Securities markets and investment conditions in the EU improved in 2012, especially in the second half of the year, according to the European Securities and Markets Authority (ESMA). At the same time, systemic risk in EU securities markets decreased in the fourth quarter.
These are the headline findings of the first ESMA report on trends, risks and vulnerabilities in European securities markets, which was released on 14 February along with a risk dashboard for Q4 2012.
The report examines the performance of securities markets in 2012, assessing both trends and risks in order to develop a comprehensive picture of systemic and macro-prudential risks in the EU.
It links the recovery to the European Central Bank's announcement of Outright Monetary Transactions (OMT) in early August, which alleviated pressure on euro area sovereign bond markets and reduced uncertainty among market participants. However, risk indicators remained at high levels, due to the ongoing sovereign debt and banking crisis, the realignment of risk assessments by investors, funding risk, potential long-term implications of low interest rates and obstacles to orderly market functioning.
"ESMA's risk analysis points to important first signs of easing in EU financial markets, but risks remain high and regulators, market participants and investors should remain vigilant about risks in the financial markets," said Steven Maijoor, ESMA chair. "This report provides a guide for securities regulators on those areas requiring regulatory focus in order to build on recent improvements in financial markets and to foster financial stability in the EU."
As far as securities markets are concerned, while conditions improved as a result of the ECB's OMT announcement, sovereign bond markets continue to struggle. Asset managers saw total net asset values rise to €8 trillion, compared to €7.4 trillion in 2011. The main beneficiaries were bond, hedge, real estate and exchange-traded funds. Overall however, fund inflows remained volatile.
Trading on EU venues significantly decreased in 2012. Uncertainties surrounding the European sovereign crisis and the macroeconomic outlook weighed on investors' willingness to trade. Recent figures for turnover were well below the five-year average of €640 billion. According to the report, the same decline was observed for OTC trades and trades executed through dark pools. Use of central counterparties (CCPs), however, increased. Some 60% of worldwide interest rate swaps are now centrally cleared as are 10% of credit default swaps.
Collateral dangers
In addition to market trends and risks, ESMA continues to monitor market developments that it considers may represent possible vulnerabilities. In this category, ESMA highlights growing aggregate collateral needs. The collapse of unsecured markets during the financial crisis, as well as regulatory initiatives, have led market participants to rely increasingly on collateral as a means of mitigating counterparty risk. ESMA expects additional demand for collateral to exceed additional supply in 2013-2014, making collateral comparatively scarcer.
"This trend could heighten financial stability risk, as financial institutions lacking higher-quality collateral may use lower-quality collateral to mitigate their counterparty risk, enter into collateral swaps with third parties or pledge some of their assets, resulting in rising asset encumbrance," says the report.
The extent of the shortfall is difficult to estimate as it depends on the assumptions of the underlying model. David Little, head of securities finance at Calypso, a major provider of collateral management and optimisation solutions, points out, for example, that the Bank of England's study of future collateral needs assumes 85% netting efficiency. "The Bank points out that that number is critically sensitive," says Little. "Obviously, a few percentage points lower on the netting will add hugely to the collateral shortfall."
Financial intermediation provided by hedge funds and prime brokers may also be vulnerable to any negative impacts on the price of assets pledged as collateral, which may lead to scarcer collateral, reducing liquidity and ultimately hamper repo financing.
The risk dashboard for Q4 2012, released in conjunction with the report, suggests that liquidity risk began to disperse across market segments and member states in 2012, though it remains significant to the sovereign bond market. Overall EU issuance increased, but was focused on high-risk assets.
"Banks and sovereigns exposed to high-risk premia concentrated on shorter maturities," the ESMA report notes. "Should market conditions worsen, those issuers may face funding difficulties and substantial credit and rollover risks remain."
ESMA will update its report and risk dashboard semi-annually.