Risk Analysis & Economics - Markets Infrastructure Investors

The European Securities and Markets Authority (ESMA), the EU’s securities market regulator, has conducted a study on the use of derivatives by UCITS equity funds in collaboration with researchers from the Technical University of Munich (TUM). TRV 2 2019 Derivatives contract types

 

The study, included in the latest Trends, Risks and Vulnerabilities report uses data collected under the EMIR framework, and finds that the tendency, and frequency, of these funds to trade derivatives is explained to a large extent by asset managers characteristics, such as fund family and fund family size. Over time, cash inflows as well as currency risk seem to have a significant influence, which suggests that derivatives are used for transaction costs or risk reduction purposes.

After the financial crisis in 2008, global regulators started to shed more light on derivatives markets, including the use of derivatives by market participants. Under various regulatory frameworks (such as EMIR in the EU) derivatives transactions are reported to the authorities, enabling a granular analysis of derivatives transactions, leading to a better understanding of the market and making it easier to spot potentially problematic development at an earlier stage.

The analysis included in this study provides new insight into the type of derivatives that are traded by UCITS equity funds, why some of them trade derivatives whilst others do not, what makes some more active traders and to what extend the trading in derivatives is a reaction to daily changes in the market. UCITS equity funds mainly use forward contracts on currencies (80% of trades) and futures or options on equities (26%).

ESMA will continue to use its regulatory data to provide analysis and insights into the functioning of different sectors of the financial markets in the EU. 

TRV figure v27 performance

The European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, has carried out a study of the performance of active equity funds as compared to passive equity funds, ETFs and relevant benchmarks. The study, included in the latest Trends, Risks and Vulnerabilities (TRV) report finds that actively managed funds have in past years underperformed, in net terms, both passive equity funds and equity ETFs, as well as their own benchmarks, primarily due to the large impact of ongoing costs.

The share of passive investing in the equity fund market segment has been increasing materially, however active equity UCITS still accounted for about 75% of the overall market in 2018. Over the last few years, the top 25% of actively managed equity UCITS outperformed those that were managed passively both before and after costs. However, as the composition of the group of the top 25% changes over time, there is limited opportunity for investors to pick consistently outperforming actively managed equity UCITS.

Going forward, ESMA will continue to look at the topic of costs and charges in line with its investor protection mandate, working in collaboration with national competent authorities aiming to harmonise the situation for investors across the EU.

Following the significant pickup in the issuance of leveraged loans and collateralised loan obligations (CLOs) in the US and EU, supervisors have expressed concerns about the potential risk to investors.

TRV figure V4 - CLOs

The European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, in a study included in the latest Trends, Risks and Vulnerabilities (TRV) report, looks at the exposure of investment funds to this market and finds that the EU fund industry’s exposure remains limited at this stage at EUR 130bn (less than 1% of EU fund industry net assets). This study is the first carried out using actual data from the relevant sector, combining regulatory data with commercial databases to ensure a more complete view of the market.

The surge in the issuance of leveraged loans and CLOs is an indication of how market-based finance can supplement bank credit to finance the real economy. At the same time, the deterioration of underwriting standards coupled with low spreads point to a potential underpricing of risk. Average credit ratings of outstanding leveraged loans have recently deteriorated, and simulations carried out by ESMA show that model uncertainty can impact the credit ratings of CLOs, potentially triggering forced sales from some types of investors. 

Looking ahead, ESMA will review the quality of the rating process methodologies for CLOs, with a view to ensuring these are robust.

The European Union's (EU) banking, insurance, pensions and securities sectors continue to face a range of risks, the latest report on "Risks and Vulnerabilities in the EU Financial System" published today by the Joint Committee of the European Supervisory Authorities (ESAs) shows.

The 2019 Autumn ESAs' report highlights the following risks as potential sources of instability:

  • Uncertainties around the terms of the United Kingdom's withdrawal from the European Union
  • Persistently low interest rates, which combined with flattening yield curves, put pressure on the profitability and returns of financial institutions, incentivise search-for-yield strategies and increase valuation risks
  • Transition to a more sustainable economy and environmental, social and governance (ESG) related risks, leading to possible challenges to the viability of business models with high exposures to climate sensitive sectors.

In light of the ongoing uncertainties, especially those around Brexit, supervisory vigilance and cooperation across all sectors remains key. Therefore, the ESAs call for the following policy actions by European and national competent authorities (NCAs) as well as financial institutions:

·       Contingency planning: Financial institutions and supervisors should continue their work on contingency planning and assurance of business continuity in the case of a no-deal Brexit. Considering the variety of measures undertaken by the ESAs and national supervisory authorities and other competent authorities, the EU financial sector should be well informed and prepared to manage risks from a micro-perspective. The ESA’s will also continue to closely monitor ongoing political and market developments and consider the need for further communications on that basis.

·       “Low-for-long” scenario: Supervisors and financial institutions should continue taking into account a “low-for-long” interest rate scenario and associated risks. Low interest rates are an important driver of low bank profitability and remain the main risk for the insurance and pension fund sectors. They contribute to the further build-up of valuation risks in securities markets as well as to a move into less liquid and more leveraged investments through search-for-yield strategies. On the investment fund side, a convergent application of the rules on liquidity management and (for UCITS) eligible assets as well as a consistent use of stress testing will be important supervisory tools.

·       Bank profitability: There is a need to further address unprofitable banks and their business models in order to increase the resilience of institutions to a more challenging economic environment. Further investments into financial technologies and exploring opportunities for bank sector consolidation are among responses to low profitability. Transparency and the consistent application of common prudential requirements and supervisory rules across jurisdictions are preconditions, which could contribute to the use of opportunities cross border consolidation, may offer.

·       Leveraged lending market: Risks related to the leveraged loan market and Collateralized Loan Obligations (CLOs) in the financial sector should be further explored and identified. There is a lack of clarity about the total volume of leveraged loans outstanding and about the ultimate holders of risks of many CLO tranches. Supervisors have raised concerns about a possible underpricing of risks.

·       Sustainable finance and ESG risks: Supervisory authorities and financial institutions should continue their work on identifying exposures to climate related risks and facilitate access of investors to sustainable assets. Scenario analysis and stress testing are important tools that can be implemented by supervisors with a goal to incorporate sustainability considerations into risk assessment. Financial institutions should incorporate climate risk and other ESG factors into their risk management framework and should play a stewardship role by taking into account the impact of their activities on ESG factors. Going forward, the ESAs should take a proactive stance in fulfilling mandates on sustainable finance, including on how ESG considerations can be incorporated into the regulatory and supervisory framework of EU financial institutions.

 

Background

The Joint Committee is the forum for cooperation between the European Banking Authority (EBA), European Securities and Markets Authority (ESMA) and European Insurance and Occupational Pensions Authority (EIOPA), collectively known as the European Supervisory Authorities (ESAs).

Through the Joint Committee, the three ESAs cooperate regularly and closely to ensure consistency in their practices. In particular, the Joint Committee works in the areas of supervision of financial conglomerates, accounting and auditing, micro-prudential analyses of cross-sectoral developments, risks and vulnerabilities for financial stability, retail investment products and measures combating money laundering. In addition, the Joint Committee also plays an important role in the exchange of information with the European Systemic Risk Board (ESRB).

The European Securities and Markets Authority (ESMA), the EU’s securities regulator, has published the second Trends, Risks and Vulnerabilities (TRV) report for 2019.  The report identifies a deteriorating outlook for the asset management industry and continued very high market risk.  Recent trade tensions have triggered renewed volatility, and concerns over a no-deal Brexit remain key risk drivers for the second half of 2019. 

Investors are facing very high market risk, as they navigate an environment of potentially inflated asset valuations, subdued economic growth prospects, and flattening yield curves. Changed monetary policy expectations may boost their risk appetite and reignite search-for-yield strategies, leaving investors vulnerable to volatility episodes and abrupt shifts in market sentiment.

Credit risk and liquidity risk remain high, with isolated events highlighting pockets of risk in the asset management industry. While the level of credit risk is stable, the deteriorating quality of outstanding corporate debt, the growth in leveraged loans and collateralised loan obligations should warrant the attention of public authorities. As a result, ESMA’s risk outlook for the asset management sector has deteriorated.

In this edition of the TRV, ESMA also looks in more detail at three vulnerabilities facing the financial markets:

 

-        Leveraged loans and collateralised loan obligations (CLOs): Simulations carried out by ESMA show that uncertainties can impact the credit ratings of CLOs, potentially triggering forced sales from some types of investors.  Considering the significant increase in the issuance of leveraged loans and CLOs in both the US and the EU, and the context of looser underwriting standards, higher indebtedness of borrowers and compressed credit spreads, this is a potential vulnerability in the market. In addition, ESMA has for the first time conducted a study of the exposure of investment funds to this market and finds that the exposure of the EU fund industry remains limited;

-        Performance and cost of active and passive EU equity UCITS:  Active equity funds have in past years underperformed, in net terms, both passive equity funds and equity ETFs, as well as their own benchmarks.  This is shown in an analysis of the cost and performance of EU equity UCITS funds, which distinguishes between active and passive investment management, and ETFs, and is due to the large impact of ongoing costs; and

-        Use of derivatives by UCITS equity funds: Using data collected under the EMIR framework, ESMA has conducted a study on the use of derivatives by UCITS equity funds. The tendency, and frequency, of these funds to trade derivatives is explained to a large extent by asset managers characteristics, such as fund family and fund family size. Over time, cash inflows as well as currency risk seem to have a significant influence, which suggests that derivatives are used for transaction costs or risk reduction purposes.

 

This report is split into two parts with the statistical annex published as a separate document. Also accompanying the report is the third Risk Dashboard for 2019.

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