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Pablo Portugal
The Low-Carbon Transition – Why are compliance and voluntary carbon markets so important?
29 Oct 2021
When policymakers congregate at COP26, there will be a sense of urgency. The world is falling short in its battle against climate change. To limit temperatures from rising above 1.5 degrees in the next two decades transformational changes are needed in the global economy. One key lever in this transformation will be to achieve a rapid scaling and deepening of carbon markets. What are compliance and voluntary carbon markets? Carbon markets are based on the purchasing of credits (allowances) that enable an entity to offset its carbon output. These markets are split into two categories: compliance and voluntary markets. Compliance markets aim to establish a carbon price by laws or regulations which control the supply of permits that are then distributed by national, regional and global regimes. These permits are then traded within a controlled emissions trading scheme (ETS), which economically incentivises emitting organisations to reduce their carbon footprint. In contrast, voluntary markets are not legally mandated and consist of companies and individuals choosing to offset their emissions. This could be motivated by an organisation looking to offset longer-term climate risks facing their organisation or for ethical or other reasons. Due to the carbon credits in voluntary markets not being administered by a specific government, they are accessible to every sector globally in contrast to compliance markets. Both compliance markets and the voluntary carbon market can play significant and complementary roles in the decarbonization of the global economy. However, both categories are undersized. A report produced by the Global Financial Markets Association (GFMA) and the Boston Consulting Group (BCG) finds that close to 80% of greenhouse gas emissions are not covered by regulated carbon pricing in compliance carbon markets. This limits their effectiveness in accelerating the global green transition. Expanding ETS Scale Within ETS coverage/compliance markets there is scope to expand not only within and across sectors but also the number of countries or municipalities. By including sectors that will need to acquire sizeable credits to offset their carbon output, the ETS will gain scale and more accurate pricing that will aid in the global green transition. To accelerate the expansion of the ETS scheme, policymakers should look to include more high-intensity emission sectors. These include energy and power as well as transportation, oil and gas industries (to name a few). Furthermore, the integrity of the ETS scheme needs to be facilitated. Collecting verified emissions data and classifying carbon allowances as financial instruments, as already done in the EU, would help ensure financial and price stability. The Integrity of Voluntary markets Similarly, voluntary carbon markets have the potential to channel finance into carbon removal projects and address the residual emissions of firms, but they are held back by issues of market integrity. This includes a lack of consensus on how the market credits align with science-based decarbonisation pathways, the overall “quality” of the credits available, as well as fragmented reporting standards. For voluntary markets to fulfil their potential, standard-setting bodies need to develop a consensus on the role of voluntary carbon market credits. This includes providing guidance on the accounting and disclosure for the credits and how they relate to net-zero/carbon-neutral claims. Providing this guidance will help remove ambiguity from the market and avoid greenwashing. Regarding the “quality” of credits, standard-setting bodies should also apply consistent standards for the underlying projects. By providing transparency and clarity surrounding the quality of credits, participants can gravitate to the credits that suit their needs. Lastly, market participants should also create global registries that reduce the fragmentation of the voluntary credit market across regions. A unified registry will enable more seamless transactions and enable authorities to track global progress toward the Paris Agreement goals. This would also allow them to identify the next necessary steps to accelerate the global transition. When key stakeholders and policymakers gather at COP26, scaling carbon markets should be pursued with a sense of urgency. If the world is to prevent global temperatures from rising beyond 1.5 degrees in the next two decades, ambition in scale, interoperability and market integrity will need to be achieved in carbon markets. Like any flourishing financial market, carbon market credits need to be regulated, valued and trusted. Carbon markets are very much still in their infancy, but the world cannot afford them to remain this way for much longer. To learn moreread GFMA and Boston Consulting Group's report titled,“Unlocking the Potential of Carbon Markets to Achieve Global Net Zero”.
Michael Lever
Do European banks need much more capital?
27 Oct 2021
Today the European Commission launched its proposed Directive and Regulation – CRDVI/CRR3 which seeks to implement the final Basel III standards in Europe. Despite assertions by the authorities to the contrary, these proposals will require European banks to raise significant additional amounts of equity capital to maintain their current ratios. They come at a time when banks hold record capital levels and have demonstrated considerable resilience throughout the Covid-19 economic collapse. Not only this, but they have exhibited their ability to withstand catastrophic stress test scenarios and have started to release bad debt provisions. The proposals themselves limit the extent to which banks can make use of their internal models to calculate their capital requirements. One way they do this is by not allowing modelled capital needs to fall below 72.5% of those calculated using a simpler standardized approach. They also introduce fresh rules on market and operational risks, imposing more precise capital requirements on areas of banks’ activities that were hitherto less specifically targeted. The December 2017 Basel III agreement is supposed to be the final element of the post 2008 financial crisis repair programme. As part of this, the Basel standard setters committed to no further post crisis regulatory capital increases and also claimed that the proposals would not lead to any significant overall increase in banks’ minimum capital requirements. Unfortunately, impact studies requested by the European Commission from the European Banking Authority and the Commission’s updated study published today - which suggests single digit capital increases - are based only on minimum required capital standards. So not only do the studies assume that all proposals are fully accepted by the co-legislators, but they also completely fail to show the real capital increase. This is likely to be in double digit percentages especially for the largest European banks which will to continue to operate at capital levels well in excess of minimum standards. In monetary terms therefore it is probable that the true capital shortfall compared to market required levels is a multiple of what the Commission is suggesting. This in turn could have negative consequences for lending and broader economic activity as balance sheet growth is constrained to conserve capital. Since the last financial crisis, European banks have raised hundreds of billions of equity capital taking their average Core Equity Tier 1 ratio – the best measure of capital strength - to a record 15.9% at March this year. Recently, banks have proved their resilience throughout the Covid-19 induced economic crisis. They have also been subjected by the EBA to its harshest ever stress test based on assumed massive falls in GDP, huge increases in unemployment and catastrophic falls in asset and market prices, emerging with a strong average CET1 ratio of over 10%. So what is the purpose of additional capital requirements? While significant financing is still required to aid the recovery from Covid-19; rather than taking on additional debt, businesses need more equity or equivalent instruments which should be raised on the capital, rather than the banking markets. In this respect, progress has already been seen with capital raising of €52bn by euro area corporates so far this year. This compares to net bank lending to euro area corporates of €56bn. However, smaller and medium sized entities - unable to easily access capital markets - are likely to continue to rely on banks for their financing needs. To the extent that the new EU proposals constrain banks’ ability to satisfy this requirement, (particularly through the application of the Output Floor, introducing a less risk sensitive approach to lending), then this may harm economic recovery. Some will also point to the need for additional capital to meet the risk of increased credit losses from banks’ customers as government support is withdrawn. While a pickup in losses is anticipated, this is likely to be manageable. And having built up significant reserves against prospective losses, banks have recently been releasing some of these suggesting confidence over provisioning levels. There are of course new risks on the horizon which could hit banks’ capital. The threats from climate change are often mentioned in this context. Yet climate related risks are very largely the amplification of already well-established risk categories such as credit, interest rate, counterparty, and foreign exchange. And while such amplified risks should certainly be incorporated in banks’ overall risk assessments and capital requirements, it is unclear that they need their own separate pot of additional capital. The Basel capital standards have played a major role in improving the resilience of banks, removing their implicit funding subsidy, and reducing systemic risk. The Basel Committee was right when it said that no significant additional system wide capital requirements should result from its final standards. European banks are already very well capitalized, and while some modest adjustments to requirements might be appropriate, European co- legislators should keep this firmly in mind as they evaluate the Commission’s latest proposals.
Webinar Summary - A CMU that works for all investors: The role of the consolidated tape
13 Oct 2021
Moderator: Pedro Pinto, Director, Head of MiFID, Advocacy, AFME Speakers: Tanya Panova, Head of the Capital Markets Unit. European Commission, DG FISMA Christiane Hölz, Managing Director, DSW (Deutsche Schutzvereinigung für Wertpapierbesitz e.V.) Elisa Menardo, Director, Public Policy Europe and UK, Credit Suisse Neil Ryan, Consultant, Finbourne Technology Keshava Shastry, Managing Director and Head of Capital Markets, DWS Tanguy van de Werve, Director General, EFAMA (Tanya Panova, Keynote speech recording) On 30th September AFME, EFAMA hosted a joint webinar on the establishment of a consolidated tape for the benefit of all investors. The webinar featured a range of perspectives from the capital markets landscape, including the views of Tanya Panova, head of the Capital Markets Unit, at the European Commission DG FISMA. The webinar kicked-off with Tanguy van de Werve, EFAMA, outlining the need for Europe to remain relevant and attractive to global investment flows. In this regard, he highlighted how there has been a consolidated tape in the US for decades, and similarly UK Treasury has been consulting on a tape for the UK market. Pre-empting later conversations, he highlighted the importance of data quality to the functioning of the tape and how retail investors may benefit from the use of the tool. Tanya Panova, EC, provided a keynote on the Commission’s work on the CMU project over the past year. She outlined how much of their work has gone on behind the scenes, stating that she expects many of their proposals to come out in the coming period (the Solvency II reform was already proposed on 22 September). The intention behind the proposals will include plans to help address barriers to financing companies. She highlighted that there will be two proposals focussed on data, addressing its fragmentation, and increasing value, as well as a proposal related to the establishment of a consolidated tape. She explained that the tape would only make a difference if done properly, highlighting that one of the main reasons why the tape did not emerge since the application of MiFID II is due to poor data quality. Among the points Panova raised on data, she stated that it needs to be consolidated efficiently, but also have extensive coverage. Only if most of the venues and their data are included will it be of value to brokers and all groups of investors. She also noted that the tape is likely to coexist with any other data products. Neil Ryan, FINBOURNE, acknowledged that there are existing vendors such as his organisation who can already deliver a consolidated tape with an independent view, applying cutting-edge technology to solve the data quality challenge. Singing the praises of the benefits a consolidated tape could bring, Elisa Menardo, Credit Suisse, stated that it would help democratise access to data and access to funding. By giving greater visibility to businesses that choose to list on a particular venue, it makes them more likely to raise more funding next time they go to market. Keshava Shastry, DWS, concurred stating that the added visibility would be helpful to investment managers and end-investors and outlined a number of use cases where a real-time consolidated tape for equities would help asset managers managing their investments in a more effective way. However, Christiane Hölz, DSW (Deutsche Schutzvereinigung für Wertpapierbesitz e.V.) argued that the consolidated tape’s use case is not clear yet. She highlighted that there are urgent and serious issues facing the real economy that need to be addressed first. This included trading on dark venues, as well as data quality and access. Panova in response emphasised that taking such an approach would bring about more challenges and would not bring markets closer to the final result of establishing a tape that benefits investors. Menardo concurred stating that data quality issues can be addressed during the legislative process. As the webinar drew to a close panellists agreed that despite the challenges to establishing a consolidated tape, the transparency benefits make it a tool worth pursuing.
Rick Watson
The challenge of defining climate finance
25 Aug 2021
Defining green investments is not an exact science. A lack of clarity around what should be classed as a climate-friendly investment has long been an obstacle preventing funding from flowing to green projects. The EU has been keen to change this by introducing a classification system, known as the ‘Green Taxonomy’, as part of its wider efforts to become the first continent in the world to be carbon neutral by 2050. The Taxonomy became law last summer and provides a framework to determine whether a company’s economic activity is deemed sustainable. While this initial classification has provided a helpful starting point towards providing better definitions to boost green investment while avoiding greenwashing, there are still a number of grey areas which need further clarity to ensure sustainable finance can flourish and the EU’s Taxonomy becomes a leading standard of sustainable finance. For example, the Taxonomy currently lacks the desired flexibility in how it recognises green investments, particularly with respect to companies already taking intermediary steps on the path towards being more sustainable. Companies need a framework that recognises overall improvements in the environmental performance of their activities, as opposed to the current binary system which defines low carbon "green" economic activities and neglects other types of activities. The problem with a framework that doesn’t sufficiently recognise activities that contribute to an improvement in the company’s environmental performance is that it leads to lower capital inflows and curtails activities which are on their way to being considered green. Going forward, the Taxonomy needs to include both activities and companies that are already low carbon, but also be forward-looking and include companies that demonstrate the commitment and potential for transition. A further limitation relates to the Taxonomy’s coverage of sectors of the economy, which restricts the use of taxonomy-based labelling schemes such asthe EU Green Bond Standardand theEU Ecolabel. The EU has recognised these limitations in its recentRenewed Sustainable Finance Strategy, which is a positive step towards achieving its net-zero carbon emission objectives. Finally, more clarity is needed around how the Taxonomy should be applied – for example, at the moment it only applies to a company’s economic activities, but it should really be applied more broadly to companies as a whole. As it stands, companies can only finance specific projects linked to eligible green activities. This is generally done by issuing bonds, because the company will use the proceeds from issuing the bond on green projects and, in turn, the bond may qualify as green under the EU Green Bond Standard. But as the screening is only possible for activities, it is difficult to use the Taxonomy to identify green or transitioning companies who issue equity, for example. If it was possible to use the Taxonomy to screen companies, banks would be able to provide more general-purpose sustainability-linked funding to green companies or companies on a credible transition path. This entity-level approach would mobilise a wider range of supporting financial instruments such as such as loans, bonds, equity, derivatives and structured products. It is no easy feat to define a new and rapidly growing area of sustainable investment opportunities which span multiple sectors and regions. Such differences mean pathways to transition will be different across jurisdictions and industries. For this reason, a single global taxonomy is a near-impossible task. Therefore, what will be important is for regulators to cooperate to ensure taxonomies work together. There are signs this is already happening, particularly with theInternational Platform on Sustainable Finance, which includes members from 17 jurisdictions, representing 55% of both global greenhouse gas emissions and GDP, with the goal of developing mutually compatible taxonomies and sustainability reporting standards. At the global level, it will be vital for policymakers to agree on a minimum set of global guiding principles and definitions to underpin taxonomies across regions. This was also recommended by the Global Financial Markets Association and Boston Consulting Group in a recent report ‘Global Guiding Principles for Developing Climate Finance Taxonomies – A Key Enabler for transition Finance’. Although there will continue to be grey areas to resolve around the evolution of such taxonomies, they remain vital for determining whether investments in certain activities are aligned with climate goals. Going forward, the main challenge will be to ensure taxonomies are flexible enough to broaden the set of eligible sources of financing to unlock as much funding as possible for a greener economy. This article was originally published in Thomson Reuters Foundation09/08/2021
Emmanuel LeMarois
Striking A Balance With The Digital Operational Resilience Act (DORA) – Promoting Resilience And Innovation In The EU Financial Sector
25 Aug 2021
The pandemic has shown that the future will be digital and the pace of this evolution is accelerating. Innovation and new technology adoption promises to deliver efficiency gains to the economy, enabling businesses and clients to interact more quickly and at lower costs, all of which will support the economic recovery. With the publication of the EU Digital Finance Strategy in September 2020[1], a 5 year plan by the European Commission to transform EU financial services into a truly integrated digital single market, the EU has set an ambitious roadmap to become a major player in the digital economy. This is underpinned by several initiatives and regulatory reforms such as the DORA (Digital Operational Resilience Act)[2]. DORA will lay the foundation for a harmonised, secure and resilient EU digital financial sector. However, while the EU’s ambitions and the rapid progress of the digital transformation of financial services is positive, it is important to ensure that the quality and implementation of regulatory reform, remain a central component of the EU’s work program. Crucially, new regulatory frameworks should strike the appropriate balance between promoting security and resilience whilst fostering innovation. The importance of digital operational resilience Digital operational resilience is the ability to build, test and continuously improve the technological and operational integrity of an organisation[3]. It aims to ensure that an organisation can guarantee the continuity and quality of its services in the face of operational disruptions impacting its information and communication technologies (ICT). As identified in the DORA proposal, the existing EU regulatory framework for the management of ICT risks has been fragmented thus far. For instance, when financial entities have to report cyber incidents to regulatory authorities, they are subject to various frameworks which all have their own terminology and template (e.g., NISd, PSD2, GDPR). This fragmentation dramatically increases pressure on financial entities as, in parallel, they are in a race against time to safely recover and protect their business from a potentially major cyber-threat. DORA, aims to harmonise these requirements and ensure that all stakeholders in the financial sector have the necessary security measures to prevent or mitigate ICT risks. With the adoption of this new proposal, we see strong benefits for financial entities to have a harmonised and comprehensive framework for ICT risk management. Not only will DORA bring synergies at EU level, but it will also have the merit to contribute to the creation of a robust digital single market for financial services. Striking a balance between resilience and innovation DORA’s scope is significant and covers many aspects of how financial entities should manage ICT risks. While DORA is principally focused on requirements for the EU financial sector, the direct oversight of ICT critical third parties (ICT CTPPs) has far reaching consequences for technology companies like Cloud Service Providers (CSPs). Indeed, the oversight framework introduced in DORA will determine which third-parties are ‘critical’ for the EU financial sector and establish a number of provisions to subject ICT CTPPs to EU financial supervisors. Supervisors could impose specific requirements on how ICT CTPPs service EU financial entities and in worst case scenarios (when a risk from an ICT CTPP is deemed too great), requiring outright termination of contractual relationships with a financial entity. So far, the European Parliament and Council of the EU are progressing discussions on DORA at a rapid pace. While this gives hope for a final text in Q1 2022, the financial services industry is yet to see amendments that account for the holistic nature of such an ambitious proposal. Requirements in DORA could have significant impacts on the EU financial sector. For instance, the risk of immediate termination of contracts could make it more difficult for EU financial entities to use ICT CTPPs, which offer innovation and efficiency benefits. It may even deter some technology providers from servicing the EU due to the increased regulatory uncertainty. An opportunity for global leadership It is crucial that EU policymakers continue to appreciate that the speed of regulatory development is not the only priority, the outcome must be a long-term fit-for-purpose framework that will reduce fragmentation in the EU single market, support innovation and technology adoption, whilst promoting robust standards for managing ICT risks. Achieving this goal will support EU competitiveness in a fast growing digital market. The EU also has an opportunity to set the tone globally on how ICT risks stemming from third party technology providers should be managed and regulated. So far, despite progressive discussions, many of these providers have not fallen under the purview of a significant regulatory framework. Crucially, in an increasingly interconnected global financial system, the EU must work in close cooperation with other jurisdictions and international bodies, setting an example on achieving economic recovery without compromising financial stability risks over the long run. [1]https://ec.europa.eu/info/publications/200924-digital-finance-proposals_en [2]https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0595 [3] Operational resilience is the ability to continue servicing critical functions despite disruption
More, rather than less competition is needed in European equity markets
7 Jul 2021
Diverse and liquid equity markets are the cornerstone of healthy capital markets. Without them, there is less choice and higher trading costs for investors, which in turn negatively affects savers and pensioners. Therefore, it is essential to resolve the current disagreement over where trading should take place in order to ensure best outcomes for investors. In recent years, Europe’s capital markets have undergone a host of changes. Since the introduction of European markets legislation, MiFID II, in 2018, a careful balance has been struck between different types of equity trading mechanisms. According to a new report from economics and finance consultancy, Oxera, 83% of equity trades take place on venues, such as stock exchanges, with alternative trading mechanisms, such as systematic internalisers (which are normally owned by banks or investment firms), accounting for 11% and over-the-counter trades just 6%. According to this in-depth analysis, alternative trading mechanisms are far from dominating the landscape, but instead provide much-needed choice for investors. Market diversity is important because if trading is concentrated on a particular type of venue it could hamper market competition, reduce choice for investors and keep the costs of trading high. This would also hold back the growth of Europe’s primary markets and IPOs, which rely on the deepest secondary market liquidity pools for the highest valuations, making Europe a desirable place to list. For example, in 2020, only €17.5 billion in IPOs took place in Europe, compared to €154.5 billion in the US, including the IPOs of some highly innovative European companies. Yet, some market participants quite worryingly argue that an even greater share of trades should take place on venues. They call for regulatory intervention to significantly constrain the activities of alternative trading mechanisms and this is likely to limit competition and investor choice. These arguments are driven by the notion that trading on exchanges is more transparent and alternative trading mechanisms are “dark forces”. Alternative trading mechanisms, or systematic internalisers are the particular focus of their concerns. Therefore, it is worthwhile taking a closer look at these arguments. Systematic internalisers are a key part of the market. They are owned by banks or investment firms which use their balance sheets to provide liquidity and take on risk positions to trade with their institutional investor clients directly when clients wish to use them to achieve the best price and minimise trading costs. They also facilitate transactions for their clients at times when other market participants might be unable or unwilling to trade. These functions are particularly important for pension funds or other asset managers who manage the pensions and savings of individuals and therefore are looking for the maximum return on investment and to keep the cost of trading low. As for transparency, systematic internalisers provide the same pre-trade transparency as exchanges for smaller trades. In fact, many European exchanges themselves are also operating so called “dark pools” that respond to specific investor needs. While the transparency of lit trading on exchanges is undoubtedly a contributor to efficient price formation, so-called “dark trading” - which caters for specific transactions, such as large size trades, creates additional liquidity that otherwise would not be available. In any case, trading on alternative trading mechanisms remains at very low levels and certainly does not dominate the trading landscape. This is evidenced in Oxera’s analysis, which paints a clear picture of the current state of liquidity in Europe. As Europe looks to navigate its recovery from the pandemic, now more than ever its capital markets need to be diverse and competitive. This goes hand-in-hand with building well-developed primary markets. It would also contribute to the necessary re-equitisation of Europe’s economy. Before looking to adjust equity market structure rules in the EU, policymakers need to have a full understanding of the existing secondary market trading landscape. For this they need to ensure that they have the right data analysis to hand which clearly shows where liquidity lies. Otherwise, Europe’s capital markets could be less able to support the post-pandemic recovery in the coming years, and in the longer run could risk losing their global competitiveness. This article was originally published in Les Echos (14 June) and Boersen Zeitung (2 July).
Balancing Ambition with Pragmatism - Europe’s Sustainable Transition
6 Jul 2021
The world is in a race against climate change and, while there is still a long road ahead, the EU is confidently leading the pack. With the publication of the EU Renewed Sustainable Finance Strategy, Europe continues to power ahead with regulatory reform that will lay the foundations to accelerate its sustainable transition and reach its net-carbon neutral 2050 goals. However, while the EU’s rapid progress on sustainable finance is positive, it is important to ensure that the quality and usability of regulatory frameworks, as opposed to the speed of regulatory development, remain the central considerations in the next stages of the work programme. Crucially, the new regulatory frameworks should balance ambition with pragmatism. Data quality should be prioritised Time is of the essence in tackling climate change, but data quality and usability should not be compromised. The existing and upcoming ESG disclosures rules require banks to produce and report a highly granular quantity of ESG information, requiring the tracking of hundreds of data points against potentially thousands of companies. To meet these obligations, banks have to use estimates, proxies and data from third-party vendors, which means their quantitative disclosures are less reliable. This undermines one of the key objectives of the EU in supporting the transition, which is to develop a solid reporting framework to fight greenwashing. There is unquestionably a need for banks to share details on the ESG impact of their activities but avoiding unnecessary complexity and granularity would go a long way towards helping firms’ transparency efforts. Additionally, there have been many concerns surrounding the sequencing between financial institution and non-financial institution reporting obligations. We appreciate that the Commission has taken them into consideration in the recently published legislation on disclosures under the EU Taxonomy Regulation. Still, from 2023 banks will need to start preparing new ESG regulatory disclosures (so called Pillar 3) based on data supplied from their borrowers and investee companies whilst non-financial corporates will not start reporting relevant information until later in 2023 or when the Corporate Sustainability Reporting Directive will enter into force. Corporates are therefore unlikely to provide the data necessary for banks to fulfil their reporting obligations in full, leading to less transparency and possibly penalties. There is also an issue of supervision. With the enormous challenge for the financial services sector to provide regulators with these vast amounts of data, ESG data and rating service providers will often have to help fill in the gaps, but financial institutions are concerned about a lack of transparency over the methodologies used by such providers. Therefore, the quality, reliability and comparability of these services will be key to Europe's sustainable transition and should be appropriately supervised. An EU level supervision of ESG service providers would ensure that a consistent supervisory approach is adopted, and that financial and non-financial companies can build on reliable and comparable data. Support companies in transition For the global economy to meet the goals of the Paris agreement, there also needs to be greater recognition of what are considered as “transition activities”. These are activities that help contribute to reducing carbon emissions in the economy. Presently, the definition and screening criteria that determine a “transition activity” do not include many of the sustainable actions companies are in fact taking. Such activities still make a meaningful contribution to decarbonization, but are currently not recognised as such. If such activities are missed out, then less capital or a higher cost of funding will be applied to financing these activities which disincentivises further sustainable activity, when in fact they should be supported. Moreover, financing transitioning companies could be expanded by broadening taxonomies to capture entity-level activities. Both of these changes would go a long way to helping accelerate Europe’s pathway to achieving net-zero carbon emissions by 2050. As the European Commission unveils a Renewed Sustainable Finance Strategy it should continue to appreciate that the speed of regulatory development is not the only priority. EU authorities need remain focussed on the availability of relevant, reliable and comparable information that helps facilitate capital flows towards sustainable activities. Europe is a global leader in sustainable finance and if authorities can balance ambition with healthy pragmatism and close cooperation with other jurisdictions, Europe will remain the global leader for many years to come.
Pablo Portugal
Strengthening the ESAs and supervisory convergence in Europe: reflecting on progress and next steps
3 Jun 2021
As the European Supervisory Authorities (ESAs) mark their ten-year anniversary this year, the European Commission’s recent consultation on supervisory convergence and the single rulebook provided an opportunity to reflect on their functioning and the evolution of financial markets supervision in the EU. The latest review of the founding regulations of the ESAs, which concluded in late 2019, led to targeted changes to the tasks, powers and governance of ESMA, EBA and EIOPA. While it is premature to provide a full assessment of the impact of the changes, recent developments have provided practical experience on the effectiveness of current arrangements, including areas for potential improvement. An effective response to the Covid-19 crisis The unprecedented challenges arising from the lockdown measures in early 2020 were a major test to the resilience of EU financial markets and the ability of the ESAs to react to urgent situations in a timely and effective manner. The Covid-19 emergency showed that the ESAs have the capacity to respond quickly to major challenges in financial markets, and put forward measures to coordinate actions at the EU level. The clarifications and regulatory forbearance statements issued by ESMA during this period were critical to help firms manage resources and avoid unnecessary stability and operational risks at a time of heightened market volatility. Market participants also welcomed the guidance on the recording of telephone communications, the postponement of certain measures and pronouncements pledging to ensure open and functioning markets, among other actions. The EBA, meanwhile, took several steps to provide operational relief to banks. These includedcalls to supervisors for flexibility and pragmatism in the application of the prudential framework, while banks welcomed guidance in relation to debt moratoria and accounting issues, as well asthe postponement of the 2020 stress test to 2021. One area for further consideration is the use of the“no-action letters” procedure that was introduced following the ESAs review. As acknowledgedby ESMA, its experience during the COVID-19 crisis illustrated the limitations of this mechanism under the current legal framework. During the crisis ESMA continued to issue “de-prioritisation of enforcement” statements which do not have the same status as the no-action relief tools available to authorities in other major jurisdictions. These non-binding statements issued by ESMA, while very important, do not offera guarantee that national regulators will act in a harmonised mannerand mean that market participants stillface the potential need to liaise with several competent authorities on whether they intend to follow the advice of the ESAs, in addition to managing any emerging divergences. Further reflection is needed onthe design of a more effective tool that would allow the ESAs to address sudden market developments and provide a higher degree of legal certainty to market participants. Enhancing supervisory mandates and supporting the competitiveness of EU markets As markets and supervisory needs continue to evolve, it is important to consider how the mandates of the ESAs should be adjusted to reflect evolving priorities in the financial sector. The focus on the Capital Markets Union (CMU) project creates a strong case for embedding the promotion of competitive and efficient EU financial markets in the mandates of ESMA and the other ESAs, alongside their existing core mandates. The importance of competitiveness is manifested in a number of areas. For example, an efficient and competitive securities trading ecosystem leads to better outcomes for end-users, and is important to attract global market participants and promote the growth of EU financial centres. As part of the focus on competitiveness, the policy outputs of the ESAs should give greater emphasis to economicanalysis and impact assessment. Recommendations issued by the ESAs to the Commission – for example, ahead of a legislative review – carry significant weight and play a major role in the formulation of legislative proposals and the work by the co-legislators. It is therefore important that the ESAs regularly conductcost-benefit assessments ofhigh-impact proposals and technical standards they put forward in order to understand their impact on investors and the general functioning of markets, including on their efficiency and liquidity. By way of example, AFME members believe that aspects of the securitisation Level 2 framework have led to unduly complex and costly requirements that outweigh the benefits for market participants. The mandates of the ESAs could formally also reflect the aim of ensuring that all outputs are consistent with and serve to advance the CMU. Regulatory frameworks should be tested against the objectives of making market-based mechanisms attractive and encouraging participationin the EU’s capital markets. In the sustainability area, a welcome aspect of the 2019 ESAs review was the requirement for ESMA to take into account risks related to environmental, social and governance related factors in performing its tasks. The increased demand for reliable and comparable ESG data and ratings should lead to reflections on extending ESMA’s direct supervisory powers to cover providers of such services. Supervisory convergence in Europe – an ongoing process In its report of June 2020, the CMU High-Level Forum rightly highlighted that “high-quality, well-resourced and convergent supervision based on a single rulebook is a key pre-requisite for a well-functioning Capital Markets Union.” These needs remain more pressing than ever as EU policymaking focuses on scaling up the capital markets ecosystem, deepening financial integration, advancing the green and digital transitions and navigating a complex international landscape.The trend pointing towards a more multipolar wholesale markets environment in the EU, featuring a range of financial centres serving as hubs for various activities, reinforces the need for consistent and coherent supervisory approaches across Member States. While it may be too soon to undertake another comprehensive reform of the ESAs’ founding regulations, targeted efforts should continue towards promoting an inclusive and transparent approach to supervisory convergence. Reinforcing certain aspects of the ESAs’ working practices and strengthening mechanisms for the assessment of outputs and consultation with market participants is particularly important to ensure that supervisory objectives are achieved, and outcomes are conducive to stronger EU financial markets. In conclusion, in the decade since their establishment, the ESAs have made a number of achievements and delivered significant progress towards more robust and integrated regulation and supervision in Europe. In today’s financial markets environment it is increasingly recognised that their role is fundamental not only to the preservation of stability and investor protection but also to thepromotion of an efficient, competitive and sustainable financial system in the EU, objectives that should be at the heart of the European policy agenda in the coming years. Read AFME’s response to the Commission’s consultation on supervisory convergence and the single rulebook.
Post Pandemic Compliance: Preparing for What Happens Next - AFME Webinar
11 May 2021
On 29 April, AFME held a webinar featuring industry policymakers and participants, discussing the changing landscape of compliance in light of the pandemic, and how firms can prepare for what will happen next. Changes in supervisory expectations create challenges for compliance functions but also opportunities, as there is room to expand the role and impact of compliance within the organisation. These changes are taking place across several key areas such as technological change and ESG, as well as culture, behaviour, and conduct. Lessons Learned from COVID Speakers acknowledged that, while compliance models coped remarkably well with the impact of the Covid-19 pandemic, they have also had to swiftly adapt. Compliance practices have become increasingly digitised in adapting to accommodate hybrid working, while also addressing the ever-present cost and efficiency challenges. Compliance teams have also had to adopt greater flexibility, with priorities changing more frequently and have learned to implement change ‘overnight’. This has emphasised the importance of both hiring staff with the adaptive skillsets, and being able to bring together at short notice stakeholders from across the business to implement rapid responses to new circumstances. On a related note, connectivity between second line functions has been key to prudent risk management during the pandemic, with many firms considering how greater long-term efficiencies can be achieved in this respect. On the other hand, this must be balanced against the need to maintain the independence of the Compliance function – the willingness to challenge and to escalate. Whereas business continuity and risk assessments were the main priority at the outset of the pandemic, compliance functions now need to consider what the ‘new normal’ may be and what practices from the past year should be wound up, continued or adapted. From a supervisory perspective, the experience has also been revealing. There has been a need to shift to remote, rather than on-site, supervisory inspections, elements of which may be able to continue longer term. Operational resilience and firms’ adoption of outsourcing has also come under increased scrutiny, proving the supervisory view that firms need to be prepared to respond ‘when’, not ‘if’ they face challenging circumstances. Technology The shift to remote working driven by COVID-19 naturally accelerated changes in the application of technology within compliance. As well as an increase in voice (and in some cases video) recording, many firms accelerated their adoption of more advanced surveillance and data-collection systems to compensate for the lack of face-to-face contact, in some cases incorporating advanced techniques such as Artificial Intelligence. This has presented compliance teams with an abundance of structured and unstructured data, which brings challenges as well as rewards. Firms will need to establish the integrity of complex data sets and ensure that data is being harnessed for client benefit in order to build trust with stakeholders and clients. Moreover, since there is potentially endless scope to invest and expand, compliance teams will need to identify the right targets, prioritise their resources and establish what they want to achieve with their use of data. ESG Environmental, social, and corporate governance (ESG) factors will play a fundamental role in the future financial system, which is leading to increased focus within compliance. There are many expectations in respect of how commercial enterprises address ESG, but the topic is still also new to many and developing fast. Trust is key in this area, since it is necessary to build confidence into approaches to avoid the appearance of ‘greenwashing’. As part of this, firms need to evolve and mature their disclosure practices in relation to ESG, which will be a key area for compliance input. Compliance functions will also need to assess their future involvement in ESG and build expertise in this field, in order to advise the business and help manage associated risks. Culture and Conduct One of the greatest challenges for compliance teams has been maintaining and building culture and good conduct in a remote working environment, while staff have been navigating so much change. This encompasses not only long-standing relationships between colleagues, but also onboarding and training new starters. Firms have made increased use of virtual workshops to keep staff connected and up to date with the latest skills and practice. Encouraging debate of practical market conduct scenarios in small groups, even in a virtual environment, has proved successful, particularly with junior staff. The importance of remaining true to corporate values was also emphasised and how firms should remind their staff to consider the concerns of other staff and stakeholders in remote working environments. Compliance Priorities for the Coming Months As the webinar drew to a close, the key message conveyed by speakers focused on the importance of ongoing prioritisation of resources and targets. Compliance functions should identify their unique value proposition and obtain stakeholder buy-in, in order to avoid becoming spread too thinly between ever-expanding objectives – one speaker used the neat analogy that if you add more lanes to a motorway, you’ll just end up with more cars, rather than greater efficiency. This will be key to maintaining a sustainable compliance model as firms transition into new ways of working.
Unpacking the Disclosure Landscape - AFME ESG Webinar
20 Apr 2021
(Online Recording) Europe’s Sustainable transition cannot wait – this was the key message permeating the views of policymakers and industry participants during AFME’s webinar held on Wednesday, 14 April. After a comprehensive overview (presentation available here) from Latham & Watkins outlining the structure of its joint report with AFME ‘ESG Disclosure Landscape for Banks and Capital Markets in Europe’, panel discussions began. Europe has been making rapid progress in developing regulation to support its sustainable transition and it holds similar ambitions in the development of ESG disclosure requirements. Policymakers outlined the need to make sustainability reporting requirements, including under the NFRD, more standardised, accessible, comparable and consistent with existing regulation to accelerate its adoption. Emphasis was also put on ensuring the framework developed is effective globally and avoids fragmenting standards across jurisdictions. A key point of discussion among panellists was the challenge this speed poses to financial services. Industry participants on the panel placed particular importance on synchronising the timing and content of the various sustainability reporting frameworks. Financial Institutions will face a significant challenge in meeting deadlines for their disclosure obligations due to corresponding data from clients likely not being available due to non-financial corporates having a later deadline. Panellists highlighted that greater time and coordination would help alleviate this problem. Moreover, it was highlighted that if financial institutions resort to using different approaches to meet disclosure requirements - using proxies and estimates - their disclosures may not be comparable to other institutions. This would defeat the purpose of the sharing of information. Other challenges mentioned also included the granularity of the European framework. With hundreds of data points needing to be produced against potentially thousands of counterparties, the scale of the undertaking for financial services is large. It was suggested that the demand for data could be focused on a reduced number of data points, while still disclosing valuable, actionable ESG information. Policymakers acknowledged the challenges facing financial services but emphasised that the timing was being driven by the urgent need to address climate change and that this is supported at the highest political level in Europe. At the same time, ESG disclosures are a work in progress and financial services firms are not expected to perfect their reporting processes overnight. Industry participants noted that using proxies during an intermediary period while corporates build up their own disclosures will have some limitations in terms of quality and comparability. It would therefore be more practical and effective to focus on a smaller and simpler set of disclosure requirements as a starting point that would capture the most material issues and where reliable data can be sourced. The requirements can be adjusted progressively as the data and reporting capabilities mature.
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