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Turning up the heat on CMU – AFME’s Spanish Capital Markets Conference Round-up
18 Feb 2020
The Capital Markets Union (CMU) project is still “not in the oven” - these were the words of José María Roldán, the President of the Spanish Banking Association (AEB), when opening AFME’s 11th Spanish Capital Markets Conference in Madrid on February 13. Roldán was one of many speakers to acknowledge that the CMU has not fulfilled its potential and further work is required to advance the European project. First introduced five years ago, the CMU project is still yet to see significant progress; as much as 88% of European funding comes from banks rather than Capital Markets. Pablo Hernández de Cos, Governor of the Bank of Spain, in his keynote address acknowledged the need toreinforce the European financial union amid growing industry risks and challenges. These risks include factors such as the deterioration in the global and euro growth outlook, as well as new challenges such as climate and technology risk. He also said the recent departure of the UK from the European Union has made progressing the CMU even more relevant. This is due to the need to accommodate the loss of the City of London and the important role it plays in financial services for the EU. At the conference it was also discussed how further investment could be attracted to Spain over the next decade. On a panel chaired by Editor in Chief of Bolsamania, Eduardo Segovia, it was agreed that it was too early to tell what impact the new Spanish coalition government would have on the markets; so far there had been no obvious immediate effect. However, Victor Rodríguez Quejido, Director General of Strategy and International Affairs at the Spanish National Securities Markets Commission (CNMV) said this outlook could depend on the government’s stance on Brexit and the impact this could have on market fragmentation. Rob Ford, Founding Partner and Portfolio Manager at TwentyFour Asset Management, added that the new government’s decision-making could potentially be hampered by coalition, and the lack of a clear majority. All panellists, despite the lack of certainty over the implications of Spain’s new coalition government, agreed that regulatory harmonisation and tax incentives would be key tools for attracting further investment in Spain and progressing the CMU. These were among the issues highlighted by José Manuel González-Paramo, Executive Board Director and Chief Officer of Global Economics and Public Affairs at BBVA. In his keynote address, he said the key to progressing the CMU would be harmonising rules in areas such as insolvency and tax, as well as harnessing technology change across the continent in areas such as blockchain. This was echoed by a call-to-arms by David Wright, Chair of EUROFI and Partner at Flint-Global, emphasising more strongly the need for a political ex-ante agreement and timetable to commit European authorities to the CMU project. It was clear from various interventions at the conference that if Europe does not commit more strongly to the CMU project soon, it is likely that five years from now, industry participants will be having the same conversation about how the CMU is not fulfilling its potential.
LIBOR Transition: Views on Managing the Conduct and Compliance Risks
6 Feb 2020
On 21 January, AFME and Simmons & Simmons hosted a panel session with the FCA to discuss in more detail some of the themes raised in our paper LIBOR Transition: Managing the Conduct and Compliance Risks. The session began with an audience survey, which concluded that 60% of attendees considered litigation risk to be the biggest compliance risk facing firms. Much of this relates to the challenge of identifying and transferring clients to replacement rates, particularly given the FCA’s statement that firms must not “move customers with continuing contracts to replacement rates that are expected to be higher than what LIBOR would have been, or otherwise introduce inferior terms”. The panel discussed the tension between the desire to pursue a broadly consistent approach and the complexities of meeting individual clients’ needs. No matter what a firm’s core market, their client base will contain a range of businesses, from sophisticated to simple, multinational to local, multi-banked to single-banked. Some clients are already well-sighted on their LIBOR exposure, others less so. Firms need to understand not only what products each client holds, but the underlying financing or investment need, in order to propose a suitable transition plan. As an example, the FCA was clear that LIBOR transition is an opportunity for firms to move customers to rates that are simpler and easier to explain. As such, firms will be coming under increasing pressure from the regulators if they continue to issue LIBOR linked products for new business. The timing of that transition is also key. Considering the size and scale of the project, it might be seen as prudent to begin transitioning continuing contracts as soon as possible, particularly as this approach offers transparency to clients. However, while LIBOR continues to exist, it is possible that client contracts that have already been transitioned may reference a rate which turns out to be higher than LIBOR. While noting the FCA’s recent letter to ISDA on the subject, it is also not certain at this stage whether LIBOR will promptly cease to exist at the end of 2021, or tail off as individual submitters withdraw. In the latter scenario, firms would be exposed to the risk of comparison between old and new rates beyond 2021 – compounded by the potential for LIBOR to become more volatile and potentially unrepresentative as the LIBOR panel shrinks. The FCA was clear that firms would need to make reasonable judgements in ensuring a replacement rate for LIBOR was expected to be as economically equivalent as possible at the time a decision was made. While a short-run risk of comparison was acknowledged, the FCA noted that firms would also need to consider the risks if client engagement and transition away from LIBOR is left very late and rushed through, or some clients remain exposed to a LIBOR rate that ceases to be representative after 2021. Over the last few years, industry groups, including ISDA and the Working Group on Sterling Risk-Free Reference Rates (RFRWG), have been engaged in helping to build market consensus on how individual asset classes can transition away from LIBOR. The FCA acknowledged the efforts of these UK working groups and encouraged firms to align with the market consensus to agree suitable alternative rates where appropriate. It was clear from the discussion that the ongoing nature of these important efforts makes the compliance challenges more complex – firms cannot wait for these discussions to conclude before acting. The FCA has also been clear that firms are not beholden to these market recommendations and are free to make their own commercial decisions about how and when to transition, although a departure from a ‘market consensus’ approach will need to be justified. More broadly, the FCA called upon firms to ensure that they have a comprehensive plan with intermediate deadlines throughout 2020-2021 – leaving too many key milestones until the end of the transition period will not be viewed well by supervisors. The panel also discussed the FCA’s expectations regarding firms’ communications with clients in relation to transition. Firms should expect the FCA to be looking for them to have produced clear communication strategies, which take into account different client and product types. System readiness was raised as a key dependency for firms’ transition plans, particularly against the backdrop of a market concern that system updates may not be ready in time to meet regulatory expectations on transition timeframes. The FCA encouraged firms to start preparing for the integration of system updates and clarified that a lack of system readiness should not be a reason for firms to delay LIBOR transition. Finally, the level of industry support for a legislative solution was discussed. While many in the room felt this would be helpful, the panel cautioned that it would be a complex process that might not bring the promised benefits. For instance, without a globally coordinated approach, firms would be under different legal obligations in each jurisdiction, meaning a ‘safe harbour’ in one might be outlawed in another. Legislators would also be faced with creating a solution tailored to the individual needs of each market and asset class, a tall order in the time left. The FCA’s parting message was that it expects to see an increase in the use of SONIA in the sterling derivatives market post March 2020, and will continue to monitor this closely. Evidently, the challenge facing compliance teams is huge and multi-faceted. The conduct issues discussed by our panel were only a few of those that firms need to consider and there are significant dependencies on the work being undertaken by market experts on the legalities and practicalities of the transition. The message, though, was clear: the danger of waiting is too great and firms need to start engaging with clients and mitigating the conduct risks now. AFME Contacts Richard Middleton Managing Director, Head of Policy [email protected] +44 (0)20 3828 2709 Fiona Willis Associate Director, Policy [email protected] +44 (0)20 3828 2739
Jacqueline Mills
Squaring the circle of banking regulation and capital markets in Europe
17 Jan 2020
Banks’ investment and trading activities are fundamental for the functioning of European capital markets. They assist governments, corporates and businesses to raise funds through the issuance of new securities and use their balance sheets to support these fund-raising activities by making secondary markets in the securities issued. This facilitates liquidity by lowering the borrowers’ initial funding costs in the process. Through their capital markets activities, banks also provide hedging solutions to a wide range of corporates and institutions, facilitating access to investment and saving opportunities across the globe which lowers risk through diversification. Banks which provide these important services are often amongst the largest, internationally active ones, as these are the players with the scale and resources required to access global pools of capital. Such scale is also needed to invest in the infrastructure, technology, trading expertise and risk management skills required to conduct such activities efficiently and soundly. Yet banks’ capital market capacity has decreased significantly since the crisis. As the EU prepares to reinvigorate its plans to develop the region’s capital markets via its Capital Markets Union (CMU) project, a closer look at how banks’ market intermediation and market-making functions are impacted by global regulatory initiatives will be key to ensuring the deepening of market-based financing in the EU. Banks have retreated from capital market activities - but does it matter? In January last year, a report from the Committee on the Global Financial System (CGFS) examining structural changes to the banking system following the crisis, observed that global banks had shifted away from trading activities[1]. In April 2018, AFME and PwC issued a report looking at how the balance sheets of 13banks, representing 70% of global capital markets activity, evolved between 2010 to 2016[2]. This study was able to quantify that these banks had reduced fixed income and equity assets by just under 40% during this period of post-crisis regulatory reform. Importantly, the study also looked at the reasons behind this reduction in capacity. It determined that changes to the prudential framework, and to risk-based capital requirements and the leverage ratio in particular, were responsible for about two-thirds of the explainable decline in capital market assets. Changes to prudential regulation were of course not designed by policy makers to be neutral in terms of impact, but to balance the requirement to strengthen the financial position of banks and the financial system against the need to preserve effectively functioning markets. In this respect it is legitimate to ask whether banks’ capital market capacity may have shrunk too far. Along these lines, the question also arises as to whether the EU has a banking system which, in addition to supporting direct lending to the economy, can also help improve the size and depth of its capital markets in line with the ambitions of its policy makers? At first glance, there may not be any visible cause for concern regarding the supply of financial services. Years of accommodative monetary policy have generally kept the cost of finance down and the non-bank sector, which operates without the same regulatory constraints that banks face, has stepped in to replace some of the capacity previously provided by banks. However, monetary policy and economic conditions can of course evolve, and the non-bank supply is untested and may not prove to be as resilient as that from banks in times of stress. Global dealer banks have in the past been able to use their large inventories of securities to help mitigate market volatility. But with shrunken levels of such assets, will they be able to do so in the future? The previously mentioned GCFS report also recorded worsening liquidity conditions in some market segments, particularly for assets which typically trade less frequently than others. Could this be an indication that banks are not able to provide liquidity as they were before, and that there are fewer alternatives for less frequently traded assets? Should we be concerned that banks’ post-crisis business model adjustments have given rise to capital market activities being increasingly concentrated in a smaller number of players, with European banks in particular having withdrawn from these businesses? A moving target: evaluating reforms while implementing further regulatory change More research needs to be done to answer these questions. Encouragingly, after a decade of regulatory reform, policy makers at both global and European levels have signalled they are shifting from rule-setting to monitoring and adjusting their reforms if necessary. In principle, this approach bodes well for the development of EU capital markets. We are however faced with a sequencing issue. Regulatory reform is in practice not yet finished andthe last piece of the prudential puzzle, known as the final Basel 3 agreement, is still to be implemented. With this critical aspect of reform outstanding, it is extremely challenging for policy makers and industry alike to evaluate the consequences of the full regulatory package. This is especially true in the context of banks’ capital market activities where there are multiple interactions between different parts of the regulatory framework and where prudential and markets policy makers often appear to work in silos without reconciling their objectives. In Europe, the process for implementing the final Basel 3 agreement will start with proposals from the European Commission for a 3rd Capital Requirements Regulation; possibly before summer next year. This will be followed by the usual negotiations between the European Parliament and Member States, which typically last two years. Therefore we are still a way off from knowing the final shape of the prudential framework and truly being able to assess how banks and their clients will ultimately be impacted. Especially in the context of depressed market valuations for European banks, uncertainty on the regulatory end-point is a significant challenge to manage and could lead to a further reduction in European capital markets capacity. It is therefore essential that this is carefully navigated. What might Basel 3 mean for European capital markets? A key feature of the final Basel 3 proposal is the so-called output floor, a measure designed to act as a backstop to capital requirements based on banks’ own estimates of risk weighted assets (RWAs). The output floor ensures that that internally modelled RWAs are not less than 72.5% of the corresponding amount calculated under standardised approaches for credit, operational and market risks. Contrary to previous rounds of regulatory reform where most market participants saw overall increases in capital requirements, the output floor is largely intended to capture outliers. This means it will affect banks unevenly, depending on their use of internal models and their type of business. Given the distribution of internal model usage, it is not surprising that initial impact assessments by the Basel Committee and European Banking Authority (EBA) show the output floor is likely to affect larger banks more than smaller ones and European banks more than their US counterparts[3]. The EBA’s work also shows that 7 of the 8 European G-SIBs in the sample analysed will be bound by the output floor instead of capital based on internal measures of risk. This move away from a risk-sensitive capital framework is undesirable because when regulatory capital becomes increasingly separate from underlying risk levels, this can lead to sub-optimal capital allocation decisions within banks and investments in riskier assets, rather thana safer system overall. Additionally, over recent years, many European banks have undertaken considerable efforts to improve their models under regulatory and supervisory programmes of the EBA and the European Central Bank (ECB) respectively. . It is understandable that the banks that have invested in these changes do not welcome the limitations the output floor places on the use of their models. Nevertheless, the output floor is a key part of the agreement reached between the members of the Basel Committee, and European authorities have repeatedly stressed their intention to implement it faithfully, placing a high weight on the importance of maintaining their credibility at the international negotiating table. While the output floor is likely to lead to overall increases in capital requirements for European banks, the final Basel 3 package includes other changes which will specifically affect their capital market activities. For instance, the new rules for calculating capital requirements for trading activities (known as the Fundamental Review of the Trading Book (FRTB)), will result in higher capital levels for market risk than today and becoming binding under the Commission’s CRR3 proposal. Banks will also no longer be allowed to model credit valuation adjustment (CVA) risk which reflects losses arising from changes in the credit quality of a counterparty to a derivative contract. Beyond the treatment of market risk, the final Basel 3 package also includes a new standardised approach for determining the capital that banks must set aside to deal with counterparty credit risk, or the risk of loss arising from a counterparty defaulting before it is able to meet its obligations under a derivative contract. Not only does this new approach intervene in the determination of the standardised output floor constraint, it is also relevant to several other areas of the prudential framework, leading to cumulative impacts on the availability and pricing of hedging solutions which have not yet been considered holistically by policy makers. Given that risk weighted assets for market risk make up a relatively small fraction of European banks’ total RWAs on average, the potential effects of these changes could appear to be comparatively small. However, as capital market activities are largely undertaken by of a relatively small number of large firms, these banks will be much more impacted than the average. Appreciating the extent to which these banks’ market activities have already impacted as shown above, the final parts of prudential reform must be implemented with caution if Europe does want to see banks support the growth of its capital markets. What should Europe do when implementing Basel 3? It is well known that the global regulatory community struggled to reach a final agreement on the Basel 3 package, and it will be important for all jurisdictions to implement it consistently and within the spirit of the agreement. This will be particularly crucial for the parts of the proposals which relate to global market activities where banks compete internationally. At the same time, the EU recognises that some of its banks will be the most heavily impacted by the proposals. European legislators should therefore ensure that their implementation of does not go beyond the intended impacts of the international standards. For instance, the output floor needs to be implemented as a true backstop measure. This can be achieved by basing its calculation on Basel minimum or Pillar 1 requirements and internationally agreed capital buffers rather than also including European and bank specific requirements as has been suggested by the EBA. Additionally, as with all Basel requirements which are calibrated at the group level, it is important that the floor applies to banks at a consolidated level rather than individual entity level to ensure that it does not distort or unduly impact specific businesses. It has already been stressed that that policy makers must reflect carefully on how the new changes to the prudential framework might further constrain banks’ market intermediation and trading activities. This should be done now, before the requirements are integrated into the rulebook. Without more joined up reflection between banking regulators, and those who wish to promote capital market development in Europe, there is the very real possibility that the reduction in capacity will continue. If this occurs, there is little hope that other CMU initiatives on their own can achieve the thriving capital markets Europe aims for and needs. The European economy will not benefit from the spare tyre function of having more developed market-based financing, nor it will it enjoy the much-needed private risk sharing and shock absorbing function that strong and integrated capital markets can bring. Beyond Basel 3, European policymakers should also examine how bank and market-based finance can be better linked. For instance, by enabling banks to make greater use of securitisation. In an economy that has been diagnosed with overbanking, banks need to be able to shift assets into capital markets. Not only will this reduce risk on their balance sheets, freeing up capacity, it will also provide investors with access to otherwise illiquid exposures. However, for banks to be able to engage in such transactions they need to make economic sense. This will only be the case if the cost of transferring risk to the market is translated into a commensurate reduction of the regulatory capital charge of the securitised assets. Policymakers should therefore also consider whether the rules governing regulatory capital relief, when risk is transferred outside of the banking system via securitisation, need to be revisited. Here, supervisory authorities, and the ECB, as the supervisor of the largest Eurozone banks, also have a key role to play to ensure that these rules can be operationalised as smoothly as possible. The new Commission and European legislators have a challenge to better integrate their approach to banking regulation and capital markets. By following the above recommendations, they can go a long way to building the capital markets Europe needs to retain a dynamic and sound economy. This article first appeared in Revue Banque on 10 January 2020 [1]Structural changes in banking after the crisis, 24 January 2018, Committee on the Global Financial System [2] Impact of Regulation on Banks’ Capital Markets Activities: Anex-postassessment, 12 April 2018, AFME & PwC [3] Basel III Monitoring Report, March 2019, BCBS and Basel III reforms: impact study and key recommendations, 5 August 2019, EBA
Michael Cole-Fontayn
What can Europe’s capital markets expect in 2020?
9 Jan 2020
As Europe enters a new year it does so with a brand-new Commission, a long list of regulation to review, and a complex relationship with the UK. While the past five years have been focussed on getting post-crisis regulation delivered, the next political cycle will be ensuring the regulation is calibrated so it works for markets and citizens. However, the new Commission also acknowledges a number of new challenges. While the Juncker Commission focused on boosting economic growth and post-crisis reform, the von der Leyen Commission is taking office with a focus on wider social priorities such as climate change, technology and globalisation. This will have a clear impact for the future direction of Europe’s capital markets. The new Commission has already outlined grand plans to ensure Europe is carbon neutral by 2050 in its EU Green Deal. However, in order to achieve this target clear definitions of green finance and sustainable assets will need to be clarified through the EU sustainable finance taxonomy. This will deliver a universal standard of what is considered “sustainable” across the EU and mitigate “greenwashing” – labelling products as “environmentally friendly” without a means of verification. For the EU to remain globally competitive and at the forefront of innovation, the Commission has also identified that a focused digitaltechnology agenda will be vital for the next political cycle. FinTech is transforming capital markets by introducing platforms and servicing solutions; increasing competition with the intention of increasing efficiencies, enhancing risk management, lowering costs and improving services for businesses and investors. However, the future success will depend on the EU’s ability to prioritise investment and a culture of innovation across the industry. Innovation in particular is an area where Europe will look for improvement next year. In contrast to the US and Asia, Europe doesn’t have a single digital champion in the mould of Amazon and Google. In order to increase the chances that the next digital unicorn is from Europe, more investment in smaller entrepreneurial companies is needed. This can be achieved by progressing the Capital Markets Union (CMU) project, with hopes that the Commission’s High Level Forum can recommend concrete, consensus-driven recommendations to take forward. Reducing fragmentation and encouraging greater investment across borders will be critical in improving Europe’s global capital markets competitiveness and ensuring it does not fall behind other global markets. However, the CMU project faces its greatest challenge yet in 2020 with the departure of its largest capital market, the UK. Brexit means there is more urgency than ever to complete the CMU project to ensure it can deliver on its objectives of creating deeper, more integrated capital markets which can support growth and investment for the remaining EU Member States. Following the outcome of the UK general election, it appears clear that the UK will leave the EU on 31 January. The forthcoming negotiations on the future relationship and the adequacy and equivalence arrangements for financial services will have significant implications for European wholesale capital markets. It is critical that the EU and the UK work together to developa future relationship which supports financial stability and minimises fragmentation in wholesale markets, ensuring an effective and stable relationship for the future. Equally, Europe will have to ask questions of its engagement with the rest of the world. Financial markets are global by nature and to be truly transformative the CMU must embrace globalisation. By supporting interconnected markets, investment will then be unlocked both within the EU and the rest of the world to drive economic growth. As Europe embarks upon a new year it can look back on 2019 as a period where the groundwork has been laid for progress in 2020. Despite having made some advances on climate change, technology and globalisation, 2020 is the period when wider change is expected. Crucially, with the rise of citizen activism in Europe, change will not only be expected, it will be demanded.
Europe was not built in a day – key takeaways from the FEBAF/AFME Rome Investment Forum 2019
17 Dec 2019
Rome was not built in a day, in fact, like the rest of Europe, it is still being built. Following the financial crisis, Europe has focused on attracting greater investment in the hope of strengthening its global competitiveness and supporting economic growth. However, this growth is yet to be felt equally across many of the EU’s Member States, with Europe as a whole lagging behind in key areas such as cross-border finance, infrastructure investment and digitalisation. These issues, among others, were discussed in early December at the 2019 Rome Investment Forum organised by FEBAF and with support from AFME, where senior figures spanning Italy and the broader EU economic and political landscape gathered, emphasising patience and persistence in the face of various challenges. Paolo Gentiloni, EU Commissioner for Economy, in his keynote address shared optimism regarding the change we could expect from the new Commission elected in November. He felt the new Commission has arrived at a more favourable time compared to the previous one. While the Juncker Commission took office in the aftermath of the financial crisis and had to overcome the challenges facing the single currency, the new Commission is taking office after years of moderate growth and relative stability. Gentiloni said this means, while there are complicated challenges for the Commission to face, there is a greater opportunity to tackle issues that are social and environmental. Similarly, Guest of Honour, Giuseppe Conte, Prime Minister of Italy discussed the Italian roadmap for boosting investment through public and private partnerships, as well as investment in innovation and sustainability. Conte highlighted the challenges Italy faces in how to improve competitiveness amid increased globalisation. As part of the opening plenary session AFME’s Chairman, Michael Cole-Fontayn, emphasised the key topics for discussion, “Competitiveness”, “Sustainability”, and “Growth”. He said Europe must continue its push to become more competitive than other regions by increasing cross border investment which in turn will help progress the Capital Markets Union Project (CMU). Earlier in the year AFME published its key performance indicators report measuring the progress of the CMU, highlighting how the flow of capital continues to be fragmented along national lines and capital markets need further scale and depth to support economic growth and innovation. Cole-Fontayn highlighted the report findings for Italy, which show that while it is a leader in disposing of non-performing loans, representing 53% of the EU total in 2018, it is lagging behind other EU Member States in certain areas of the CMU project, such as providing funding for Fintech companies and making risk capital available for SMEs. In order to achieve the goals of the CMU, Fabio Massimo Castaldo, the Vice President of the European Parliament spoke of the need for carefully designed industrial policy. Roberto Gualtieri, Italian Minister of Economy and Finance, concurred saying there is a need to define a new single industrial strategy that allows EU companies to reduce emissions, develop digitisation and leadership in tech. Speaking on the panel, David Wright, Chairman of Eurofi, warned that if the EU continues to go down the same route, where there has been fragmentation and a lack of decision-making, in five years’ time the EU will be discussing the same unresolved issues. Highlighting the recent progress made in sustainable investing, Mario Nava, Director of Horizontal Policies, DG FISMA at the European Commission, said we are now seeing conversations surrounding sustainable investments become more nuanced. He said while the questions posed to firms previously revolved around what they were doing to help the environment, today the questions are more specific around how the nature of the market will affect their assets. On the topic of the future post-Brexit relationship between the EU and UK, David Marsh, Chairman of the Official Monetary and Financial Institutions Forum (OMFIF), optimistically said he thinks the UK could in fact become more European following its exit. He suggested that after Brexit the UK will no longer have the EU to blame for its domestic issues, giving more responsibility to UK politicians and a greater opportunity to appreciate the merits of the EU. The session concluded with panellists agreeing that like the historic city of Rome where the forum was hosted, the European Union is a project that cannot be built in a day, and it is on a long journey to fulfil its potential.
What are the regulatory implications for digital assets in Europe?
29 Nov 2019
As interest in “digital assets” and their potential benefits has grown, so too has the regulatory focus and the variety of use cases being adopted. Technological innovations, such as cryptography and Distributed Ledger Technology (DLT), are also closely associated with digital assets, and many different definitions and terms are being used across the industry today to describe this broad concept. On November 22nd, five panellists from Europe’s capital markets discussed this important topic for Europe at the AFME’s 2nd Annual Capital Markets Technology & Innovation Conference in Paris. Richard Hay, Linklater’s UK Head of Fintech, moderated the panel and opened by asking the panellists to help unpick the complexity surrounding the digital assets space. Teanna Baker-Taylor, Executive Director of Global Digital Finance, started the discussion by describing a digital asset as something that has been tokenised, emphasising that this wide scope encompasses a range of products, from crypto-currencies such as Bitcoin or Ethereum, to traditional securities (e.g. tokenised securities). When asked about his firm’s journey into the digital assets space, Teunis Brosens, Lead Economist for Digital Finance and Regulation at ING, said that there has been various stages of acceptance and denial in the market. Having a clear separation between the various terms that encompass digital assets was important for ING to increase acceptance of blockchain technology within the firm. Brosens emphasised that having regulatory clarity and delineation on the different types of digital assets will help market participants reap the benefits of the underlying technology (e.g. DLT) and move discussions beyond Bitcoin. Regarding the regulatory treatment of digital assets, Adrien Delcroix, a Market Infrastructure Expert at the European Central Bank (ECB), confirmed that digital assets would have to comply with relevant financial regulation. He also underlined that, since the innovative nature of those assets often lies in their built-in transfer arrangement, the application of the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMIs) needs to be considered in parallel with the regulatory classification of the asset. In this regard, operational resilience of DLT networks is a key concern. He noted that the distributed nature of DLT arrangements could improve resilience by reducing single points of failure, while increasing the surface of attack from a cyber risk perspective. In his view, fully decentralised systems with no accountable entity are not a desirable feature and such arrangement would not be permitted under current regulation. Swen Werner, Managing Director and Global Product Manager at State Street, said that overall regulation currently allows for the adoption of new technologies to support digital assets, but specific requirements ought to be reviewed. For instance, he noted the European Central Securities Depository Regulation (CSDR) should be adapted to fit to the transaction lifecycle of digital assets, where it may not be necessary to have a settlement agent or a Central Securities Depository (CSD). Adding to this, Daniel Heller, Head of Regulatory Affairs at Fnality International, noted that the issuance of regulatory guidance helps market participants get a better understanding of how to apply the current regulatory framework, clarifying or even resolving certain issues with regulatory compliance. The panel concluded by emphasising the encouraging discussions currently taking place between financial services firms, and regulators, in identifying areas of the current regulatory frameworks which require additional consideration in a DLT environment. Panellists agreed that it will be crucial to maintain an open dialogue across the industry in order to mitigate risks and better realise the benefits that digital assets and DLT can deliver. In a report published earlier this month, AFME called for greater supervisory convergence in the regulation of crypto-assets in Europe, and provided five recommendations for regulators in delivering this convergence. This included recommending that regulators establish a pan-European taxonomy in order to harmonise the classification of crypto-assets. The report is available to download on our website here.
Rick Watson
Europe’s Unfinished Business – what is left to do on CMU?
25 Nov 2019
As the EU gears up for another 5-year political cycle, there is an increasing sense of urgency around the need to deliver the Capital Markets Union (or CMU) project. Some have recently called for the project to be rebranded. For example, the finance ministries of Germany, France and the Netherlands (known as the Next CMU High-Level Group) have recently called for the project to be renamed the “Savings and Sustainable Investment Union” to make the project more accessible for citizens and companies. But it will take more than a new name to get this epic project over the line. The new Commission will need to prioritise and focus on the “big ticket” CMU initiatives. And there is a need to focus on fewer, but more impactful, priorities and to set clear timelines. As the newly appointed Commission prepares to relaunch the CMU project, there are a number of key areas to focus on. First, Europe needs to make its markets more efficient. A fundamental challenge is to ensure that all the elements of the securities market structure are interoperable, can communicate with each other, and can function in a cost-efficient manner, so that EU savers and investors can achieve the benefits of a single market. Here a review of the sweeping EU markets regulation, MiFID 2/R is required, as well as addressing the long-standing barriers to an integrated post trade system. Second, for the CMU to be successful, Europe needs to expand the size, capacity and liquidity of its capital markets. Owing to market uncertainty, there is a scarcity of companies in the EU deciding to take the plunge and undertake an Initial Public Offering. To encourage companies, particularly SMEs, to go public, the EU needs to strengthen its public markets and ensure there are no unnecessary regulatory burdens or costs that might act as a deterrent. Third, the EU needs to catch up with other nations on facilitating FinTech innovation. FinTech provides opportunities to lower costs and provide more efficient services, while offering greater access to finance to a wider range of consumers. However, EU27 FinTech companies have benefited from a mere $7.2bn in investment since 2009, compared to a huge $120bn in the US, $23.8bn in China and $20.3bn in the UK. Going forward, the CMU needs to focus on this important sector in order to make the single market fit for the digital age. For this to happen, regulation and supervision need to be tailored to the fast-evolving digital challenges to ensure that innovation is not quashed. Artificial Intelligence (AI) and bigdata also present opportunities for disruption and revolutionising financial services, which should be explored in full, while closely monitoring the potential risks. Fourth, Europe must continue to strengthen its global lead in sustainable finance. As a percentage of global issuance, the EU28 remains ahead of the US and China by a significant margin due to the rate of growth of sustainable bonds issuance. For example, the EU issued 43% of global sustainable bonds in 2018 compared to 18% by China and just 16% by the US. Now the challenge for the EU is to further build on its leadership by providing clarity on assets that can be considered sustainable. Having clear labels and standards for sustainable products would allow investors to make informed choices which is key for the transition towards a climate-neutral economy. Finally, Europe needs more capital markets and less lending. According to AFME’s annual report which tracks the EU’s progress against the CMU’s objectives, European companies received 88% of their new funding in 2018 from bank loans and only 12% of funding came from markets-based finance (such as bonds and equity). In fact, Europe’s reliance on bank lending has increased since 2013-2017. Therefore, Europe needs to broaden its funding options to increase the share which is delivered by capital markets, allowing borrowers to access the full range of funding opportunities appropriate to their needs and the maturity of their businesses. In this respect, more investment from retail investors could help to put savings to more productive use in the capital markets. Deep pools of capital help to channel investment into the real economy, supporting company growth and job creation. Another way to unlock Europe’s growth potential is through the creation of a powerful financing union consisting of integrated banking and capital markets. The Banking Union and Capital Markets Union projects are intrinsically linked and mutually reinforcing. A fully functional and integrated Banking Union can help achieve a more integrated capital market in the EU – supporting economic growth and helping to diversify risk. The next five-year political cycle needs to be bolder and more decisive on CMU. Simply rebranding the project won’t take the project to the next level. There are a vast range of issues to be tackled which will require strong political leadership and a renewed focus on the top priority issues. This opinion was originally published in Revue Banque on 22 November 2019
James Kemp
Artificial Intelligence and Machine Learning in capital markets is picking up the pace
21 Nov 2019
The use of artificial intelligence (AI) and machine learning (ML) is increasingly widespread in capital markets. Banks are investing in AI/ML to rationalise cost-intensive manual processes such as KYC (know-your-client), fraud detection and regulatory compliance, as a paper by the ACPR (French Prudential Supervision and Resolution Authority) outlined last year. AI/ML is also powering data analytics in areas from risk management to client engagement and is being used by supervisors to perform market surveillance, according to a Bank for International Settlements (BIS) report. Regulators look to get a grip on AI/ML risk While AI/ML could help banks improve services or streamline costs at a time of unprecedented margin pressure, its impact on market integrity and consumer protection is increasingly being monitored. Authorities in several EU Member States (including France and Germany) have issued consultations or analysis of key risks. In addition, the ethics (e.g. fairness) of AI/ML in capital markets is also being examined. The Dutch Central Bank has been first out of the blocks with suggested guiding principles. But the biggest area of interest is the technology’s impact on market stability. This includes the possible emergence of new systemically important financial services providers, who can quickly adopt such technologies, unencumbered by legacy systems, but who may fall outside the scope of existing regulations. Finding the right regulatory balance Even though the risks posed by AI/ML must be understood, regulators cannot be too prescriptive, as this risks slowing down innovation. Fortunately, regulators have generally managed to strike the right balance by adopting a policy of technology neutrality, at least when overseeing innovations like distributed ledger technology (DLT). We hope to see an equally measured approach on AI/ML. At the most basic level, regulators need be confident that firms are applying their existing regulatory obligations, such as treating clients fairly, to their use of AI/ML. This should start with firms mapping out the stakeholders in an AI project (e.g. programmers, management, control functions and clients) along with an analysis of the levels of transparency that they will need. The focus should then be on delivering that transparency. Firstly, the assumptions made in the development of the model should be clearly defined and justified – from the methodologies used to the way that the results of the model will be measured. Secondly, testing the model, both before and during deployment, is critical. Such testing might include analysing the model’s behaviour against real and hypothetical market conditions, or the interaction between the model and other systems. All of the testing processes – along with the results – should be documented and shared with the regulators if required. The problems with explainability Explainability – namely the extent to which complex internal mechanics of an AI/ML model can be expressed is a key issue. Just as the proprietary code shaping computer-based trading strategies are rarely – if ever - shared with institutional investors, it should not be a requirement for the coding of an AI/ML model to be made available, as it will not be comprehensible out of context. If specific levels of technical explainability were mandated, use of AI/ML would be severely restricted to only the simplest models, which would come at a cost to their accuracy. The documentation of assumptions and testing is therefore a better way to deliver transparency into an AI/ML model, while retaining full accountability. Creating a proportionate regulatory framework Regulators need to pursue a risk-based approach when determining the transparency requirements it will demand from financial institutions, based on factors such as criticality and scale. For instance, an AI/ML-enabled trading algorithm might need more scrutiny than, say, an AI/ML tool used to deliver back office efficiencies. As a minimum, organisations should document how they use AI/ML and provide evidence, when required, that it is being used appropriately and safely to internal and external stakeholders. There may also be circumstances where transparency needs to be actively curtailed. Banks using AI to detect and combat fraud could find their systems being compromised if they are forced to disclose too much. If the benefits of AI/ML are to be maximised, the regulation guiding it needs to be pragmatic and carefully thought through. This blog was first published in L’AgeFi Hebdo on 21 November 2019
James Kemp
FX is transforming rapidly, and so is its talent
2 Jul 2019
A diverse range of skills and people are needed to ensure the success of the FX industry for the future In the past, a career in foreign exchange was often synonymous with busy trading floors, where whoever shouted the loudest was the most likely to be noticed. While this kind of environment may have served the markets of the past well, the overriding message from AFME and GFMA’s NextStepFX event last week was that the industry has changed dramatically over the last decade. Whether that’s through new technology revolutionising how trading is done, a revamped approach to conduct and culture in the wake of the financial crisis or a greater focus on working collaboratively to achieve the best outcomes both for firms and their clients. Our speakers had several different perspectives on this issue. For Robbie Boukhoufane, aportfolio manager at asset manager,Schroders, it was clear that despite the fact that the vast majority of trading now takes place electronically, human interaction and relationship building is still hugely important. For him, the key factor is that “we all strive to be more efficient and to get better outcomes for our clients”, but that you won’t join the FX industry and be “sat next to a robot”. Hanna Assayag,a Managing Director in FX at HSBC agrees and said that while, of course, “technology and data are important” facilitating effective interaction between data and analytics teams and sales, and having the skills to effectively do that, is also vital. Thalia Chryssikou, Co-Head of Global Sales Strats and Structuring at Goldman Sachs, said that for her one of the biggest changes has been the difference in what she spends her time doing day-to-day, with her role today much more varied than in the past. A lot of her focus is now dedicated to developing digital platforms and client solutions. Diverse skills needed All of this means that today’s FX industry needs, and is looking for, a whole host of different skills - from the more technical side, with expertise in coding and data analytics, to softer skills in communications and creative thinking. Diversity of talent in the broadest sense is hugely important. As the Bank of England’s, Executive Director for Markets, Andrew Hauser argued in his opening remarks, diverse teams make better decisions as they have “more ways to approach problems, and are better at self-challenge” and diversity also “improves a firm’s connection to, and empathy with its customers”. And as David Hudson, Co-Head CIB Digital & Platform Services at JP Morgan, pointed out, diversity of talent, where you recruit people with different backgrounds and prior careers, brings new ideas into your organisation. There is a hard business case too, research by McKinsey, looking at the economy more broadly, has found that the most diverse firms at an executive level are 20 – 30% more likely to outperform their peers. Attracting women into an FX career Our event last week in particular focused on why this exciting and fast-changing industry could be an appealing career path for greater numbers of women. I was pleased by the positive response we received from attendees and I had the opportunity to speak to a range of people during networking - some were currently working in a different area of financial services, others were considering a return from a career break - but common to them all was a newfound appreciation of the fact that FX was an industry where their skills and experience were in high demand. The importance of building networks Continuing to create connections between industry and the diverse talent that it wants to attract, must be a priority. As Sian Hurrell, Head of FICC Europe and Global Head of FX atRBC argued, “in this industry in particular, people will find their careers through their network” and one of the most important things that industry can do is “to create more opportunities to build networks” such as through events, structured programmes or via social media. For Robin Savchuk,International Treasurer at BNY Mellon, individuals should also feel confident to reach out and make connections. She says these contacts “don’t have to be in a formal programme, I would encourage people to seek out people you respect, want to emulate or whose opinion you value and talk to them, get their advice. With that advice echoed by Emma Norman, Director, Head of e-FICC, Europe and Americas at Westpac. It is clear that both firms and individuals should be cultivating new networks and connections, so that we can all take advantage of the opportunities innovation in FX is creating.
Jacqueline Mills
Europe’s economic future depends on better integrated financial markets
21 Jun 2019
After the 2008 financial crisis, policy makers and regulators worldwide took steps to strengthen banks against future shocks. As a result, banks today are much less likely to fail and, should a failure occur, it is very unlikely they will be bailed out with taxpayers’ money. While these are extremely positive developments, European banks’ profitability remains low, with the average return on equity (RoE) for ECB supervised banks only just above 6% at the end of 2018. This is partly due to overcapacity in the banking system, but is also caused by the effects of ultra-low interest rates, poor cost efficiency, as well as ongoing and cumulative regulatory demands. The performance of the banking sector matters as profits are the first source of additional bank capital, which is necessary to support lending to the wider economy. As outlined by the ECB, banks need to earn returns above their cost of equity – and a 6% average RoE is not enough to outweigh this cost. We also have yet to see cross-border banking activity in the EU resume to the extent is has in other jurisdictions post-crisis, be it in terms of the provision of finance directly across borders or via cross-border merger and acquisitions activity. Even in the Eurozone, where there is a single supervisor and resolution authority, national authorities continue to limit cross-border capital and liquidity flows within banking groups by putting up national “fences”. They do so as a means of dealing with the “European in life, national in death” experience of the financial crisis. While understandable, particularly when national authorities are accountable to their own parliaments, this approach disregards the significant improvements in banks’ resiliency and ignores the system-wide capacity that has been built up to absorb losses if they do occur. And while there may be a protective advantage for a single state to act in this way, when all states do the same, the entire system becomes brittle and inefficient, and everyone loses. At a recent AFME conference, delegates heard that at least an estimated EUR180billion of liquidity is “trapped” locally in Member States. This results in increased costs to end users of financial services who also pay different prices for the same service, depending on which country they are in. This is not an optimal allocation of resources and negatively impacts banks’ end customers and profitability alike. Restoring, and pursuing, EU financial integration since the crisis has clearly been a challenge. While the recent European Parliamentary elections were far more positive than some had expected, with the anti-European vote being fairly limited, many national governments still struggle to see, and deliver, the benefits of European financial integration. As evidenced by the recent report of a high-level group of national experts, Member States have reached an impasse in taking the steps we need to move forward. European Commission officials have noted the lack of ambition of Member States. And international and market observers, including those who are fully aware of the complexities of European decision-making, wonder why progress is not being made. Yet it is clear that it is precisely by moving forward with the well-known steps identified by the European Commission to complete the Banking Union and build up our capital markets that economic progress will be made which will benefit all. For instance, by promoting deeper capital markets, EU economies will not only reduce their reliance on bank financing, thereby opening up a wider range of financing options, especially for new or smaller growth companies which need equity financing, but it will also allow risk to be diversified and shared more widely. This is something which is currently lacking in the EU compared to other more integrated markets, such as the US and will further reduce the need for any public risk sharing. Moving forward with the European Deposit Insurance Scheme, which guarantees the protection of EU depositors’ money in the event of bank failure, is also necessary to create the trust required to overcome fragmentation and achieve an integrated banking market in Europe. This will be key to enabling the efficient allocation of capital and liquidity across banks, avoiding ring fencing and enhancing the safety and growth potential of the entire European economy. Unlocking Europe’s growth potential through the creation of a powerful financing union consisting of integrated banking and capital markets is long overdue. We urgently need better integrated markets that are serviced by strong, profitable financial institutions, capable of meeting the borrowing and investment needs of all Europe’s population. The goals are clear. But we cannot afford to wait for another 10 or even 5 years for this to become a reality.
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