ESMA warns of high risks amid fragile markets, despite a “remarkably stable” H2

The regulator’s first Trends, Risks and Vulnerabilities (TRV) report of 2023 warns that high levels of uncertainty and fragile market liquidity are limiting the resilience of the financial system against further external shocks.  

The first TRV report of 2023 from the European Securities and Markets Authority (ESMA) has warned of high risks due to fragile financial markets this year; although it also notes the second half of 2022 was characterised by “remarkably stable” financial markets, with economic sentiment becoming more positive in early 2023.  

However: “High levels of uncertainty and fragile market liquidity are limiting the resilience of the financial system against further external shocks,” says the regulator, confirming that in its view, overall risks to its remit remain at the highest level. 

Key themes for last year include the slowdown of economic activity, high inflation, global tightening of financial conditions, the geopolitical environment and the materialisation of peripheral risks linked to leverage and liquidity, together with growing concerns over business practices in the crypto space.   

Overall for 2023, contagion and operational risks are still considered very high, along with liquidity and market risks. Credit risk remains high and is expected to rise, reflecting the growing concerns over public and corporate indebtedness; as do risks in securities markets and for asset management. 

ESMA notes that equity prices were particularly volatile last year, but partially recovered in Q3 on the back of stable inflation and positive corporate earnings. However, the asset management industry and notably the EU fund sector saw outflows and low performance across most fund types in H2, with assets under management experiencing their sharpest decline since the global financial crisis.  

Maturity mismatches in commercial real estate funds is a key issue in the sector, while the impact of the UK gilt market turmoil on leveraged liability-driven investment funds raised further concerns around fund liquidity risk management and excessive leverage, as well as contagion risks due to the strong systemic interconnections. In terms of market structure, the report warns that: “Structural vulnerabilities expose markets and participants to the risk that shocks to markets could be amplified by liquidity supply and demand imbalances.” 

The crypto market was also singled out for concern, with the regulator noting that crypto-asset valuations have fallen by almost 70% year-on-year, driven by macro-economic factors and several high-profile collapses in 2022, plus a major market correction following the FTX crash. However, although contagion within the crypto sector has been substantial, the relatively low exposures by EU market participants mean that the turmoil has not yet made a major impact on the wider EU finance sector.  

Despite the cautious optimism in some areas, ESMA remains on high alert for the coming year.  

“Financial markets remained remarkably stable in 2H22, despite the general volatile environment. Although economic sentiment has become more positive in early 2023, there is no room for complacency. ESMA is keeping the overall risk assessment across its remit at the highest level,” said chairperson Verena Ross.  

“The confluence of high risks across the ESMA remit and fragile market liquidity may test the resilience of the financial system against possible future shocks.”