European Capital Markets Institute, Chairman, Special Advisor of the EU Presidency
European Commission, Director, Financial Markets Directorate
Ministry of Finance, the Netherlands, Director International Affairs
Vincenzo La Via
Ministry of Economy and Finance, Italy, Chairman, Financial Services Committee and Director General of the Treasury
Bolsas y Mercados Españoles, Head of Equity Unit
Eric Le Brusq
Natixis, BPCE Group, Global Head of Equity Derivatives
Tradition, Advisor to the Chairman
Nasdaq Nordic and Nasdaq Stockholm, President
Better Finance - The European Federation of Investors and Financial Services Users, Managing Director
Detailed SummaryThe Chair explained that European capital markets have experienced significant growth in recent decades and have contributed greatly to the financing of EU corporates, particularly larger ones. There have therefore been positive achievements by the EU in this field. Many tools are available to allow companies to list securities and raise capital, and to enable those securities to be traded across the single market thanks to a harmonised regulatory framework that is mostly efficient.
However, a number of weaknesses have become visible, notably since the financial crisis: the number of IPOs has not returned to pre crisis levels; capital increases are mainly achieved by very large companies; trading volumes, despite their increase, are fragmented across several trading platforms with diverse regulatory regimes, which challenges price formation; market makers who provide liquidity for those markets have reduced their activity; books are highly captive of high frequency traders; and the cost of cross border clearing and settlement has not yet significantly decreased. Thus there is room for progress in EU capital markets.
Furthermore most of the current EU regulatory framework has been designed for large corporates and has only recently been amended to create a more proportionate regime for small and mid caps.
The question therefore is whether Europe needs to do more to develop equity financing, whether the Capital Markets Union (CMU) agenda is the right one, and whether there are other necessary initiatives.
1. The importance of developing equity financing in the EU
1.1. Equity to support retail pension savings and long term investment
A policymaker emphasized the specificities of equity financing compared to bank lending in particular. One element is that equity investment is linked to the performance of the business and the company. Thus it is ‘patient capital’, the capital that aims at achieving long term results and is more likely to contribute to the long term objectives of the businesses that it finances. Another element is that it offers a broad investor base diversification.
A market observer commented that equity funding and equity investment are important for individual investors, but crucial when the current and future generations look at retirement. The European Commission’s (EC) White Paper on pensions, and the OECD, advise saving as early as possible. That is the best way to get ‘pension adequacy’, which means a high level of replacement income. However, the most crucial success factor in having pension adequacy is the return. The market observer also noted that end investors ultimately bear the risks of equity investment and therefore are also interested in sharing the rewards of investment.
Thus, much more equity would need to be allocated into pension savings and investments, particularly for the more affluent and financially literate people. Moreover, direct equity investment by pension savers should be allowed and even promoted because one key factor of low returns in pension savings is too often the excessive commissions and fees that are charged on packaged pension products. If this is not done, this will be catastrophic for retirement.
Getting individual investors back into equities is also good for capital markets. Recent academic research shows that individual shareholders tend to be contrarian, whereas institutional investors tend to be momentum investors. They also proportionately invest more in SMEs than institutional investors, which is not only good for the economy, but also for investors.
Finally, equity allows creating a closer link between long term household savings and the real economy into which savings are eventually invested.
An industry representative, speaking from the perspective of an EU retail broker, agreed that the retail investor is important for the equilibrium of the market.
1.2. Equity financing may increase the resilience of the EU economy
A public authority representative explained that one essential aspect of CMU is that it may reinforce the stability of the EU economy. The US, which is a complete fiscal, monetary and capital markets union, deals with asymmetric cross border shocks mainly through capital markets which absorb two thirds of the shocks, whereas only 13% is absorbed by the fiscal capacity. This shows that the CMU and developing integrated capital markets in Europe is of key importance because it is the best channel for improving stability in Europe and the Eurozone, and the ability to absorb asymmetric shocks. The CMU needs to be developed in order to become the key risk absorption channel in the EU alongside the EMU.
2. Main challenges to be addressed for the development of EU equity markets
2.1. Addressing differences in maturity of European equity markets and leveraging local initiatives
A policymaker explained that a first key issue is the fragmentation and the difference in maturity of EU equity markets, which is a challenge to the CMU project. The EC wants to harmonise the maturity of capitals markets in Europe. There is a desire to create capital markets where they do not exist, strengthen existing ones where they are weak, and enhance those that are between those two positions. The CMU approach, however, needs to be careful and respect the level of maturity that currently exists in the different EU Member States. That is a further challenge for the CMU project, which is very complex.
The CMU cannot erode or interfere with local ecosystems. It should sit atop them and learn as much as possible from them. In those cases where the ecosystem does not exist, the EC is trying to create the conditions for it to develop.
A representative of a public authority emphasized that capital markets have existed in Europe for several centuries but still have significant room for progress; for example the third largest economy of the Eurozone has a market capitalisation that is no larger than the market capitalisation of Apple. There are many legislative and regulatory avenues that can be pursued at the EU level in order to develop its capital markets, but improvements at the national level regarding equity markets and equity culture are also essential. This can be done through country specific recommendations relating to the themes that are covered at the European level. Some of those recommendations are to do with corporate law and defining which corporates are allowed to tap the capital markets, and others are to do with taxation and prudential rules. In addition, if people can only save through an insurance product for their pensions, and if that type of product forces the insurance company to buy more sovereign bonds instead of equity for example, then there is a departure from the objectives of the CMU. Europe should examine what each individual country can do in terms of improving corporate governance, taxation, pension law, especially for SMEs, with all the relevant contributors.
2.2. Addressing potential MiFID II impacts on equity research and market data
An industry representative outlined that an initial challenge is that there is almost no research on cross border SME investments for retail clients. After MiFID II, and the rules relating to inducements and unbundling of research, there will no longer be any research. Consequently, clients will continue to purchase mainly domestic stocks, for which trading fees are similar, and those interested in buying foreign stocks will buy US ones rather than European ones. Thus, cross border investment with the US will develop rather than cross border European investment.
There are two further points on MiFID II. First is regarding the threshold that will be applied for trading on alternative platforms. Most of those platforms are located in the UK, so the question arises of what data will be available and how the threshold can be calculated. Second is that MiFID II is scheduled for implementation on 3 January. The issue is that there will be a market on 2 January, which means that old MiFID I rules will still be in place on 2 January before migrating overnight, which could prove disruptive. It could be risky for some assets and especially equity. It will be bad for the market if there are issues on 3 January when the market opens.
Another industry representative outlined that when talking about markets, the two essential concepts are transparency and liquidity. Both are related; one cannot have liquidity without transparency. MiFID II aims to increase transparency, which was also a main objective of MiFID I. One objective of the new regulations is to bring more volume to the order books and attract them from OTC. That is important in the price formation process because many prices used outside of regulated markets use those prices as a reference. Moreover, the higher the volume, the higher the quality of the price formation is in the market. That forms one side of the information needed.
Information is also needed on the buy and sell prices and the buy and sell interest, on what is being traded in the market and whether this information has sufficient depth. This is particularly important for retail investors and SMEs because a fair valuation of companies is crucial. Information is also needed about the companies. It is important that SME companies should have lower requirements, but also important to have an appropriate balance between these lower requirements and the information that investors are provided with, because it will also be important for the price formation and the correct valuation. Finding research for those companies is difficult and a challenge for the future will be how to obtain more research for small companies, which will be good for the quality of the market.
A third industry representative expressed concern about what will happen in the future in terms of research, especially for SMEs with MiFID II unbundling rules, which may ‘break the financing model’ of research. The representative’s organisation finances basic research on all of their listed companies in their main and junior markets. They pay an external company to conduct that research, so that basic information is available on all the listed companies in a uniform way, particularly for investors who do not have access to Reuters or Bloomberg.
A fourth industry speaker explained that the research topic is essential and instrumental, and MiFID II needs to be carefully monitored as far as equity research is concerned. One key point relates to the equity financing of SMEs. The main challenges are supporting the liquidity of the secondary market, post IPO and the availability of mid cap equity research which has an impact on liquidity. MiFID II, PRIIPs and the MAR regime definitely impact upon SME equity research. The evolution of those regulations should be carefully monitored.
2.3. Developing cross border equity investment in the EU
An industry representative highlighted the important issue of retail investors disappearing from equity markets, for reasons already mentioned such as the lack of equity culture, information on stocks…, but also because it is difficult for them to invest cross border. The withholding tax on cross border flows is a major obstacle for retail clients. There is also a lack of harmonisation of property rights and corporate actions. Moreover, many investors have a home bias and are not interested in foreign securities. A further, and important, point for retail investors is that the post trade is inefficient for cross border trading. It is very costly, which is an issue for individuals who are used to paying low fees.
From an inter dealer broker perspective, cross border collateral trading is also an issue.
3. Actions underway for supporting the development of equity financing
3.1. CMU actions underway for developing SME equity financing
A policymaker explained that the mid term review of the CMU offers the opportunity to take stock of what has been done and to look forward to see what more can be done. Of the 33 actions announced in the first CMU action plan of 2015, more than half have been delivered, with some already adopted and others being discussed by the legislators. The EC intends to announce another set of measures. Up to 60 measures are under development, which is something ambitious in terms of the objectives to achieve.
The EC is ambitious, but realistic. The CMU is a toolbox made of a number of initiatives, none of which are sufficient alone, but which should contribute together to delivering the objectives of the CMU. For the objectives already achieved, it is difficult to prioritise those that are more important for SMEs in particular, but several measures proposed by the EC should contribute to injecting equity financing into the economy.
For the pre IPO phase, the package to increase venture capital financing with the creation of the EU venture capital fund framework should help in that context. For the companies aiming to be listed, or already listed, prospectuses will be improved. The EC has in particular proposed to raise the threshold above which a new fully fledged prospectus needs to be prepared by the issuer. At the end of the negotiating process the threshold was higher than what the EC had recommended; a €20 million threshold was proposed, but in the end an €8 million threshold was retained, which is already a significant improvement. These new prospectuses will be a key ingredient of another measure that will bring major benefits, which is the creation of SME growth markets. This new category of MTFs will enter into force in 2018 and will alleviate significantly the conditions under which SMEs operate.
Regarding the supply side, capital charges are being reviewed for insurance companies investing in SMEs and ELTIFs where 70% of the money is invested in SMEs. The cross border distribution of funds is another project the EC is working on in order to remove the barriers that asset managers have when they want to use their passports to raise money cross border. Proportionality will be introduced whenever possible for SMEs even in the post trading space. The EMIR review is coming and the EC wants to alleviate the unnecessary burdens there also. The reporting obligations for companies, particularly small companies, will notably be looked at to ensure there is no double-reporting.
The Chair mentioned that a prospectus has already been introduced for mid caps. However, when the requirements were drawn up, this was done rapidly and effectively amounted to deleting a few requirements in the full prospectus. This time, the real specificities of mid caps should be considered. The question is not so much about alleviating the prospectus, but making it proportionate and specific to the kind of companies concerned, depending on their level of maturity, capital structure, and whether the founder is the main shareholder and manager of the firm. It is therefore about tailoring the requirements in accordance with the specificities of mid caps, which is important in making the prospectus effective and meaningful for the investor, and providing the investor with appropriate information.
3.2. Existing practices in EU Member States
An industry representative underlined that Spain has two markets for two different types of products. There is the main primary market for small and mid caps that has some special requirements. For the time being, a prospectus is not required, but information that is important for investors, such as financial information and corporate governance, is provided.
On the trading side, in Spain they try to apply to small and mid caps the same rules as for blue chips in terms of transparency. This is necessary to make the market work. For those securities, there is also complementary liquidity and the presence of market makers. These markets are regulated to some extent in MiFID II, which is something that contributes to liquidity. Although perhaps not universally agreed, it is good news that MiFID II is reaching into non equity, the speaker believed, because it will extend requirements on transparency, and liquidity, which is important for retail investors especially.
Another industry representative stated that First North, the representative’s institution’s European growth market, designed for small and growing companies, uses the same rulebook for the seven countries it covers (Finland, Sweden, Denmark, the three Baltic countries and Iceland). Prospectus requirements for capital raising use a threshold that is below the one proposed for the EU, i.e. €2.5 million in Sweden and €5 million in Finland. This prospectus is called the ‘company description’. It has been specifically defined for First North markets, but is standardised for all seven countries and provides investors with sufficient information. It comprises typically 50 60 pages, compared to a full prospectus of 100 800 pages. They have tried to focus on what investors want to know in terms of the company they are about to invest in, as opposed to a number of pages of legal disclaimers. They use the same trading models that they have for the main markets. The only difference concerns small caps for which there is an intra day auction in the afternoon. This auction does not work that well, but it supports the liquidity of small cap stocks to a certain extent.
Regarding the CMU toolbox, the representative’s institution’s markets have a toolbox and share best practices from Sweden in particular, which has an SME market that works really well for listed companies and investors, with the six other countries, in terms of what could be done with the pension system, taxation and investor incentives. In Sweden, for instance, the investor savings account is a success.
However, the experience so far of sharing best practices shows that it is not that easy, even in the Nordic/Baltic region, which is useful for assessing the CMU ambition across the EU27. There are inevitable objections from each country because countries are not easily prepared to copy something that works in a neighbouring country. Sharing the toolbox is nevertheless something that needs to be done to create an equity culture and an environment where even small and medium sized enterprises can come to a public market, raise capital, grow, create jobs, and “conquer the world”. There is a recipe but it is a struggle to find agreement and create the necessary culture, especially in developing markets such as the Baltics, which only started 25 years ago. The difficulty is that they have state owned enterprises that they do not wish to privatise. In addition they do not require their pension systems to invest back into the country, which means that the pension money of the Baltic countries goes into global benchmarks and nothing is re invested locally.
A public authority representative noted that Europe is still missing out on growth opportunities for smaller companies, but agreed that there are many interesting initiatives to build upon. For example, in Sweden, as mentioned previously, there are positive experiences, there is a real equity culture and small firms are able to raise capital. Italy is also developing specific legislation for smaller firms. Many other countries are, together with the EC, working on harmonising their equity framework.
4. Additional actions needed
4.1. Developing equity investment in the context of the PEPP Project
A market observer outlined, regarding what can be done, that it is stated in the CMU action plan that retail investors in Europe are currently less directly involved in capital markets than in the past. The proportion of retail investors among all shareholders is less than half the level it was in the ‘70s. The problem is that the CMU action plan contains nothing to address that problem.
Two actions are essential for developing retail investment in equity. The first is to improve the transparency of performance fees in long term savings. The second is the Pan European Personal Pension product (PEPP). That could be a useful instrument, but in order to have a successful PEPP able to support the CMU, direct equity investments into the product need to be allowed. When the EC and EU authorities talk about getting more retail investment into equities, they need to follow through.
Another industry representative agreed that one of the key points is to help to develop long term saving plans. Europe has quite a fragmented landscape in that area. In the Nordic countries, there is a very active pension fund industry that tends to favour investment into equities, whereas in Southern Europe there is less of that scope with regard to pension funds.
The lack of equity investing culture, compared to the US for example, is an important challenge. Important efforts have to be made in that respect. Many initiatives are coming over, for example in France, encouraging retail investors to move short term deposits into UCITS type products; however, the gap before having retail clients keen to invest in equities is still very wide.
Responding to a question about the timing of the PEPP initiative, a policymaker explained that the timetable for the PEPP initiative is yet to be confirmed, but suggested that the proposal may be published at some time between July to September. It depends on how quickly the EC addresses all of the technical challenges that the project entails. One particular challenge is that the EC is keen to ensure that the product they design can deliver advantages for a broad spectrum of investors. The representative moreover confirmed that, in terms of investment policy, equity is high on the agenda of the PEPP.
4.2. The need to strengthen local equity market ecosystems
An industry representative agreed with other panellists that investors need to obtain appropriate return. That is all about providing an appropriate and well functioning equity ecosystem that works as well as it can. The stock exchange system was almost killed by regulation and needs to be recreated with less regulation and proportionate regimes. The representative’s organisation operates seven exchanges in seven countries in the Nordic/Baltic region, which have different ecosystems with different levels of maturity, and all require different approaches in terms of how to develop that ecosystem to cater for investors to get their returns and for the companies that need the capital. It is about having on the one side the entrepreneurs and companies who want to grow and need capital, and on the other side the investors who need appropriate investments.
The Stockholm Stock Exchange is the best stock exchange globally in terms of real rate of return, with 8.7% average annual returns over 50 years. The world’s number two market is Finland and the Helsinki Exchange, with 8.6%. South Africa is number three. Number four is the Copenhagen Exchange in Denmark, with 7.5%. Interestingly, the US is number 16, with a 5.3% real rate of return.
The system needs to work for investors. The Nordic countries, and Sweden in particular, have a very strong equity culture, and the junior markets have been redefined in all seven Nordic/Baltic countries. It works well in Sweden because they set the bar right in terms of what the rules are to get to that market, what kind of disclosure needs to be offered, and so forth. Sweden has an SME market that is already 10 years old and there are more than 300 listings on the market. This year, the Swedish market will have more companies in their junior First North market than on their main market. The Nordic/Baltic region is the only one in Europe that shows net growth in the number of listed companies over the past three years. The number of listed companies everywhere else has been gradually declining for 50 years.
The seven ecosystems of First North differ. The speaker’s organisation has taken the approach that the ecosystems cannot be harmonised. Best practice can be shared, but they need to be local and local ecosystems need to develop first. Something in terms of a CMU can then be built on top of that, but without a working local ecosystem, one cannot create anything on a higher level.
4.3. Developing crowdfunding at the EU level
An industry representative emphasised that 99% of all non financial companies in the European Union are SMEs. Going beyond the scope of the traditional activities provided by the financial sector for the funding of SMEs (i.e. organising access to SME investment for a investors through primary markets and IPOs, or providing leverage to private equity funds for LBOs), it is important to mention the SME equity market disruption emerging from fintechs. Fintechs will play an important role in SME financing in the years to come; and when speaking of fintech and new technology, the focus is on crowdfunding in particular.
Harmonised European legislation could help to develop crowdfunding. The European crowdfunding market is indeed fragmented. It is highly concentrated in a small number of member states with diverging legislations and limited cross border activity. In that respect, the EU could take inspiration from what was done in the US in terms of President Obama’s JOBS Act, which was intended to foster the funding of small businesses, especially after the crisis of 2008. That type of initiative would make sense for Europe in order to encourage harmonised legislation regarding crowdfunding platforms in particular. This would be in line with the CMU project, and its objective to broaden access to equity markets with the use of innovative solutions.
Another area to examine is the role that banks may play in supporting the development of crowdfunding. The first way is by providing investors and issuers with a proper custodian service and possibly leveraging new blockchain technologies. A second way is by developing the investment products that will offer risk mitigants and diversification and ensure appropriate customer protection. A third way is by organising information-sharing between investors and issuers, and by ensuring the calibration, validation and labelling of SME information.
A public authority representative agreed that crowdfunding may play an important role in the future in funding SME companies and that a European approach could make sense in that area. The EU will no doubt be going down the same route regarding crowdfunding as with equity markets. Member States are developing their own crowdfunding markets and legislations taking into account their national specificities in terms of pensions, tax, insolvency…. This is good for starting the market , however a need for harmonisation, and possibly a role for ESMA will probably appear in the future. The EU perhaps ought to start with a European framework for crowdfunding. This would provide an end perspective on a more harmonised market allowing participants to learn from each other.
An industry representative suggested that one option worth considering for making crowdfunding business models viable and reinforcing their role in the ecosystem is for them to become distributed on public IPO markets. That has been done in Finland and Sweden where two crowdfunding platforms have become licenced MiFID brokers and are using their digital platforms, and their crowdfunding capabilities, for distributing IPOs on a main stock market which, for some investment bankers, is a better investment model than the crowdfunding platforms themselves.
Another evolution to be considered is developing secondary markets for crowdfunding platforms. Crowdfunding platforms which are currently focused on primary deals will need price formation and secondary markets for the share issues that they are handling. Exchanges such as the speaker’s institution are ready to run markets for crowdfunders because that is the way ahead. A proportionate regulatory regime will be needed to make this possible, as well as an evolutionary path for companies as they grow. Companies could then start with crowdfunding, then go on to a junior market, and then they will eventually be listed on an exchange. The representative’s organisation is currently working on developing such an ecosystem with all the relevant stakeholders.
The Chair concluded that the EC has thus far been in observation mode about crowdfunding. The representative suggests that it is perhaps time for them to consider a crowd funder passport, or something similar, which would allow investments and businesses to flourish more in a single market.