ESMA Risk Analysis addresses known market risks and the identification of new manifestations of risks through the following actions:
- analysis and development of micro- and macro-prudential policy instruments in the non-banking sector;
- enhancing the availability of information at EU level for consumers, market participants and regulators via an up to date IT and data strategy;
- developing innovative and practical analytical tools (e.g. risk indicators, stress testing);
- improving insight in and oversight of financial innovation;
- providing analysis in the area of sustainable finance, in particular with reference to ESG investing and Climate risks; and
- further intensifying cooperation with similar functions at national authorities and other relevant international and EU authorities.
In undertaking risk analysis, ESMA monitors and assesses market developments and risks within its remit, with a specific focus on:
- Securities Markets, Infrastructures and Services
- Asset Management
- Market Based Finance
- Financial Innovation
- Sustainable Finance
The topical analysis is carried out with a view to supporting ESMA's objectives of promoting investor protection, orderly markets and financial stability.
Securities Markets, Infrastructures and Services
In March 2021, the default of Archegos, a US family office, led to large losses for some global banks. Archegos was able to accumulate large exposures to and leverage on equities by entering into derivatives transactions with bank counterparties. When the price of the underlying stocks started to decline, the firm was unable to meet variation margins, resulting in the liquidation of the stocks by the counterparty banks. In this article, we use EMIR data to analyse Archegos positions and show that it is possible to track the steep increase in concentrated exposures that the family office undertook in February and March 2021. Our findings show how regulatory data collected under EMIR can be used to monitor leverage and concentration risk in derivatives markets.
This article investigates how credit ratings evolved during the exceptional circumstances of early 2020, exploiting ESMA’s extensive RADAR database of credit rating actions, which covers not only EU ratings but also a large number of non-EU ratings. It shows that corporate and sovereign ratings were downgraded rapidly following the onset of the pandemic, with non-financial corporates particularly affected. Underlying this were strong impacts on businesses in sectors particularly vulnerable to declining economic activity, such as the energy, and consumer cyclicals sectors. Sovereign ratings experienced downgrades in bursts, with many of these occurring with the first and second waves of the pandemic, though the extent of downgrades varied greatly by jurisdiction. In structured finance products, commercial mortgage-backed securities appear by far the most affected, with persistent downgrades reflecting the ongoing challenges to the performance of commercial mortgages. Collateralised loan obligations, a concern before the pandemic, also experienced a wave of downgrades during summer 2020, but otherwise appear to have been relatively resilient, with senior tranches largely unaffected.
In Europe, the three largest CRAs have for years had an overall market share of more than 90 %. EU legislators sought to reduce this imbalance 10 years ago by supporting the use of small CRAs in Europe. This article applies SupTech-related techniques to take stock of market conditions since then, using a unique dataset containing all EU ratings issued and outstanding since 2015 (when the CRA Regulation’s reporting requirement entered into force), covering EUR 20 tn worth of EU financial products and nearly 6 000 issuer ratings. Using network analysis techniques, it is clear that the landscape for small CRAs at the EU level is a challenging one: small CRAs are used almost exclusively in local single-rating markets (the ‘periphery’), and are locked out of the larger ‘core’ market (of issuers seeking more than one rating for their products or themselves). This larger market is shared almost exclusively among the three largest CRAs, and the associated industry-wide Herfindahl-Hirschman Index (HHI) levels are consistently at levels usually deemed to be “highly concentrated”. Lastly, the article introduces a simulation exercise for alternative legislative rules designed to boost competition in EU markets for credit ratings. Strengthening legislative requirements to make use of small CRAs when seeking an additional rating for a product or issuer is associated with an average reduction in overall EU CRA industry concentration of roughly 40 to 55 %, leading to HHI levels that are no longer “highly concentrated” from a competition perspective.
The benefits of securitisation depend on its ability to effectively engineer and limit credit risk. This article explores the approaches to modelling CLO credit risk adopted by the three main CRAs. It discusses the differences and some limitations in approaches and how these might potentially affect credit ratings’ accuracy. Finally, it sets the discussion in the context of some of the recent developments in the leveraged loan and CLO markets, including those stemming from COVID-19. Together, these make clear the importance of sensitivity analysis to identify model and credit rating limitations and how the transparency of these is key to informing investors’ reliance on ratings.
We provide evidence on the impact of MiFID’s DVC mechanism on European equity markets in the first six months of its application. The DVC mechanism introduces limits on the amount of transactions executed in dark pools and aims to protect the price discovery process in equity markets. We find that, overall, for equities, most of the trading is executed in lit markets. We also analyse the impact of the DVC mechanism on market liquidity in lit markets, building on a set of market liquidity indicators. The results are mixed. For equities banned by the DVC mechanism, market liquidity in lit markets improved in terms of tightness, breadth and depth (measured by bid ask spreads, turnover, and the Amihud index), while it worsened when measured by the turnover ratio and average trade size.
Recent years have seen a significant pickup in the issuance of leveraged loans and collateralised loan obligations (CLOs) in the US and the EU. The surge in issuance occurred against a backdrop of looser underwriting standards, higher indebtedness of borrowers and compressed credit spreads. This article provides an overview of the leveraged loans and CLO markets in the EU. In particular, we assess exposures of the EU fund industry to leveraged loans and CLOs, which remain limited at the current juncture. In addition, the article uses a simulation analysis to show how model uncertainty can impact the credit ratings of CLOs, and potentially trigger forced sales from some types of investors.
The EU Securitisation Regulation includes a number of due diligence and monitoring requirements for investors. ESMA is tasked with developing draft transparency technical standards that will assist investors in fulfilling these obligations, in line with its investor protection mandate. At the same time, securitisation capital requirements are also changing, with important implications for the types of transactions to be observed in the future. This article uses a loan-level and tranche-level dataset of 646 securitisations to simulate the securitisation features that can arise when originators seek to use securitisation as part of their capital management exercises. The draft ESMA disclosure templates can assist investors in fulfilling their due diligence and monitoring tasks to better understand the risks and aspects of these instruments.
Market volatility, and its potential to undermine financial stability as well as to impose unexpected losses on investors, is a subject of concern for securities market regulators. Relatively low or high levels of volatility increase the likelihood of stress in financial markets. Low yields and low volatility characterised the two years between February 2016 and January 2018. In February 2018 equity market volatility spiked as markets globally were affected by a strong correction. The main drivers of the long period of low volatility are related to lower equity return correlation, a low interest rate environment and searchfor-yield strategies, and stable macroeconomic and corporate performances. A prolonged period of low volatility may lead to a more fragile financial system, promoting increased risk-taking by market participants driven by the use of VaR models and, more recently, by the growth of volatility targeting strategies. While the AuM of these products may be considered still quite small, the number of products is sufficiently broad to become a key factor driving volatility spikes, like those that occurred in the first week of February 2018.
During the COVID-19-related market stress in 1Q20, investment funds faced a significant deterioration of liquidity in some segments of the fixed income markets combined with large-scale investment outflows from investors. In May, the ESRB issued a recommendation to ESMA requesting a focused supervisory engagement with investment funds exposed to asset categories that were affected by the liquidity stress. This joint supervisory exercise between ESMA and the NCAs took the form of a data-driven assessment of the impact of the liquidity crisis on funds, and an assessment of funds’ preparedness for future shocks, involving STRESI exercises under several assumptions. This article presents the results of the stress simulation: while funds have been resilient to the market stress, the fund simulation also highlights existing vulnerabilities. In its response to the ESRB, ESMA concluded that funds needed to enhance their preparedness.
The COVID-19 turmoil has highlighted the risks of market-wide stress, not least for investment funds. This article assesses the connectedness among EU fixed-income funds. Our empirical results suggest high spillover effects, indicating that funds exposed to less liquid asset classes are more likely to be affected by shocks originating in other markets than funds invested in more liquid assets. Alternative funds are found to be the main transmitters of shocks, while high yield (HY) and corporate bond funds were net shock receivers during the COVID-19 market stress.
The acute market stress period of March 2020 showed that EU money market funds remain vulnerable to liquidity risk on their asset and liability sides. This article identifies a series of structural risks. The evidence related to these risks can serve as input to the currently ongoing discussions on MMF regulatory reforms. On the asset side, non-public debt MMFs have very high and concentrated exposures to private money markets that have low liquidity, making MMFs highly vulnerable to a symmetric liquidity shock as in March 2020. Regulatory constraints might also make some MMFs more vulnerable to runs from investors, as a result of concerns related to redemption fees and gates, or of tight constraints on NAV deviations. Finally, MMF ratings also add to the constraints on managers, by restricting their eligible assets and by penalising the use of liquidity management tools provided in the Money Market Fund Regulation (MMFR).
Closet indexing’ refers to the situation in which asset managers claim to manage their funds in an active manner while in fact tracking or staying close to a benchmark index. Panel regressions using annual fund-level data for the period 2010-2018 suggest that investors face lower expected returns from closet indexers than from a genuinely actively managed fund portfolio. At the same time, potential closet indexers are only marginally cheaper than genuinely active funds. Overall, the net performance of potential closet indexers is worse than the net performance of genuinely active funds, as the marginally lower fees of potential closet indexers are outweighed by reduced performance.
This case study focuses on the impact of a potential credit shock on the EU fund industry. We simulate the effects of a wave of downgrades of BBB-rated corporate bonds (fallen angels) on bond funds, amid a rise in risk aversion. Overall, the direct impact would moderately affect fund performance with no significant performance-driven outflows. Similarly, asset sales from bond funds in response to the shock would only have a limited and non-systemic impact on asset prices. However, it also shows that in this scenario EU bond funds could amplify shocks coming from passive funds, especially non-EU ETFs.
MMFs play an important role in the EU money market by connecting investors investing in short-term liquid products with governments and institutions that are in need of short-term funding. The new EU MMFR aims at increasing the resilience of the sector by addressing the issues identified, such as the “first-mover advantage”. The Regulation introduces new stress-testing requirements, as part of fund risk management and regulatory disclosure. ESMA will design common parameters and scenarios to coherently capture the risks of the sector. Stress test results will be reported to ESMA and the National Competent Authorities (NCAs).
In this article we analyse the cost and performance of EU equity UCITS funds, distinguishing between active and passive investment management, and ETFs. In particular, we investigate the gross and net relative performance of actively and passively managed funds with respect to their prospectus benchmark. The main results show that on an aggregate basis, active funds have underperformed in past years passive funds and ETFs, in net terms, as well as their benchmarks; ongoing costs had the largest impact on performance. The top 25% actively managed equity UCITS outperformed passively managed UCITS before and after costs, as well as their benchmarks. However, the group of top 25% actively managed equity UCITS change over time, such that there is only limited opportunity for investors to pick consistently outperforming actively managed equity UCITS.
We investigate the use of derivatives by EU UCITS equity funds, based on regulatory data on derivatives collected under the EU EMIR framework. Our results indicate that the tendency and frequency of EU UCITS equity funds to trade derivatives is to a large extent embedded in asset managers’ characteristics, such as fund family and fund family size. On the contrary, we find that on the individual fund level the investment strategy, size, geographic focus, base currency, or domicile of the fund play a minor role. Over time, cash inflows as well as currency risk seem to have a significant and robust influence, which suggests that derivatives are used for transaction cost or risk reduction purposes. Our analysis does not find strong indications that derivatives are primarily used for speculative or window-dressing purposes by UCITS equity funds.
As part of ongoing efforts to improve the monitoring of derivatives markets, this article investigates the drivers of credit default swaps usage by UCITS investment funds. We present several important findings: only a limited number of funds use CDS; funds that are part of a large group are more likely to use these instruments; fixed-income funds that invest in less liquid markets, and funds that implement hedge-fund strategies, are particularly likely to rely on CDS; and fund size becomes the main driver of net CDS notional exposures when these exposures are particularly large. This article also explores the bond-level drivers of funds’ net single-name CDS positions. We find that CDS positions on investmentgrade sovereign bonds – most of which are from emerging market issuers – tend to be larger. The analysis finally sheds some light on tail-risk from CDS for funds: directional strategy funds that belong to a large group are the most likely to have sell-only CDS exposures, exposing them to significant contingent risk in case of default of the underlying reference entity. Similarly, a number of funds use CDS to build unhedged credit exposure to US non-bank financial issuers.
Monitoring retail risks aims to provide policymakers and supervisors with the information they need to better protect investors. ESMA has a longstanding mandate in this regard and regularly publishes Trends, Risks and Vulnerabilities (TRV) analysis and indicators on consumers. Underscoring the importance of such work, ESMA recently received an additional, explicit mandate to develop retail risk indicators (RRIs). Building on the existing TRV analysis, this article proposes a conceptual framework that defines key terms, considers how to measure risks practically and identifies sources of risk to consumers. Within this framework the set of RRIs should aim to reflect market developments, especially the rise of online- or mobile-based retail trading. Based on regulatory data this article presents a first selection of possible RRIs. These highlight risks around inexperienced investors, use of digital tools by younger investors and spikes in overall trading during periods of market stress.
This article analyses the impact on EU sell-side research of the MiFID II Research Unbundling provisions that require portfolio managers to pay for the research they obtain. In the past, concerns have been raised, based primarily on survey data, that the new rules could have detrimental effects on the availability and quality of company research in the EU. In order to provide a more detailed, data-based contribution to inform this discussion, we examine a sample of 8,000 EU listed companies between 2006 and 2019, and do not find material evidence of harmful effects from these rules. The introduction of MiFID II has not led to a significant difference in the number of analysts producing Earnings per Share (EPS) estimates (‘research intensity’). Recent increases in the number of companies no longer being covered by research analysts (‘research coverage’) appear to be a continuation of a long-term trend. The quality of research has been steadily improving in recent years. SMEs do not appear to be disproportionately affected in terms of research intensity, research coverage, and research quality. The descriptive findings in this article are consistent with the emerging data-based academic literature on the impact of the MiFID II research unbundling provisions and are complemented by a forthcoming ESMA econometric study. Further assessment of the impact of the MiFID II research unbundling provisions on subsets of the EU market for research, such as the impact on sponsored research, will be interesting avenues for further study.
This article provides an overview of the EU market for Alternative Investment Funds (AIFs) sold to retail investors. It presents the first EU-wide analysis of the structure of the retail AIF market, drawing from data collected as the result of the reporting obligation set out in the Directive on Alternative Investment Fund Managers (AIFMD). Overall, the size of AIFs sold to retail investors accounted for 18% of the AIF market in terms of net asset value (NAV) in 2017. Potential risks related to liquidity transformation and liquidity mismatch are analysed. 2017 data suggest no significant signs of liquidity mismatch for AIFs held exclusively by retail clients. The article also describes the heterogeneity across the EU regarding the distribution of retail AIFs which falls under national law.
Structured products sold to retail investors in the EU are a significant vehicle for household savings. Certain features of the products – notably their complexity and the level and transparency of costs to investors – warrant a closer examination of the market from the perspective of investor protection. Breaking down the EU market geographically into national retail markets reveals a very high degree of heterogeneity in the types of product sold, although among the vast array of different structured products available to retail investors each market is concentrated around a small number of common types. Changes in typical product characteristics are not uniform across national markets. Analysis both at an EU-wide level and in the French, German and Italian retail markets suggests, however, that the search for yield has been a common driver of several changes observed in the distribution of product types.
Investment funds that include environmental, social and governance (ESG) features have grown rapidly over the last years. ESMA recently determined that ESG equity undertakings for collective investment in transferable securities (UCITS), excluding exchange-traded funds, were cheaper and better performers in 2019 and 2020 compared to non-ESG peers. The reasons behind this relative cheapness and outperformance of ESG funds are of particular interest. Understanding the cost and performance dynamics may bring insights for the overall fund industry on how to make funds more affordable and profitable for retail investors. This study builds on past analyses by assessing whether portfolio composition can help to understand the cost and performance differentials between ESG and non-ESG funds. It identifies several differences between the two categories of funds, with ESG funds being more oriented toward large caps and developed economies, and it demonstrates that these factors are correlated with lower ongoing costs. However, even after controlling for fund characteristics and differences in portfolio exposures, ESG funds remain statistically cheaper and better performing than non-ESG peers between April 2019 and September 2021. Further research is thus needed to identify the other factors driving these cost and performance differences.
Regulators and supervisors have started to incorporate environmental risks, especially those stemming from climate change, and their potential implications for the financial system into their work. The objective of this article is twofold: first, to depict how environmental risks can be expected to impact EU securities markets and their participants; and second, to lay out ESMA’s approach to integrating environmental risks in the risk assessment and monitoring framework. In light of ESMA’s financial stability, investor protection and orderly market objectives, and given the unique nature of climate risks and the challenges they entail for risk monitoring purposes, we propose to integrate climate risk as a new risk category alongside the existing liquidity, market, credit, contagion and operational risk categories. This risk category is intended to capture physical and transition risk drivers and their mitigants, in addition to the potential risks associated with green finance. As part of this framework, at the current juncture we identify three core risks to ESMA’s objectives stemming from climate change: abrupt changes in market sentiment, greenwashing and weather-related hazards.
Investor interest in sustainable finance has grown exponentially in recent years. With this in mind, some credit rating agencies (CRAs) have sought to become more transparent as to how environmental, social, and governance (ESG) factors are integrated into their credit ratings. To ensure a consistent level of transparency for investors on ESG issues, on 30 March 2020 ESMA began to apply Guidelines for how and when CRAs’ considerations of ESG factors are disclosed in credit rating press releases. This article assesses the implementation of these Guidelines, as also envisaged in the European Commission’s Renewed Sustainable Finance Strategy. We apply natural language processing techniques to a unique dataset of over 64,000 CRA press releases published between 1 January 2019 and 30 December 2020. We find that the overall level of ESG disclosures in CRAs’ press releases has increased since the introduction of the Guidelines. However, there is clearly room for further improvement: the level of ESG disclosures differs significantly across both CRAs and ESG factors (especially environmental topics). Moreover, we observe divergences in CRAs’ disclosures even for rated entities that are highly exposed to ESG factors, relative to their sector peers.
The European green bond market is attracting a growing number of corporate issuers, which has implications for the environmental impact of these instruments and their liquidity. This article first investigates the carbon dioxyde emissions of green bond issuers. We show that, between 2009 and 2019, energy firms, utilities and banks that issued a green bond were much more likely to disclose emissions data, and they have on average reduced their carbon intensity to a larger extent than other firms – confirming the view that green bonds act as a signal of firms’ climate-related commitments. We then compare the liquidity of green and conventional EUR corporate bonds from green bond issuers using proxy indicators. Green bond liquidity appears to be tighter, but the differential with conventional bonds has remained small and broadly constant during the COVID-19 turmoil, suggesting no particular vulnerability for the green segment of the corporate bond market.
Within the European financial sector, investment funds are more exposed to climate-sensitive economic sectors than banks, insurers and pension funds. However, few investment fund climate-related financial risk assessments have been conducted. This article provides a first attempt to fill this gap, using a data set of EUR 8 trillion of European investment fund portfolio holdings. Funds whose portfolios are tilted towards more polluting assets (brown funds) distribute their portfolio over a larger number of companies than funds with cleaner portfolios (green funds). This apparent diversification hides a concentration risk: brown funds are more closely connected with each other (have more similar portfolios) than green fund portfolios, which tend to ‘herd’ less (have less similar portfolios to those of other green funds). This suggests that widespread climate-related financial shocks are likely to disproportionately affect brown funds. A preliminary climate risk scenario exercise confirms this: besides total system-wide losses of EUR 152 billion to EUR 443 billion, most brown funds’ losses range from about 9 % to 18 % of affected assets, in contrast to green funds’ losses, which usually range from 3 % to 8 %. In addition, brown funds have more systemic impact: they contribute more to total system-wide losses (by virtue of their greater interconnections within the fund universe) than green funds. These findings provide support for ongoing EU regulatory and supervisory initiatives on sustainable finance.
As sustainable investing gains traction, ESG ratings are growing in importance for investors and issuers, while gaining attention from global media. This article describes the market for ESG ratings, including types of ratings and key providers, and presents several use cases. In the absence of a regulatory framework, several issues and risks reduce the potential benefits of these ratings. The lack of a common definition and of comparability, together with transparency issues, could be ultimately detrimental to the transition towards a more sustainable financial system. To illustrate the impact of these issues on investors, our analysis focuses on the specific case of ESG benchmark construction
Short-termism in finance refers to the focus placed by market participants on short-run profitability at the expense of long-term investments, a tendency that political initiatives such as the EU’s action plan on financing sustainable growth seek to limit. The recent empirical evidence collected by ESMA sheds some light on commonly discussed drivers of short-termism. In particular, our findings suggest that the misalignment of investment horizons in financial markets and the remuneration of fund managers and executives that rewards short-term profit seeking could be potential sources of short-termism. Improvements in the availability and quality of ESG disclosure could serve to promote more long-term investment decisions by investors.
The growing use of cloud service providers (CSPs) by financial institutions can provide benefits to individual firms and the financial system. However, high concentration in CSPs could create financial stability risks if an outage in a CSP affects many of its clients, increasing the likelihood of simultaneous outages. Analysis using a stylised model calibrated with operational risk data suggests that CSPs need to be significantly more resilient than firms to improve the safety of the financial system. In financial settings where only longer (multi period) outages cause systemic costs, the results suggest that CSPs can best address systemic risks by strongly reducing incident resolution times, rather than incident frequency. In the model, using a back-up CSP successfully mitigates the systemic risk caused by CSPs. Backup requirements may need to be mandated however, as the systemic risk is an externality to individual firms. Finally, there is a clear need for detailed data on outages by financial institutions and CSPs.
This article presents the results of an ESMA pilot exercise to apply natural language processing techniques on a unique dataset of c. 54 000 Key Information Documents that describe structured retail products produced under the Packaged Retail Investment and Insurance-Based Products Regulation. The techniques involved include measuring linguistic richness and semantic uncertainty, as well as sentiment analysis. This work – an application of SupTech – aims to illustrate how these techniques can produce useful measures for European supervisors, policymakers and risk analysts. Information extracted from text opens up new possibilities for supervisory assessments, for example with respect to information completeness and to legal requirements that a document be comprehensible to investors. In addition, text-based information is uncorrelated with (i.e. complementary to) numerical information, which can help policymakers determine if the legislation is working as intended. Lastly, text-based information can identify new sources of financial risks to investors.
Several large technology firms (BigTechs) now offer financial services, taking advantage of their vast customer networks, data analytics and brand recognition. However, the growth of BigTech financial services varies by region, reflecting differences in existing financial services provision and regulatory frameworks. Prospective benefits include greater household participation in capital markets, greater transparency and increased financial inclusion (although some individuals may be excluded). On the risk side, the high level of market concentration typically observed in BigTech may get carried into financial services, with potentially adverse impacts on consumer prices and financial stability. The crosssectoral and global nature of the business strengthens the case for comprehensive cooperation among relevant regulators.
Regulatory and supervisory technologies are developing in response to various demand and supply drivers. On the demand side, regulatory pressure and budget limitations are pushing the market towards an increased use of automated software to replace human decision-making activities. This trend is reinforced by supply drivers such as increasing computing capacity and improved data architecture. Market participants are increasingly using new automated tools in areas such as fraud detection, regulatory reporting and risk management, while potential applications of new tools for regulators include greater surveillance capacity and improved data collection and management. With these new tools come challenges and risks, notably operational risk. However, with appropriate implementation and safeguards, RegTech and SupTech may help improve a financial institution’s ability to meet regulatory demands in a cost-efficient manner and help regulators to analyse increasingly large and complex datasets.
Advice on legislative improvements relating to ICT risk management requirements in the EU financial sector;
Advice on the case for a coherent EU-wide cyber resilience testing framework for significant market participants and infrastructures within the whole EU financial sector.
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