ESMA trends, risks and vulnerabilities report warns markets still ‘highly reactive’

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The European Securities and Markets Authority (ESMA) biannual Trends, Risks, and Vulnerabilities (TRV) report has said the overall risks to the regulator’s remit remain at “high or very high” levels, as markets adapt to the new normal of higher interest rates and inflation.

Noting that while financial markets rebounded in H1 2023 thanks to lower energy prices and a gradual unwinding of monetary policy, the TRV report suggested that markets are still “highly reactive” to adverse events.

“Going forward, markets are set to remain very sensitive, especially to potential deteriorations in economic fundamentals or risks in financial institutions, while keeping a close eye on private and public debt sustainability in the context of higher interest rates,” the report said.

“Hence there is a high risk of corrections in a context of fragile market liquidity in the equity, bond and crypto markets.”

Javier Hernani, head of SIX Securities Services, said there are signs that calm is returning to markets, despite lingering geopolitical, economic and macroprudential risks.

“But we know from the banking fragility in Q1 2023, the start of the Ukraine war and the pandemic disruption back in March 2020 that severe dislocation in markets can strike at any time. As such, market participants need to be vigilant to ensure they are able to adjust their securities operations and risk practices. Thankfully they are not alone. There is a crucial role here for market infrastructure providers, such as CSDs and clearing houses, to ensure the smooth functioning of markets and ensure that sharp increases in volatility and settlement fails do not snowball into system-wide risks.”

Looking at securities markets, the TRV report outlined how equity markets rose in H1 2023, even though the market stress related to US banks led to increased volatility and bid-ask spreads in March and April.

Uncertainty continued to prevail in fixed income markets driven by the stress in the banking sector and expectations of further rate hikes, the report said, contributing to heightened volatility and low liquidity, with both corporate and sovereign bonds mostly flat in H1 2023.

In asset management, the report said the fund sector experienced a partial recovery after the “historic decline” in 2022, primarily down to valuation effects, and with €18tn of assets under management (AUM) it remains €1.4tn AUM below its end-2021 level.

However, performance has turned positive again for equity and bond funds while flows in equity funds were muted and bond funds received inflows, which contrasts with the outflows in 2022.

In particular, the report noted, fixed income funds, which reduced their maturity and interest rate sensitivity during the monetary tightening, are now positioned to benefit from higher yields.

Philipp Sfeir, general manager EMEA North + ZAF at NeoXam, said valuation risk remains a source of asset management fund risk, especially for funds combining several vulnerabilities such as in the real estate fund sector.

“For asset managers that are pursuing diversified trading strategies including many different types of liquid, illiquid, public and private asset classes, the difficulty in accurately valuing funds lies squarely on the availability and usability of data. We live in an information age, and with all these different assets having very different types of data underpinning them, it can be a nightmare for firms to produce accurate valuations if they are relying on antiquated internal infrastructures.”

The ability of non-financial corporations to raise funds through capital markets slightly picked up in H1 2023 from the lows observed in 2022, the report said, with equity deal making mostly flat and issuance mostly driven by secondary offerings. Corporate bond issuance peaked in Q1 2023, with concentration in shorter term maturities mainly linked to monetary policy expectations.

The EU market for ESG products and sustainable investments continued to grow “at a robust pace”, the report said, despite a slowdown in ESG bond issuance in H1 2023, and the demand for funds with a sustainable investment objective remained strong

On sustainability, Sfeir said: “ESMA has identified that investors are perhaps now paying closer attention to the actual sustainability profile of funds, rather than their specific Sustainable Finance Disclosure Regulation (SFDR) regime.

“This makes sense – we have long called for investors to take control of the evaluation process themselves, rather than relying on ratings that are not necessarily always accurate. By taking control of the analysis process by delving into the ESG data that underpins the investments in portfolios, investors give themselves a far better understanding of funds’ real sustainability profiles.”

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