilant. As a Commissioner at the SEC, it is my goal to ensure that our regulatory framework not only functions well during bull markets, but that it also promotes market resilience and delivers investor protections when a destabilizing event or the next contraction occurs. Let me give you a little context.

As you may know, I am also a reservist in the U.S. Army. It is a job filled with challenges and sometimes heartache, which has profoundly impacted me in my role as an SEC Commissioner. You see, in the Army there is an exercise that all commanders must undertake regularly – risk assessment. This means continuously evaluating what obstacles and threats your Soldiers, your unit, or your battalion may face and having a plan for how to mitigate or deal with these obstacles and threats before they materialize. There is an old saying that the plan never survives first contact with the enemy, and that is generally true, but that does not counsel against doing the work to assess the risk that obstacles and enemies may present.[7]

How is this related to the financial markets? History teaches that the bigger downturns tend to follow a confluence of events that few, if any, could have predicted before they occurred.[8] Which is understandable. Some risks are very hard to foresee. For example, I’m not sure how many of us anticipated that the recent risk of default by a Chinese residential real estate developer would be linked to $250 billion in losses in digital asset and cryptocurrency markets,[9] as well as losses in our stock markets. But the difficulty of anticipating the unknown does not relieve us of our responsibility to be proactive.

As in the Army, we must, and do, conduct risk assessments. Over the last several months, we have begun looking at different ways to reduce misaligned incentives and hidden risk and to protect investors.[10] For example, as Special Purpose Acquisition Companies (SPACs), or blank-check mergers, rapidly proliferated, the SEC quickly responded by applying the federal securities laws to the complex instruments SPACs use to issue equity,[11] by rooting out fraud,[12] and by highlighting the investor protection concerns arising from fees, conflicts, and sponsor compensation.[13] But there are certainly areas that merit further attention. I will discuss a few of them today.[14] Some of these risks come from within our financial system and some, like climate change, arise externally. All have the potential to cross markets and borders.

Risks From Within

First, as I and others have noted,[15] our financial markets are no less interconnected now than they were in 2007-2009, when the failure of complex investment products with simple sounding acronyms, like CDOs, contributed to a recession that spread around the globe.[16] Since that crisis, we have lived in a notably low-interest rate environment. While this can be great for borrowers, it incentivizes investors to seek out riskier investments in a hunt for higher yields.[17] For example, certain structured products, derivatives that amplify market exposure with little money down, and trading with margin accounts can all offer the opportunity for greater returns. But it’s not clear to me that the risks associated with these products and trading strategies are well understood by all investors. Moreover, products and strategies seeking amplified returns may also pose the risk of amplified losses that extend beyond the immediate investors to other parts of our markets.

Since the Global Financial Crisis, financial professionals, academics, and regulators have been conducting risk assessments to try to determine the next Collateralized Debt Obligations (CDOs).[18] Collateralized Loan Obligations (CLOs), structured investment vehicles that hold pools of leveraged loans,[19] have received some scrutiny in this regard, and not just because of the similarity in nomenclature.[20] They share some key characteristics. Namely, both are highly complex products that involve high-risk debt that have been structured into a set of securities with AAA-rated tranches, which are marketed to investors as higher-yielding safe debt. The CLO market experienced extreme stress after the onset of the global pandemic, and were some of the worst-performing debt investments in early 2020.[21] Fortunately, the market largely recovered and we did not hear reports of CLOs imploding en masse.[22] That is good news, but I don’t think the assessment ends there. The market’s resiliency during these recent turbulent times coincided with extensive central bank intervention and the implementation of a fiscal stimulus package.[23] So although this sector was largely able to withstand the recent turbulence – with the aid of extensive government intervention – I am continuing to think about the risks such structured products can pose. Specifically, I am working to understand how deteriorating loan documentation, “covenant-lite” loans that result in fewer protections for lenders, and lower expectations of recoveries in default increase the risks attendant to CLOs.

And I am not thinking about CLOs in a vacuum. I am curious whether the risks associated with CLOs are being amplified through derivatives. While derivatives make financial sense in many circumstances, this market is noteworthy for its opacity.[24] We do not know, for example, whether or to what extent there may be derivatives tied to the performance of CLOs and leveraged loans. And because we do not know the aggregate derivatives exposure to CLOs, we cannot determine what the market impact would be if borrowers began defaulting in large numbers and CLOs experienced losses. While this market is still small, we do have some evidence that there has been a growth in collateralized synthetic obligations (CSOs), which may provide synthetic credit exposure to CLOs.[25] I expect we should have some additional visibility in this area when our security-based swaps reporting regime goes into effect later this fall.[26] I look forward to working with my colleagues to review these data, assess risks we cannot currently see, and determine whether any next steps are appropriate.[27]

This brings me to a second area I have been thinking about recently: swaps.[28] Take, for example, total return swaps, which provide another way for investors to get synthetic exposure to different assets. With a total return swap an investor gains exposure to another investment, including the potential for profits and losses, without actually owning the other investment. The use of total return swaps is not new. But the recent collapse of a family office that was reportedly heavily invested in total return swaps and the impact on its counterparties is a reminder of the potential damage such swaps could inflict when used for speculative purposes.[29] Here, the Commission can focus during its examination process on how these synthetic securities are priced and how they perform, and also explore ways to obtain information on entities’ aggregate exposures to the underlying assets and to counterparties. With these data, we could determine if the current regulatory approach achieves the right balance. It is also incumbent on swap dealers to ensure they maintain robust risk management programs and respond to early warning signs. Robust risk management may limit some near-term profits at a time when dealers are also seeking amplified yield. However, the failure to address risk can cost exponentially more. Effective compliance and risk management at financial institutions doesn’t just protect those institutions and their shareholders, it also helps make financial markets more resilient.

A third emerging trend in the hunt for yield is the increase in options trading by retail investors. While some options strategies can help hedge an investor’s portfolio against losses, other options strategies can be incredibly risky and expose an investor to sudden and severe losses.[30] And of note to me, many inexperienced investors – perhaps not well-positioned to jeopardize their savings – began options trading earlier this year.[31] Given the risks associated with options trading, there are heightened obligations for brokers when approving options trading for retail customers.[32] Such trading was, historically, quite limited. Now, the ability to trade options is just a few clicks away, and investors can easily trade without direct contact with their brokers. This likely was not anticipated when the options approval rules – which require brokers to exercise due diligence when approving customers for option trading – were originally issued.[33] At that time, the norm was that retail investors had direct contact with their brokers who could explain the impact of particular strategies and the risks particular positions entailed.

Given these changes in market access,[34] it may be that the options account approval rules are due for a review, and I look forward to thinking this through with my colleagues. I am also thinking about the implications of this phenomenon more broadly, particularly the consequences of increased numbers of retail investors using leveraged investment strategies subject to margin calls that they may not be able to meet. That may not come to pass, but, again, it’s important to consider how to modernize our regulations to meet new trends.

External Risks

Inside the SEC’s building, it is natural to focus on risks that arise from financial markets. But the truth is that financial markets are largely driven by world events. There are risks to the capital markets that originate from sources that have nothing to do with raising capital, market trading, or investment management. Three examples I will briefly mention today are climate, cybersecurity, and geopolitical risks.

It is not dramatic to say that climate change poses an existential threat to our current way of life. And acknowledging this concern, means acknowledging that our capital markets will be greatly impacted.[35] The Commission’s staff is developing a proposal that will seek to provide decision-useful and comparable climate-related disclosures to investors so they can better understand an issuer’s climate risks.[36] I am pleased that you are discussing this at this event.

Another example is the relatively recent phenomena – in securities law time that is – of cybersecurity breaches. When Congress created the Commission in the midst of the Great Depression, cybersecurity was not a risk that anyone could have foreseen. But now, after seeing the millions of dollars that a data breach can cost a retailer,[37] or the widespread impact of a data breach at a pipeline company,[38] hospital system,[39] or consumer credit reporting agency,[40] we know better. My fellow Commissioners and both of the recent administrations have highlighted this as a key risk.[41] From where I am sitting, though, the response to these calls for action has been slow. So I was glad to see Chair Gensler prioritize a cybersecurity rulemaking.[42] We should consider how to ensure investors are well informed about cybersecurity incidents on a timely basis. We should also consider whether investors are receiving appropriate disclosures about the risk these threats pose, and whether issuers have any obligations to guard against them. One way to help investors and corporations focus on this threat is through incident disclosure. Investors will know when a breach has happened and a high-profile disclosure will encourage appropriately designed internal controls for cybersecurity.

Finally, we need to constantly be aware of geopolitical risks. The Commission is being proactive in confronting many of these. For example, as many of you know, some China-based operating companies are not permitted by the Chinese government to have foreign ownership, but these companies still want to raise money from U.S. investors. So they form Variable-Interest Entities (“VIEs”), which are essentially shell companies that do not own or control the operating company but sell shares on U.S. exchanges. The Commission examined these investments, and required prominent and clear disclosures about their structure and the inherent risks of VIE ownership.[43] We are also continuing to work on implementation of the Holding Foreign Companies Accountable Act, which requires disclosure of foreign government ownership of companies and certain audit arrangements.[44] These are important steps. However, given that unilateral decisions by nation-states can impact not just the companies within their borders but also U.S. investors and markets, geopolitical risk is something we must assess continually from a variety of perspectives.


We cannot let the long run of positive stock market returns distract us from the necessary work of assessing risk. When there is a down cycle in the financial market, people feel it. When systemic failures occur, they reverberate and spread throughout the broader economy. As we saw in 2008, people lose jobs, savings, retirements, and even their homes.[45] And it can take a long time to rebuild and regain confidence in the markets.

So today, while times are relatively good in the financial markets, we should each spend time thinking about risk. As I’ve described, we do that at the Commission in a variety of ways. But our efforts alone are not enough. We need all market participants to think critically about the risks they face, including those I highlighted today, like complex synthetic and structured products, climate change, and cybersecurity threats. Issuers should disclose certain risks so that investors can make informed decisions. Market participants should think about their counterparties and markets, and make sure due diligence includes an understanding of how counterparties are prepared against risks and how they may fare in times of market upheaval. Investors should consider, and as appropriate, work with their financial professionals[46] to understand the various risks that affect their portfolios.

Of course we can’t, and should not try to, eliminate all risk. After all, risk is an inherent part of investing. But by thinking deeply about it, regulators, issuers, investors and all market participants can take steps to limit the downside of future disruptive events or market downturns. I have an open door policy, and I’d like to hear your thoughts about this important and complicated topic.


[8] See, e.g., Timothy F. Geithner, Stress Test: Reflections on Financial Crises (Penguin Random House 2014) (“Financial crises cannot be reliably anticipated or preempted.”); Brookings Institution, Responding to the Global Financial Crisis: What We Did and Why We Did It (Sept., 2018) (according to former U.S. Secretary of the Treasury Hank Paulson, “[m]y strong belief is that these crises are unpredictable in terms of cause, timing, or the severity when they hit.”). But see Columbia Business School, The Financial System Will Survive, Says Ben Bernanke (May 23, 2016) (according to Federal Reserve Chairman Ben Bernanke history doesn’t repeat itself but “it rhymes”); Robin Greenwood et al., Predictable Financial Crisis, (J. Fin. forthcoming, Working Paper 20-130) (using historical data on post-war financial crises around the world, the authors show that crises are substantially predictable, they find that the combination of rapid credit and asset price growth over the prior three years, whether in the nonfinancial business or the household sector, is associated with about a 40% probability of entering a financial crisis within the next three years).

[9] Digital assets, the exchanges on which they trade, and DeFi applications all pose market risks. Some of these risks are familiar, and some are unique or still emerging. Many appear to be exacerbated by a broad failure by issuers and market participants to comply with regulatory obligations. Digital assets are a topic about which I expect to have more to say in the months ahead.

[13] See Office of the Investor Advocate, Sec. & Exch. Comm’n, Report on Objectives: Fiscal Year 2022 at 7-8; Michael Klausner et al., A Sober Look at SPACs, 39 Yale J. Reg. (forthcoming 2021). Chair Gensler recently noted that “SPACs are rather costly exercises in financial engineering. Some sponsor raises $200 million or $2 billion or whatever and takes 20 percent — I repeat, 20 percent.” Jen Wieczner, Gary Gensler on Crypto, SPACs, and Robinhood: Wall Street’s Top Cop Wants to Police New Finance With Old Rules, N.Y. Magazine (Sept. 13, 2021).

[14] A key part of an adequate risk assessment is having the right information. I have highlighted some areas where I think we have data gaps. See Caroline Crenshaw, Commissioner, Sec. & Exch. Comm’n, Mind the Data Gaps (May 14, 2021). Unfortunately, I do not think we will ever have the manpower or the data to be as responsive to market movements as I would like. But there are steps we can take to identify risks and help mitigate them.

[15] See Allison Lee, Commissioner, Sec. & Exch. Comm’n , Playing the Long Game: The Intersection of Climate Change Risk and Financial Regulation (Nov. 5, 2020); Kara Stein, Commissioner, Sec. & Exch. Comm’n, Remarks Before the Peterson Institute of International Economics (June 12, 2014), Kara Stein, Commissioner, Sec. & Exch. Comm’n, Remarks at the ‘SEC Speaks’ Conference (Feb. 21, 2014); Luis Aguilar, Commissioner, Sec. & Exch. Comm’n, Regulatory Reform That Optimizes the Regulation of Systemic Risk (Apr. 16, 2010). See also Janet Yellen, Federal Reserve Vice Chair, Fed. Res., Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications (Jan. 4, 2013); Daniel Tarullo, Governor, Fed. Res. Board, Regulating Systemic Risk (Mar. 31, 2011).

[19] Leveraged loans refer to loans made to highly levered or non-investment grade debt. See Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications, supra note 2.

[22] See Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications, supra note 2 at 51.

[26] November 8, 2021 is the first compliance date for Regulation SBSR, which governs regulatory reporting and public dissemination of security-based swap transactions. Regulation SBSR is a key component of the security-based swap regulatory regime established by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Regulation SBSR provides for the reporting of security-based swap information to registered swap data repositories (SDRs) and for public dissemination of transaction, volume, and pricing information. See Press Release, SEC Approves Registration of First Security-Based Swap Data Repository; Sets the First Compliance Date for Regulation SBSR (May 7, 2021).

[27] I expect there will be a large volume of data collected and it will be a great undertaking to parse through it, analyze, and identify potential gaps.

[28] The swaps market can be bi-furcated into swaps over which the Commodity Futures Trading Commission has regulatory responsibility and security-based swaps over which the Securities and Exchange Commission has regulatory responsibility. See Sec. & Exch. Comm’n, The Regulatory Regime for Security-Based Swaps.

[30] See, e.g., Rob Bauer et al., Option Trading and Individual Investor Performance, 33 J. of Banking & Fin. 731, 746 (Apr. 2009) (“The losses investors incur on their option investments are much larger than those from equity trading. Risk and style tilts and differences in demographic and socioeconomic characteristics do not explain the poor performance of option traders relative to equity investors. Instead, we attribute the poor performance of option traders to bad market timing due to overreaction to past stock market movements.”).

[32] Under FINRA Rule 2360(b)(16), a member must seek to obtain and consider detailed customer information, including, among others, the customer’s knowledge, investment experience, age, financial situation, and investment objectives. See FINRA, Rule 2360(b)(16). Based upon this information, the member must determine whether it is appropriate to approve the customer to trade options. Id. This approval process must consider the appropriateness of the full range of options trading being approved for the customer. Id. As part of this approval process, members also should consider whether to approve a customer only for certain types of options transactions and not for others. Id. See also, Regulatory Notice 21-15, FINRA Reminds Members About Options Account Approval, Supervision and Margin Requirements. The Division of Examinations 2021 priorities include examination of broker-dealers to assess whether they are meeting their legal and compliance obligations when providing retail customers access to complex strategies, such as options trading, and complex products. See Div. of Examinations, Sec. & Exch. Comm’n, 2021 Examination Priorities: Division of Examinations (2021).

[33] See NASD Notice to Members 80-23 (June 1980) at 5 (“The requirement that all public customers must be specifically approved for options is intended to assure that the firm has exercised due diligence to determine that options transactions are appropriate for the customer in light of his investment objectives and financial situation, and that the customer has been made aware of the risks of options transactions.”). This NASD Notice resulted from a Report of the Special Study of the Options Markets to the Securities and Exchange Commission which  recommended, among other actions, that Self-Regulatory Organizations (SROs) amend their options account opening requirements to ensure that broker-dealers obtain and record sufficient data to support a suitability determination and require verification of such suitability information as well as supervisory review of a customer’s options account. Id at n. 3.

[34] See, e.g., Gunjan Banerji, Individuals Embrace Options Trading, Turbocharging Stock Markets, Wall St. J. (Sept. 26, 2021). To be clear, increased access to the markets for retail investors can certainly be a positive development. My concern is that we need to ensure our regulatory framework is appropriately modernized for such developments.

[41] See Hearing on the Nominations of David J. Ryder, Hester M. Peirce, and Robert J. Jackson, Jr Before the S. Comm. on Banking, Hous., and Urban Affairs. (Oct. 24, 2017) (quoting Senator Reed “I was struck, Ms. Peirce and Professor Jackson, that you both identified cybersecurity as one of the key challenges. In that regard, you seem to be closely aligned with Chairman Clayton because he said when he was here for his confirmation, `I think cybersecurity is an area where I have said previously I do not think there is enough disclosure.’”); Exec. Order on Improving the Nation’s Cybersecurity (May 12, 2021); Robert Jackson, Jr., Commissioner, Sec. & Exch. Comm’n, Corporate Governance: On the Front Lines of America’s Cyber War (Mar. 15, 2018); Kara Stein, Commissioner, Sec. & Exch. Comm’n, Statement on Commission Statement and Guidance on Public Company Cybersecurity Disclosures (Feb. 21, 2018); Robert Jackson, Jr., Commissioner, Sec. & Exch. Comm’n, Statement on Commission Statement and Guidance on Public Company Cybersecurity Disclosures (Feb. 21, 2018); White House Council of Economic Advisers, The Cost of Malicious Cyber Activity to the U.S. Economy 25, 31-32 (Feb. 16, 2018).

[46] Brokers and advisers are required to make recommendations and provide advice that is tailored to customers’ and clients’ investment profiles, based on, among other things, the customers’ or clients’ investment objectives, investment time horizon, risk tolerance, and liquidity needs. See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019); Commission Interpretation, Sec. & Exch. Comm’n, Standard of Conduct for Investment Advisers, Release No. IA-5248 (June 5, 2019).