European Securities and Markets Authority, Chair
Ministry of Economy and Finance, France, Assistant Secretary, Financial Department of the French Treasury
European Commission, Director General, DG for Financial Stability, Financial Services and Capital Markets Union
Federal Ministry of Finance, Germany, Director General, Financial Markets Policy
Bank of America Merrill Lynch Global Research, Head of International Structured Finance Research
BNY Mellon, Chairman EMEA
Deutsche Börse Group, Chief Regulatory Officer
Morgan Stanley International, Chief Executive Officer and Head of EMEA
The Chair outlined that the CMU initiative launched in 2015 aims to increase the role of capital markets in order to create more stability and competitiveness in the EU financial system. As is typical for capital markets, CMU is about a broad range of issues. In January 2017 a mid term review of the CMU was initiated. There have been some clear and tangible results from the CMU programme so far, with agreement on the revision of the prospectus regulation, the legislative proposal on securitisation being well underway, and ESMA working hard on the issue of supervisory convergence in order to foster a consistent application of rules. Brexit is an important issue to consider for the CMU, but since the Brexit vote there has been a clear commitment from the European Commission (EC) to accelerate CMU.
1. Progress made with the CMU
1.1. Objectives of the CMU
A policymaker recalled that Europe had decided on the CMU for three reasons. The first was that Europe wants to increase the funding to its economy, and mobilise savings in order to develop their productive use in financing the economy. The second reason was to increase diversity and resilience of funding. The EU currently relies on bank funding, but wants to develop in addition other sources of financing. The focus is not on diminishing bank funding; but complementing it with non bank intermediated market funding. Risk finance via capital markets should definitely expand. The third is that not all companies’ funding needs are better addressed through bank lending. The most promising companies in terms of growth and jobs need more equity financing and that needs to be increased.
The current situation can perhaps be described as market failure. There are likely more savings than ever, but they mostly have a short term horizon against the significant volume of long term investment needs. The CMU is about trying to make those ends meet. The result is that CMU is a long term and complicated project that needs a number of strings pulled to make it work.
1.2. Achievements so far
A policymaker stated that the CMU action plan of September 2015 was announced with 33 actions and is moving along as planned. 18 months on, 20 are completed and the remaining 13 are on their way. However, it can be asked whether this is enough; the EC thinks that it is not, and that they ought to now go deeper, and bolder. The situation has changed because of Brexit and fintechs in particular. They need to now move to a second phase of CMU, which should be as ambitious as possible.
Responding to a question on the measure of success of the CMU, the representative explained that the measure is, as defined by Mr Juncker, to have all the building blocks in place by the end of the mandate of the current EC, which is an administrative measure, rather than a market orientated one. It is however not the EC that will be implementing the CMU. The EC hopes to restore the balance of incentives and disincentives by 2019 so that market players have an interest in developing the CMU but ultimately it is up to the market to make it work, which will of course take some time.
A public authority speaker commended the EC for what has been done so far on the CMU. It is not an easy topic or a particularly attractive objective politically, so it is important that the EC has taken the initiative and driven it forward. The progress made with CMU however needs to be nuanced. It is essential to underline the importance of this project, but also to take stock of the current position and what remains to be done. Although 20 measures out of 33 of the CMU action plan are in place from a legislative perspective, not all of the initial objectives underlying these 20 measures have been achieved. Parts of these have been significantly delayed, probably more so by the European Parliament than by the Council. There has also been a significant deterioration of a number of important proposals, such as the implementation of Simple, Standardised and Transparent securitisation (STS), which has significantly deviated from the original intent.
An industry representative agreed that EU capital markets should develop, and that moving forward with CMU is even more important than before the Brexit vote, but emphasised that although quite a few regulatory measures have been adopted, the data shows that capital markets activity is actually deteriorating in the EU.
A recent survey by the ECB (SESFOD survey) suggests a drop in market-making most pronounced in covered bonds, sovereigns and convertibles. The survey also indicates that although banks are confident when acting under stress for securities such as government bonds and covered bonds, which have beneficial regulatory capital and repo treatment, they are not for other types of instruments. A recent AFME survey also concluded that there has been a sharp fall in equity underwriting in 2016, relative to 2015. It moreover reports a decline in European trading activity year on year, and shows that there is in parallel an increase in trading taking place away from traditional exchanges. Company delistings have moreover surpassed new company listings.
The speaker’s personal observations confirm those findings. Many traders have pointed out that there is a move away from bonds and transparent rated instruments that are often part of indexes, into loans. The speaker’s estimate of the balance sheet of insurance companies also shows that they have significantly reduced their exposure to securitisation (including that of SME and real estate loans) and decreased their exposure to venture capital and private equity. In addition, despite changes in the treatment of infrastructure investments in Solvency II, clients are unable to find such investments.
There are many reasons for these negative trends. Monetary policy and political risks play a role, but not everything can be attributed to them. There are also unjustified discrepancies in the treatment of some financial instruments under different regulatory frameworks, for instance there is incompatibility and non complementarity in treatment between Solvency II and CRR and long overdue recalibrations needed in capital, as well as continuing regulatory uncertainty.
A regulator highlighted that these negative trends concern mainly the capital market activity of traditional banking players, but at the same time the asset management industry has nearly doubled in the past 10 years going from €10 trillion to €20 trillion. Although their trading behaviour differs from the banks’, the asset management industry may have a greater role to play in capital markets.
The industry representative agreed that the asset management industry already plays a significant role, but care is needed when considering what asset managers do as direct lending and how much of that is supported through the banking system. Second, secondary liquidity and whether asset managers will be able to provide sufficient liquidity when necessary also need to be examined. In addition, a few regulatory issues need to be addressed before asset managers related to insurance companies and pension funds, can step in.
2. Upcoming priorities for the CMU
A policymaker explained that a public consultation had been launched in January 2017 by the EC regarding the mid-term review of the CMU. A little fewer than 200 replies have been received and are currently being examined. A first reading of the contributions received clearly shows that respondents want the EC to remain firmly focused on the core themes of the original action plan: i.e. improving the financing of SMEs; enabling institutional investors to invest more easily in long term assets; developing a more effective and rewarding retail investor engagement with capital markets; sustainable finance; and removing residual barriers to cross border investment.
The EU also needs to update the CMU strategy to tackle three further incoming sets of issues: the supervisory framework for capital markets, the strengthening of local ecosystems and the development of fintech.
An industry representative emphasised that the starting point in Europe is that capital markets are relatively underdeveloped. For example daily equity trading volumes amount to €50 billion in Europe compared to €155 billion in Asia and €160 billion in the US, and EU trading volumes are due to diminish significantly following Brexit. From a structural perspective, the most urgent issue for the EU is to close its entrepreneurial gap. They cannot accept that companies that want to tap into capital markets in order to grow are not capable of doing so.
In order to achieve the CMU, the EU firstly needs to remove the existing barriers to cross-border investment, which was the starting point of the CMU. Second, it needs to create the relevant supervisory structure in a post Brexit environment. Third, it needs to ensure that CMU embraces the technological developments in financial markets and ensure that the EU gets a relevant position in the global competitive landscape when it comes to fintech. This requires the private and public sectors to work hand in hand. A legislative framework can provide a growth friendly environment, but if the private sector does not fill it with relevant initiatives, Europe will lose out, which they do not want, with or without Brexit.
Another industry representative agreed with the additional steps proposed for the CMU project: developing scale, expertise and encouraging development of ecosystems; focusing on the supply of risk capital for technology and other high growth sectors; taking advantage of the potentialities of fintech and regtech; reviewing and improving the supervisory architecture; enhancing the legal, regulatory and fiscal frameworks; and making progress on the individual terms in the CMU action plan. However, there is also a need to ensure that the CMU maintains close links with the financial markets located in London that will inevitably continue to be substantial.
2.1. Improving the supervisory framework for capital markets
A policymaker stated that the supervisory framework for capital markets needs to be strengthened in the EU. The public consultation regarding the European Supervisory Authorities (ESA) review has just gone out.The ESAs need to be strengthened to work towards more supervisory convergence and less supervisory arbitrage within the EU in the future. That is true for all three ESAs and ESMA in particular.
A public authority speaker underlined that it would be wrong to say that following a first difficult sequence of pushing through legislation related to the CMU, the remainder of the EC’s target should focus on integrating supervision, and the rest will come through by itself through having a central European institution that will drive it. Supervision is an important part, but not sufficient. Further changes are needed in legislation at the Union level; STS is one amongst a number of other topics in the CMU action plan for which progress is desired, like the harmonisation of certain elements of insolvency law. Ambition and boldness is needed in this regard.
This does not mean that the EU does not need to improve its supervisory structure. Brexit has, in a way, changed the priority of where changes are needed in the current supervisory structure. Two immediate challenges coming from Brexit impact the supervisory structure. The first is third country regimes that were not designed for a country like the UK. The content of these regimes needs to be changed and a unified approach is needed for whoever does the assessments. There needs to be one authority in each sector or field that does the assessment of third-country regimes and its monitoring for the whole of the Union. The second challenge concerns the possible relocation of activities from the UK to the EU about which there is much discussion at present. The minimum standards that are required to receive authorisation and do business in the EU27 need to be urgently clarified. A first step could be to provide the ESAs with the right to oppose the granting of licences or authorisations by national competent authorities if they think that European standards are not met. Over the medium to longer term, one way to improve the authorisation process would be to consider something like a twin peak structure, or at least a European model of twin peaks strengthening ESMA for capital markets on the one hand and combining EBA and EIOPA under one roof on the other.
Europe should also review the decision making processes within the ESAs depending on the type of decision to be made and whether it is regulatory or supervisory work. There is a need to streamline decision-making by the supervisory authorities because if they receive more concrete or direct supervisory competences they will need to make many more decisions. There is currently an almost uniform way of making all the decisions in the supervisory structures and this needs to change. Processes need to be differentiated depending on whether a decision is taken e.g. on an individual administrative issue, for example a waiver or a position limit or on a regulatory standard which is close to legislation and where more time might be needed to decide . The EU may also want to examine who has a stake and competence in different issues, and therefore who should have a seat at the table. They also need to ensure that when individual decisions are taken, all those with competences who are affected by the decision have an adequate say at the table. Those are all important issues that the EC will review once it has received the feedback from the consultation on the ESAs.
A public authority representative agreed that the development of capital markets in the EU has a regulatory dimension. A number of regulations have been implemented since the CMU was launched, but initiatives need to go further on insolvency and securities law in particular and a number of other areas where harmonisation does not exist.
The representative also concurred that EU capital markets need to move forward in terms of supervision. The implicit assumption with the CMU was that there should be a first move forward on regulation in order to create more integrated markets, and that supervision, which was considered to be more difficult to agree on should be addressed in a second stage. But with Brexit that logic has changed and now a dual track approach is needed, with further progress in regulation and at the same time a more decisive move in terms of harmonising the supervision of financial markets in Europe.
That directly relates to the financial system after Brexit, which will be a more diversified and distributed system across the EU27, requiring more supervisory convergence. Supervisory convergence can be improved in many ways and in this regard it is more important to look at the missions of the authorities than their structure. One way is to look at how existing tools of supervisory convergence are used by the ESAs and ESMA in particular and whether additional tools need to be considered. In the capital markets area, there is a strong rationale for considering a strengthening of the powers devolved to ESMA. Some changes are a continuation of current developments (e.g. initiatives related to the centralisation of data gathering regarding EMIR or MiFID); others are newer (e.g. the joint or coordinated supervision of critical European market infrastructures such as CCPs or CSDs). Those European infrastructures have European clients, so the rationale for moving forward in terms of a more centralised supervision should be examined.
For all those reasons, supervision needs to be on the agenda. It is a key item in CMU and participants need to be ready to discuss it in a European forum.
2.2. Strengthening capital market ecosystems across the EU
A policymaker stressed that the EU needs to continue to strengthen capital market ecosystems across all EU member states. Regulation will play a role, but a number of Member States lack the ecosystem or administrative capacity to start building those ecosystems. Part of the innovation of CMU is that the new Structural Reform Support Service (SRSS)1 will expand the assistance of the EC beyond programme countries to all countries that have a need to build capital market ecosystems, but lack the knowledge or capacity to do so. That is extremely important. Part of this trend is also the continuation of the dismantling of national barriers to free movement of capital.
A public authority spokesperson agreed that the EU needs to recognise that local ecosystems are very important. Legislation can support an ecosystem but cannot create it. As such, sharing best practices, removing barriers and building local ecosystems are very important.
Responding to a question on how to square the concept of national ecosystems with the general notion that capital markets are typically about developing scale and size across the EU, the speaker explained that both local and EU capital markets are needed. Cross border access to capital is important and the challenge is to remove the barriers, so that any capital available in the Union is available for financing companies and projects. However, local ecosystems are also essential to build local start up communities because a local venture capital scene is necessary to first bring venture capital to local start ups, and then bring these companies to a stock exchange. That depends on local network clusters, so both local and cross border capital markets are needed.
Saving patterns are another key issue. They are deeply culturally ingrained. Incentives can be given, but it is very hard to change them by administrative fiat.
An industry representative agreed that when it comes to SME financing there are cultural differences, but what is essential is developing appropriate ecosystems. Much can be learned from looking at local projects and seeing whether they are fit for purpose in other markets and if they are capable of scaling to a European level. If not, they may still be effective at the local level, and that is also needed for the CMU. In several EU countries frameworks have been successfully created for pre trading markets. For example, in Germany, a venture network has been created to match growth companies after the start up phase with international investors, and 18 months later a funding of €1 billion has been raised for these companies.
2.3. Developing Fintech
A policymaker stated that the third priority for the CMU is fintech, which is both a disruptive challenge and a huge opportunity for capital markets. The EC is seeking to seize the opportunity and fully integrate fintechs into the design of the second stage of the CMU.
A public authority representative added that the EU needs to integrate into the mid term review the changes coming from digitalisation of financial services, which will open new angles, channels and business models.
An industry representative noted that, regarding fintechs, there is a potential conflict between local and EU development, but the two dimensions should go hand in hand in order to develop EU capital markets.
2.4. Adjusting prudential requirements
An industry representative acknowledged that many issues still need to be addressed to develop the CMU. Some are essential but will take time to achieve, such as developing risk taking, risk appetite, financial education, entrepreneurial spirit in the EU and harmonising rules such as insolvency regimes. Meanwhile, there are ‘low hanging fruits’ that need to be tackled. The call for evidence review by the EC will highlight a number of steps to be taken, but some can be considered in the short term.
The first priority is the recalibration of Solvency II, regarding private equity and venture capital. Tackling Solvency II issues for insurance companies will likely also benefit pension funds. As far as securitisation and infrastructure are concerned, the discrepancies between CRR and Solvency II need to be addressed, and the regulatory capital treatment between securitisation and covered bonds needs to be eliminated also. Continuing convergence of these two products is seen, but not of their regulatory capital treatment.
There is also much talk about qualifying exposures. There are qualifying exposures for infrastructure and an intention to establish qualifying exposures for STS, but the major question is who determines that something is ‘disqualified’, how and when this is done, and how the respective consequences for both investors and issuers are taken into account. The EU needs to expand its investor base, but that is not very difficult. It requires clarifying the definitions under AIFMD and MiFID II for securitization and also clarifying the investor base under STS. Market making activity for STS also needs to be improved, but this cannot be legislated. There was a very bad experience with the market making of covered bonds during the crisis, so that needs to be addressed, but if there are no profits then there will be no market making. The industry also needs to develop capital markets for NPLs, restore the secondary market for securitisation, and go more into secondary markets for covered loans. Some of the measures coming into place with MiFID with regard to pre trade transparency and research may have a negative effect on market making. The NSFR and FRTB could also have a negative effect on market liquidity as discussed in another session of the Eurofi Malta Seminar.
3. Implications of Brexit for the CMU
3.1. Possible consequences of Brexit for the CMU
An industry representative stressed that in the article published in the Eurofi Magazine, they had written that Brexit is both an existential threat to the CMU project and an urgent call for the EU27 to progress in building an effective CMU. The CMU is indeed everyone’s responsibility, not just the EC’s. Everyone in the European market has to take responsibility for it and build it together. There are two points to outline before making suggestions on how to take the CMU project forward.
Regarding the existential threat of Brexit, CMU is a single market project built, first, around breaking down barriers between national markets; second, around developing capital markets so that Member States are not solely dependent on bank financing; and, third, on the belief that open cross-border markets reduce systemic risks and increase stability. If Brexit means the creation of new barriers between the UK and the EU27, then this could directly challenge the existential purposes of the CMU project.
Secondly, there is clearly the possibility of a Brexit outcome that is less than optimal, which means that Brexit makes it even more important for the EU27 to develop capital market capabilities. However, at the same time Brexit also makes it potentially more difficult for the EU27 to build those capabilities, and that challenge needs to be considered. For many critical capital market activities, the scale, expertise, ecosystem and pools of capital are currently in London. The article in the Eurofi Magazine mentions that London’s share of total European activity is around 74% for trading in OTC interest rate derivatives, 78% for foreign exchange trading and around 90% for some specialist activities. Those figures emphasize the need for the EU27 to develop its own capabilities and the difficulty in achieving that without access to the existing markets, largely based in the UK. Financial markets are network industries, and London is very largely a network. Building a new network or ecosystem without access to the main existing network in Europe is very difficult. Given the possibility of difficult times ahead, complex supply and distribution chains need to remain open and functioning for clients, issuers, investors, financial markets and markets in general as much as possible.
A public authority representative agreed that the CMU with Brexit is even more important than without. Another public authority representative stated that Brexit will have important consequences for CMU and the financial system in Europe. With Brexit, the EU moves towards a more diversified and decentralised financial system in Europe, with potentially less depth and liquidity.
When considering the consequences of Brexit on CMU, the first issue that comes to mind is that the CMU needs to be accelerated to alleviate the consequences of Brexit on the correct functioning of the EU financial system. The second issue is finding a proper framework for the long term relationship between the EU and UK, both with respect to regulatory convergence and to the management of systemic risk.
An industry representative explained that there are four dimensions to the issues related to CMU and Brexit. The first is the inner EU dimension of Brexit and how EU government and institutions can tackle the issue; the second is the inner UK view; the third is the relationship between the two; and the fourth is the global dimension.
CMU is about making the EU globally competitive and improving the financing of the EU economy. CMU will now have to be implemented whilst negotiating Brexit and the European Union will be losing the biggest part of its financial market. However, this is not a ‘doom’ scenario. Ultimately, Brexit is only one stage or one reorientation in the evolving long term project of CMU. The EU’s history gives every reason to be optimistic and believe that crises can be managed, however complex. The delivery of the Banking Union in a relatively short timeframe is an example of this.
3.2. Suggestions on how to progress with the CMU in the context of Brexit
3.2.1. Avoiding fragmentation by improving the external and global dimension of CMU
An industry representative had various suggestions on how to progress with CMU, as well as warnings from past experience. The tariffs imposed by the US in 1930 and subsequent tariffs imposed in retaliation by other countries contributed to the collapse of international trade and to the severity of the Great Depression. That history has to be borne in mind as Europe faces the prospect of the UK disengaging from the current EU regulatory and supervisory environment. From both economic growth and systemic stability perspectives, the EU needs to build an international system that maintains open access and open markets, and that allows the EU to benefit from access to pools of investment wherever they are, from within or outside of the EU.
The external and global dimension of the CMU project has become more important with Brexit. International regulatory dialogue and collaboration will play a critical role. The regulatory dialogue and collaboration will need to cover micro and macro prudential matters. The EU needs to avoid a situation where, based on systemic risk concerns, regulators create barriers between markets, which may actually increase systemic risk. The EU27 needs to develop an enhanced streamlined regime for determining regulatory equivalency with third countries, as the current regime is not fit for purpose in the circumstances of Brexit.
A regulator emphasised one key characteristic of the UK, which is to be a financial hub. The representative wonders whether the EU27 having multiple financial centres and infrastructures is an issue for achieving the CMU.
The industry representative explained that many European cities are twinned with other European cities. That twinning gives the opportunity for collaboration and there are deep specialisations that take place already. Brussels in particular has a reputation for being the home of market infrastructure, and the Belgian Government for example has also been quite innovative in trying to encourage a fintech market to develop, particularly one that revolves around improving efficiency and process.
The regulator stressed that an additional difficulty will be that discussions about the future EU-UK relationship and how third country regimes will work in this context will be taking place at the same time that a range of on-going equivalence issues are being discussed.
Another industry representative stated that capital markets are global markets. Regulation and supervision need to be globally aligned for markets that have an international dimension and fragmentation needs to be avoided. What is needed is transparency regarding how interactions with a third country can work, which is about safeguarding the stability desired in the financial system and not about shutting off the access to the EU market.
A third industry representative noted that Brexit poses questions about the external dimension of the CMU and access to developed and deep capital markets outside the EU. The speaker agreed that there are issues with equivalence with third country regimes. The EC, in the second part of its term, has the opportunity to address many of those technical issues and assist capital market development.
3.2.2. An EU UK framework encouraging regulatory and supervisory convergence
A public authority representative suggested that a proper framework needs to be defined between the EU and the UK for the medium term, which includes two elements. The first is regulatory convergence, which needs to be maintained over time in order to preserve fair competition and a level playing field. The second is a good management of systemic risk. Whatever the outcome of the UK and EU arrangement, there will be significant interconnections between the EU and the UK and possible spill over risks need to be managed, and that can only be done via strong supervisory arrangements. From that perspective, the idea of moving towards more centralised supervision in Europe for financial markets is all the more compelling as it will facilitate information sharing in particular. Any efficient supervisory arrangements between the EU27 and the UK will best work if there is a centralised authority in Europe. That is how the various entities can be efficient and it goes well beyond the issue of equivalence for which there is also a case for management at the central level.
A regulator stated that the equivalence concept is premised on the UK continuing with the same rulebook. The speaker wonders how consistent that is with the UK’s decision to leave the EU.
A public authority representative considered that there is a political balance to strike. The French Treasury is in favour of integrated markets, and everyone fears fragmentation, which means loss of efficiency. For integration to work, the EU needs to use, build and abide by international standards. However in a market setting as integrated as the EU28, international standards are not enough because they sometimes remain at the principle level. Convergence is needed in terms of applicable rules, which is good for the private sector because there is clarity and thus is good for competition because it allows people to compete on the same grounds.
A speaker in the audience stated that a framework between the EU and UK also needs to take into account cultural preferences and differences, as well as linguistic issues. A CMU supervisor, in addition to the existing Banking Union supervisor would help, both in terms of Brexit and in relation to getting other things done, and will also prevent ‘forum shopping’, because there is a current danger that, with Brexit, national regulators will reduce their regulation to entice companies. This issue must be examined, because it could lead to greater fragmentation from Brexit.
A policymaker emphasised that regulatory competition is clearly an issue. Regarding the EU’s relationship with the rest of the world, equivalence is a continuous requirement, and needs to be judged on a continuous basis by one authority. If one accepts that equivalence can be determined by any of the 27 authorities, the risk of forum shopping and the risk for financial stability is great. That is one issue that will influence thinking regarding the review of the ESAs.
The risk of disruption of CMU related to Brexit is unavoidable. The only way to avoid it would be to go for a continuity scenario, but that would mean that the EU accepts that a considerable part of its financial risk is managed by a third country jurisdiction, which is something that the UK would never accept and therefore something that the EU should not accept either. Things will be different; this is regrettable, but inevitable. Although the speaker believes, like many others, that the EU and UK should aim for a win win agreement, the outcome will probably be a ‘lose least lose least’ agreement in the end.
This is an issue that also has implications for CMU 2.0, because nobody knows what the new relationship is going to be like. The representative hopes that it will be as integrated as possible. Not knowing what the outcome will be, Europe needs to prepare for the worst case scenario, and build up its infrastructures and local ecosystems.