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The EU's Cybersecurity Agenda: Coherent or Chaotic ?
29 Aug 2023
In the digital age, the creativity of cyber criminals requires constant vigilance. Banks are conscious that they remain the number one target for cyber-attacks. Therefore, the European Union’s focus on cybersecurity is both welcome and acutely needed. The intention to embed cybersecurity into the various aspects of financial regulation, including risk management controls, supervisory stress tests and incident management will ensure a holistic approach, which best protects the stability of financial markets. The question, however, is whether each of these initiatives are effectively aligning, or whether EU officials are tripping over each other in the rush to get files over the line ahead of next year’s elections? What is currently at play? Cybersecurity has been a priority for the outgoing Commission and in the realm of financial services, this focus was one of the drivers behind DG-FISMA’s DORA – the EU’s milestoneDigital Operational Resilience Act. The Regulation harmonises the operational risk landscape for financial entities, and encompasses cybersecurity, albeit partially on a voluntary basis. Alongside the sectoral overhaul, financial services are impacted by the cross sectoral cybersecurity package coming out of DG-CNECT, as underpinned by the technical cybersecurity certification schemes. Moreover, cyber risk has increasingly become an area of focus for supervisors, including the ECB, in assessing the resilience of market participants, with Threat Led Penetration Testing (TLPT) providing real-time simulations of cyber threats and a firm’s response capabilities. The overall framework is comprehensive, and the level of ambition laudable, but there are serious concerns across the industry regarding the practical implementation of these well-intended proposals Why the cause for concern? While the Commission is aware of the risks of duplication and overlap, its approach has not been consistent, and the incoming Cyber Resilience Act has caused significant worry across the industry. At first glance, this piece of product regulation could neatly sit in parallel to the entity regulation under DORA. However, the commercial reality is not so straightforward. Many financial services firms today offer products and services via technology systems and applications, which could be captured under both frameworks. The Cyber Resilience Act proposal in fact makes explicit reference to banking apps as one example. Yet this ‘product’ is very different from a good which is sold to a consumer and whereafter the provider or merchant relinquishes control. Instead a bank would retain control over such devices, and be responsible for ensuring that security and software updates are reviewed and installed. The application would, therefore, be covered by the existing DORA requirements, rendering the CRA superfluous. Within the EU institutions, some do not believe that this overlap is overly worrying. They perceive that since checks are already taking place, any additional burden would be limited. Such thinking fails to recognise that a single “service offering” can have hundreds of applications and processes sitting under it. The resourcing burden of any duplication in cybersecurity measures is therefore significant, and also ever increasing, as cyber controls and testing continue to become more enhanced and extensive. While firms are repeatedly addressing the same cyber risk, they are impeded from devoting time and effort to tackling new cyber threats. In an emerging area such as cyber, firms must retain the capacity to respond to arising threats and the increasing regulatory load is constraining EU financial firms’ agility. What is next? The immediate priority is ensuring that the incoming Cyber Resilience Act doesn’t cut across DORA. This milestone regulation marks a notable advancement for operational resilience in the digital world and merits broad Commission support. A definitive boundary needs to be established regarding the underlying systems and processes which support many outward facing products. It is also critical that any additional incoming requirements on reporting of vulnerabilities and threats is based on existing systems and lines of communication, to prevent conflicting reports and mismanaged responses. It will be crucial that the new Commission resists the pressure to introduce new cybersecurity schemes and proposals, as the current environment needs time for embedding before addressing any remaining gaps. Moreover, the worrying tendency to introduce localisation or sovereignty requirements under the pretext of cybersecurity must be countered. Such proposals have been debated at length as part of the passage of DORA, yet we continue to see the discussion reopened, most recently with regards to the EUCS cybersecurity certification scheme. Many cyber threats are cross-border in nature, and removing access to non-EU solutions will ultimately backfire by limiting the ability of EU businesses and clients to rely on software providers who could offer the most tailored expertise in enhancing cybersecurity in any particular field. The only beneficiaries in such a scenario would be the cyber criminals, who will be quick to capitalise on these vulnerabilities and blind spots. AFME’s Technology &Operations team remains on hand to discuss any of these issues in further depth, or to provide an update on the organisation’s activity in this field. Please [email protected] further information.
Peter Tomlinson
Webinar Summary: US T+1 – What should European firms be doing to prepare?
6 Jul 2023
US T+1 – What should European firms be doing to prepare? AFME recently hosted a webinar on shortening settlement cycles (known as T+1 settlement), discussing the latest developments in the US and Europe. AFME was joined by a panel of expert speakers from DTCC, the Value Exchange, Goldman Sachs, BNP Paribas and EFAMA – providing views from across the industry on the impact of the US migrating to T+1 settlement in May 2024. The panel opened with a factual overview of the new requirements by John Abel, DTCC. It was noted that as well as the new settlement timings, the industry will also have to prepare for compliance with stricter requirements regarding the process for allocation and affirming transactions on trade date. Barney Nelson, the Value Exchange, presented an overview of his firm’s market research into industry readiness for T+1. The research highlights that the operational impacts of the move will be felt hardest by smaller firms outside of North America. Firms are generally expecting impacts across the entire trade lifecycle from account opening to corporate actions, with many institutions considering changes to resourcing and operating models to facilitate the move. Panelists representing custodians (Emmanuelle Riess, BNP Paribas), broker-dealers (Sachin Mohindra, Goldman Sachs) and investors (Susan Yavari, EFAMA) identified three core areas where potential challenges are likely to arise. First, in relation to the affirmation process, which must be completed on trade date by 9pm EST. It was noted that this represents a considerable ‘squeeze’ on post trade operations, particularly for institutions based outside the US. Panelists identified the need for greater focus on automation to help solve this challenge. Second, it is expected that there will be a significant impact on funding processes, in particular where an FX transaction is required in order to facilitate settlement. The timing of FX transactions will also be compressed, with potential impacts on pricing and liquidity. A third area of concern identified was to securities lending processes. Given the shorter settlement period, securities will have to be recalled on a shorter timeframe, increasing the possibility of settlement fails. Panelists noted that this could possibly lead to less inventory being made available for lending, potentially damaging overall market liquidity. Panelists also noted that the US move to T+1 will reintroduce a global misalignment of settlement cycles, creating problems for globally active institutions, in particular, in relation to funding and cash management, and for transactions in securities with a multi-jurisdictional nexus, such as ETFs. This naturally raises the question of whether Europe should also move to T+1 settlement. Pablo Garcia, AFME, noted that industry discussions on the topic are underway in both the UK and EU. Any such move will require careful consideration, in light of the additional challenges that will face Europe, such as the increased complexity of its market infrastructure landscape and the existence of CSDR settlement discipline measures. As the industry continues its progression towards T+1 adoption in the US in 2024, and with developments expected in both the UK and the EU, there will be plenty more to discuss in the coming months.
April Day
Equity-Market Liquidity Is Leaving Europe
22 Jun 2023
European equity markets are facing a worrying problem. Liquidity is leaving Europe, and if the current state of affairs remains unchanged, this trend is probably set to continue. The European Union’s (EU’s) market capitalisation (or the total market value of shares for listed companies) was only EUR10.4 trillion at the end of 2022, compared to EUR 38 trillion in the United States—in other words, it was less than one-third of US market capitalisation. Furthermore, turnover of EU shares (a measure of liquidity) remained completely flat from 2016 to 2022, while this measure increased by 40 percent in the United States over the same period. There are, of course, multiple contributing factors to this crisis, but two initiatives are underway that may help to reverse the decline. For example, completing theMarkets in Financial Instruments Regulation (MiFIR) review with the right focus could help boost secondary-market liquidity. This review is an important moment for Europe’s capital markets as policymakers consider how to enhance the competitiveness and attractiveness of EU capital markets at the international level. Europe also aims to improveprimary-market issuancethrough theEU Listing Act, which, once implemented, can simplify access to European capital markets and streamline the listing process as well as post-listing requirements. Navigating the complexities of the EU’s regulatory framework Part of the EU’s equity problem is the complex regulatory framework governing how its markets function, including certain restrictions that do not apply in other markets. For banks, explaining this complex regulatory framework to international clients and persuading them to still want to transact in the EU is a long, involved process. In the EU, rules on share trading require investment firms to ensure that trades occur only on an EU-regulated market or multilateral trading facility. The trading amounts on certain trading venues are capped in favour of so-called public venues. Originally, this requirement was meant to increase transparency, yet it has led to firms being unable to trade in the most liquid markets or pursue the best execution for their clients. Ultimately, this can limit competition and deter investment. In addition, the costs of complying with regulations and administrative burdens can also disincentivise investment. European issuers face higher capital costs as investors require liquidity premiums for investing in securities that cannot easily be converted into cash. Over time, this impacts where businesses list, making the US more attractive in the long run. The role of MiFIR To enable equity markets to thrive, Europe needs a well-developed equities consolidated tape. This tape will provide a window into liquidity across Europe and be accessible to investors. An example is the fund manager in Singapore, who wants to look at Europe as one single market and have the ability to invest in the most liquid markets to construct a deeper and more varied portfolio. By implementing such a tape, Europe can bring visibility to its true scale, making it a more attractive place in which to invest and creating further opportunities for both investors and companies seeking to list in the EU. This is a major objective of the MiFIR review, with negotiations currently underway on how the tape should be constructed. The deeper the tape, the deeper the use cases across market participants, and the more viable the tape will become. After years of real progress failing to materialise, a consolidated tape is in tangible reach, so negotiators must now focus on implementing a tape that benefits the whole EU. In addition to a consolidated tape, the outcome of the MiFIR review should also ensure that a variety of trading mechanisms are offered to investors. Investors want choices in how they execute transactions so they can get the best possible results for their clients. Under MiFID, stocks can be bought and sold on trading venues and through systematic internalisers (SIs). SIs are important components of the European trading ecosystem as they provide investors with a service similar to how banks provide loans to businesses. When firms act as SIs, they use their own capital and balance sheets to facilitate more efficient and often better-priced executions for clients. In turn, they also benefit end investors, such as pensioners and savers, who entrust their monies to asset managers who trade with SIs to obtain the best possible results. Data shows that SIs contribute an additional EUR 3 trillion annually to European equity-market liquidity that would be lost if the provision of this type of trading were curtailed. The MiFIR review currently introduces some ill-founded restrictions on trading via SIs. By limiting the investor’s ability to choose the type of execution mechanism that is most suitable for his or her investment needs, the overall global attractiveness of European markets could be negatively impacted. Increasing liquidity through the EU Listing Act Equity markets not only rely on secondary-market liquidity but also on the health of the primary market. As more companies enter the market, the greater the number of growing companies, which will capture investors’ interest and increase trading. Here, the EU also lags behind other markets. For example, the gap between EU and US equity primary issuances has widened significantly over the last five years. From 2018 to 2022, equity issuance in the EU represented 27 percent, or less than one-third of that in the US. Seeking to improve the EU’s standing, the European Commission (EC) launched a set of proposals known as the EU Listing Act in December 2022. The EU Listing Act aims to increase the appeal of public markets to EU companies by easing the complexities and costs of accessing capital for small and medium-sized enterprises (SMEs). While this is a promising first step towards increasing Europe’s attractiveness as a desirable location for companies to list, the proposals are not perfect. The European Commission’s blanket proposals to cap prospectus length and remove any requirements for prospectuses for secondary-capital raises under 40 percent in size reduce flexibility and may create material risks for issuance stakeholders. The Listing Act proposals must be revised to ensure that market participants can continue providing the best possible disclosures to protect quality listings. Putting liquidity first Europe is at an important juncture to establish itself as a leading equity market. The opportunity to address some structural issues and revise key capital-market regulations, which govern how markets function in the EU, now rests with policymakers. The US offers deep and broad pools of capital, leading to a market with attractive listed companies and higher activity levels from retail investors. Investors want choices in how they execute transactions to achieve the best executions of regulatory requirements. The EU now has the chance to step up: first, by establishing a meaningful consolidated tape, which will draw investment focus to Europe as a whole, and second, by ensuring there are sufficient choices in trading mechanisms, which will help to attract investment within and into Europe. To reverse the deteriorating trends in equity-market liquidity, policymakers must ensure that Europe’s attractiveness and competitiveness as an investment destination are at the forefront of their decision-making.
Perez Adelaja
Firms Need a License to Innovate: Artificial Intelligence and Machine Learning in Financial Crime Compliance
29 Mar 2023
Artificial Intelligence and Machine Learning (AI/ML) have been in the news again with the release of OpenAI’s chat bot, ChatGPT. This tool uses elements of artificial intelligence to communicate with people in a human-like way and has fascinated the public with its swift and detailed responses and potentially wide-ranging uses. However, ChatGPT is merely the latest public development in the long-established field of AI/ML, which the financial sector has been exploring for numerous years. AI/ML has the potential to transform the financial industry through rapid analytical tools and enhanced data processing capacity. For example, huge volumes of data can be analysed more efficiently to improve trading strategies or to optimise capital models. Financial regulatory authorities around the globe have equally been paying close attention to AI/ML, as they acknowledge it has many conceivable uses within the sector. The EU is currently developing an AI Act, while the UK has released a discussion paper on AI/ML, to which AFME responded.A key message was the need for more dialogue with supervisors on areas where firms may find it more challenging to innovate, such as financial crime compliance. This is an area with huge potential for the use of AL/ML, although barriers still exist to its deployment. The Potential for AI/ML in Financial Crime Compliance AI/ML could prove especially transformative in the prevention and detection of financial crime, including anti-money laundering and combatting the financing of terrorism (AML-CFT). By taking advantage of the advances in data analytics derived from AI/ML, financial institutions can more effectively use their client, communications and transactional data created by their products and services. Financial institutions’ surveillance systems could benefit from more sophisticated incorporation of unstructured data into datasets (for example, to contextualise transaction data with current affairs) or better oversight of internal and client communications using natural language processing capabilities to detect misconduct. The incorporation of AI/ML will also aid in improving the accuracy and relevance of the alerts that are generated by these surveillance systems, for both financial institutions and their supervisors. For instance, Europol estimates that currently just 10% of suspicious transaction reports submitted lead to further investigation by competent authorities. Barriers to Deployment Integrating AI/ML solutions into financial crime compliance, however, is not simple. To ensure a suitable baseline standard, the relevant regulatory frameworks tend to be rule-based, rather than principles-based. For example, these frameworks mandate analysis by specific risk indicators or variables, with minimal scope for a highly tailored approach or innovative technological solutions. A key benefit of AI/ML as a technology, on the other hand, is its ability to find new solutions for the task it is set, incorporating different data sources and finding new patterns. Given the mismatch between regulatory requirements and the adaptive nature of AI, FIs interested in implementing AI/ML applications in financial crime compliance therefore cannot use them to retire their current systems, even where a new approach can produce more effective results. In addition, where FIs determine that they can deploy AI/ML in financial crime compliance, they must ensure that they are able to provide sufficient transparency on the applications’ outputs. This is to satisfy both themselves and their supervisors that the application is performing to a suitably high standard of accuracy and efficiency, while not contravening FIs’ ongoing obligations in areas such as data and client protection. This will need to be assessed throughout the lifecycle of an application and will involve upskilling both for FIs' compliance teams and their supervisors, to ensure that the right level of challenge is present. Steps in the Right Direction Despite these challenges, the industry is keen to explore how AI/ML can be incorporated to fight against financial crime, while continuing to meet regulatory expectations. In December 2022, the Wolfsberg Group of FIs released their “Principles for Using Artificial Intelligence and Machine Learning in Financial Crime Compliance” to support the wider industry in their technological innovation in this field. These serve as a helpful guideline for how FIs should apply AI into financial crime compliance. Globally, regulators have also begun to recognise the significance of AI/ML in financial crime compliance and the importance of supporting its development. Notably, the Monetary Authority of Singapore (MAS),announced in October 2021 that it will introduce a digital platform and enabling regulatory framework for financial institutions to share with one another relevant information on customers and transactions to prevent money laundering, terrorism financing and proliferation financing. US regulators have also spoken about the potential improvement of AML-CFT through the use of technologies such as AI/ML. In the UK, the FCA released a 2019 report on Machine Learning in Financial Services, which explored financial crime as one of its case studies. In 2020, the French ACPR included AML-CFT as one of its series of technical workshops on how AI can be developed within the sector. The ECB has also been considering the challenge of digitisation, including AI/ML, in the context of its new European AML framework. Conclusion It is encouraging to witness multiple regulators believing in the potential of AI/ML in preventing and detecting financial crime. However, further collaboration with authorities will be required to ensure that innovation in this field can be supported within the context of continuing to meet regulatory expectations – and, as recently noted by the Financial Action Task Force, even statements of regulatory support for the adoption of new technologies do not always translate into real supervisory acceptance of compliance practices and new procedures.To quote the Director of the US Financial Crimes Enforcement Network: “innovation will only happen if the private sector feels it has latitude to innovate. AFME would welcome further discussions with authorities in this area and looks forward to supporting the development of AI/ML in the fight against financial crime. References
Elise Soucie
Can the EU's DLT Pilot Regime truly champion a digital future?
23 Mar 2023
As the EU’s Distributed Ledger Technology Pilot Regime goes live today, AFME discusses whether it will truly enable innovation in capital markets. Finance and innovation have always been closely linked, and historically, technology has played a key role in modernising systems for consumers and markets. Financial services has continued to evolve at pace with the development of new technologies. In recent years, distributed ledger technology (DLT) has been identified as a key innovation that could transform capital markets. DLT is a framework and protocol that combines database technology and cryptography, allowing multiple participants to each maintain their own copy of records in a shared dataset and make updates to it. All copies remain consistent through computerised consensus mechanisms rather than through a trusted third party. DLT implementation could be used in almost any industry that collects and uses data. For financial services, it could generate substantial efficiencies across the securities lifecycle, improve the resiliency of market infrastructure, reduce settlement risk and ultimately change the way market participants interact with one another. However, the legislative and regulatory framework governing EU securities markets was designed prior to the advent of these new technologies and did not envisage the potential use of DLT in traditional capital markets. In order to investigate what legislative changes might be needed for DLT to be used in capital markets, the EU launched the DLT Pilot Regime (DLT PR) back in 2022 as part of its digital finance package. The DLT Pilot Regime is an example of a regulatory sandbox, which allows established market participants and new entrants to test products in a controlled environment. It enables them to find out whether a particular technology can be implemented in a new and innovative way, while still meeting the appropriate regulatory outcomes and risk tolerances. Under the DLT PR, entities will be able to apply for temporary exemptions from certain requirements of existing European financial legislation which have been deemed 'incompatible' with the use of DLT in order to provide issuance and post-issuance services (including trading and settlement) through DLT-based market infrastructures. As the EU DLT PR goes live today, the question arises as to whether the sandbox goes far enough. Does it truly allow for the necessary experimentation, innovation and the potential development of new infrastructures and a different ecosystem? Approaches around the globe The EU is not the only jurisdiction looking at how DLT could shape the future of capital markets. The UK Treasury is also looking at establishing sandboxes that would enable financial market infrastructures and other designated parties to test and adopt new technologies and practices by temporarily suspending, amending, or even applying certain laws. The UK Financial Market Infrastructures (FMI) sandbox has the potential to be much broader and could involve participation beyond Multilateral Trading Facilities (MTF) and Central Securities Depositaries (CSDs), however the UK Treasury has yet to consult on exactly what shape the sandbox will take. In Asia, the Philippines is using a test-and-learn approach, which represents an alternative to the regulatory sandbox. In this strategy, regulators can use tools like letters-of-no-objection or case-by-case waivers to give innovators access to a regulatory-free environment while allowing oversight over the testing process and to step in when results become more apparent. Additionally, the Monetary Authority of Singapore (MAS) is running both a FinTech Regulatory Sandbox that enables experimentation with innovative financial products and services, as well as Project Guardian which supports collaboration with the financial industry to test the feasibility of applications in asset tokenisation and DeFi. The Hong Kong Monetary Authority also has a Fintech Supervisory Sandbox which includes both regulatory tech (regtech) use cases as well as a small fraction of DLT projects. Comparing these approaches, it is evident that the EU has been bold with the EU Pilot Regime initiative. Positively, the EU has been able to put effective measures in place faster than other regions to facilitate experimentation with DLT in trade and post-trade processes. The EU has gone further, faster, and may have a distinct first-mover advantage, gaining valuable knowledge and first-hand experience of how DLT can be applied in securities markets. However, while bold, there are aspects of the EU DLT PR that may not encourage broad engagement in the sandbox from market participants. Throughout the DLT PR consultation process, AFME has raised concerns about the relatively low thresholds on both the size of permitted issuances of DLT-based securities and the market capitalisation of the issuer, as well as the process for authorisation following the sandbox exercise. There is still a lack of clarity on what the roll off to the real-world would look like and this could see participants disincentivised from investing time and money in new and innovative projects with an uncertain future. Where are we now? Market participants have keenly followed the legislative process and developments around the DLT pilot regime. The regime is an important step in facilitating DLT experimentation in capital markets. Many believe that the digitalisation of capital markets could represent a transformation comparable, if not greater, in scale and significance to the shift from physical to electronic securities. Nonetheless, there are certain challenges with the EU DLT Pilot Regime and its sandbox. The divergence and inconsistency across the EU for the regulatory treatment of digital securities and their legal status under national securities laws could limit the effectiveness. For example, in Germany, Luxembourg and France there are local regulatory regimes capturing digital securities which are different in approach and not harmonised. While the EU regulatory framework is designed to be technologically neutral, it has been constructed with traditional financial market infrastructure in mind. Therefore, there are concepts in regulations that are inconsistent with DLT environments. The DLT PR goes some way to address this, by providing derogations from certain regulatory requirements. This is an understandably pragmatic approach, but ultimately may leave little room for a more ambitious reimagining of how capital markets infrastructure is organised, and how networks of participants are connected. Overall, the ability to successfully transform financial legislation to support the use of DLT across financial services will depend on how broadly the sandbox is used by industry participants and what the level of uptake is. The more participants adopt new and innovative structures, the better these structures can be applied successfully in the real world within the appropriate legislative and regulatory parameters, and the greater the benefits that can be derived from new technology. However, true success for the DLT PR, which launched today will depend on whether the industry believes that a sandbox experiment will be beneficial. It will also depend on whether the parameters are open enough for them to be truly innovative in meeting regulatory requirements, rather than just using the new technology within an identically structured ecosystem. A robust digital economy will thrive within an appropriate regulatory perimeter.It will be interesting to see what the uptake of the DLT sandboxes will be and how capital markets participants continue to innovate and implement new technologies.
Adam Farkas
Europe’s competitiveness depends on reviving capital markets
25 Dec 2022
The last few years have tried and tested EU corporates and SMEs. Through six years of extreme disruptions, starting with Brexit, stretching through the pandemic and the fallout from the war in Ukraine, businesses have faced continuous challenges. Now, the current energy crisis and soaring inflation mean EU businesses are once again in uncharted waters. Especially, at times of crisis, it is all the more important that businesses can rely on strong capital markets that can provide necessary funding. However, it is well-known that European enterprises continue to heavily rely on bank lending to finance their investments. According to recent analyses by EY, Eurozone bank lending is predicted to fall next year for the first time since 2014. The ECB estimates 75% of corporates in the Euro area still continue to seek bank loans over other types of market finance. An important aim of the Capital Markets Union (CMU) is to help reduce this dependence on bank funding and to cut the cost of raising capital, in particular for SMEs. This will only be achieved by building a financial system in which deeper and integrated capital markets will absorb more of citizens’ savings and play a greater role in business finance. The case for a Europe-wide CMU is, therefore, greater than ever before. The CMU has been discussed in Europe as a long-term project for years, but progress has been slow to materialise. Stumbling blocks – EU equity market gap AFME’s research shows that a few key obstacles are preventing the CMU project from truly taking off. Chief among these are the EU’s equity finance gap, which continues to widen compared to global peers, and the subdued securitisation market, which remains a material loss to the EU’s financial system. Overall EU equity markets are making slow progress. The EU is performing far below its potential, reflected in the declining proportion of global equity market capitalisation of listed shares. For example, EU domestic market capitalisation of listed shares has fallen from 18% in 2000 to just 10% of the world’s total today. This drastic fall is a result of a combination of factors – an ongoing trend of company delistings, fewer IPOs and most recently, lower company valuations linked to the uncertain economic outlook. As a result, the EU as a whole is becoming less and less attractive as a place for businesses to access deep pools of capital and go public. To address this, public markets and the IPO environment need improvement. The EU Listing Act will be important in this respect, and it will boost cross-border competitiveness of the EU markets for listings, both for companies already listed at exchanges and new entrants. This initiative should aim to facilitate for a vibrant environment for listings, by cutting down on the costs for businesses of all sizes where possible, while ensuring that investors continue to benefit from legal certainty and strong reporting mechanisms. Features of the existing EU framework that are unclear, disproportionately burdensome on issuers and which fail to provide adequate reassurance to investors, should be addressed in this review. Securitisation market remains subdued The European securitisation market has also failed to take off and falls behind that of its global peers. For example, EU securitisation issuance levels decreased by 10.9% during 2020-2021, while US securitisation grew by 74.5% during the same period. In addition, during the pandemic, securitisation played a supporting role in freeing up capacity for bank lending outside Europe, but in the EU, average annual securitisation issuance has declined by 10.9% compared to pre-pandemic averages. There is a wide view among market participants that regulatory impediments are holding back the growth of the European securitisation market. While changes to the securitisation framework were delivered at EU level with a new Simple, Transparent and Standardised (STS) framework, these have not had the desired effect on the recovery of the securitisation market. The absence of a well-functioning securitisation market is a strategic loss to the European financial system. It is undermining the competitiveness of European financial institutions and limiting their ability to recycle capital to support new financing. It has also driven institutional investors towards other products that do not offer the same advantages in terms of protection, transparency and liquidity. As a tool, securitisation is uniquely placed to support the European economy through its ability to transfer risk while enhancing banks’ capacity to manage their balance sheets efficiently to continue to lend to businesses and households. To overcome this, further work needs to be done to unlock the contribution of this important instrument for financing EU growth. Imbalances in the European securitisation framework need to be urgently addressed in order to encourage issuers and investors back to the market. There is no doubt that there have been some considerable policy achievements over the last five years, but EU legislators should now grasp the opportunities provided by the current legislative discussions on the CRR3/ CRD6 and Solvency 2 to include adjustments to securitisation-related calibrations in these legislations and concrete mandates for further revisions to be undertaken. Positive steps forward on CMU It becomes clear that the EU needs to continue working towards significantly expanding and deepening its capital markets capacity. This is even more important in view of the capital mobilisations demanded by the green and digital transitions. Capital markets have the innate ability to contribute the building blocks to this goal and in the last five years, the evolution of ESG markets has been particularly remarkable in this respect. The amount of EU ESG debt issuance increased from €61bn in 2017 to €360bn in 2021. EU green bond issuance continued to rise in 2022, albeit at a slower pace this year, with volumes up 8% year-on-year in the first half of 2022. The EU continues to consolidate its global leadership in sustainable finance. EU and national authorities have encouraged this transition via strong strategies to combat climate change and ambitious decarbonisation targets. The development of the regulatory framework in this area – particularly the EU taxonomy for sustainable activities, the ESG reporting framework, and an EU green bond standard – are expected to further support the EU’s sustainability transition and global leadership. The European Commission launched an unprecedented bond issuance programme in the form of social, green, and conventional bonds accumulating more than €200bn in proceeds as of 2022 (and expected to surpass €750bn). In the realm of digital finance, 2021 was an extraordinary investment year for FinTechs. 2022, on the other hand, has seen a decline in investment activity globally. AFME has found that investment has declined in all major regions from about USD 90bn in 2021 and expected to reach USD 80bn in 2022. Nonetheless, the EU has progressed on the road towards greater digitalisation, as Member States have improved their local regulatory frameworks with new sandboxes and innovation hubs. The number of FinTech unicorns increased from 13 to 18, suggesting an overall improvement in the environment for financial technology. These digital trends, have, however, brought about challenges for supervisors and regulators as unregulated financial activities (some via Decentralised Finance protocols, or DeFi) have grown exponentially over the last years. A long road ahead As the current EU legislative cycle enters its final year, it is more critical than ever for the EU to take further steps towards putting in place a strong and diversified financial system capable of effectively mobilising Europe’s deep pools of savings, supporting businesses of all sizes, promoting innovation and attracting leading global players. The deteriorating economic outlook this year has further highlighted the strong case for progressing CMU, reinforced further by the combined challenges of the capital mobilisations demanded by the green and digital transitions. Reflecting on the past five years, it is apparent that capital markets have remained resilient, but policy makers need to keep the momentum going on CMU. Without this, Europe’s position among leading global capital markets risks falling further and further behind. Success ultimately depends on the quality of regulation and its effects in advancing the CMU objectives, and not the number of legislations adopted. Current initiatives under discussion as part of the second CMU Action Plan and upcoming Commission proposals have the potential to deliver significant progress. EU authorities should seek policy outcomes that focus on investor and corporate needs and which create the right conditions for building the EU’s wholesale markets capacity and potential to be at forefront of innovation in global financial markets. The road to CMU remains a long one.
Elise Soucie
Beware the Duty of Care! Why a level playing field for responsible data sharing in financial services is essential
8 Nov 2022
The EU is looking to take a leading role in the battle of Web 3.0 – making the internet smarter, more autonomous, and open with an ever broadening range of participants. For financial services, these developments mean that financial data may soon be shared more broadly across sectors, creating new opportunities for innovation but with the potential for new risks to emerge. To deliver on their goal the EU is taking the first steps in developing frameworks for data sharing, which includes the upcoming Open Finance framework that is expected to be published by the European Commission within the next few months. An Open Finance framework would expand the sharing of financial services data, but its success will be contingent upon the effective implementation of a level playing field across sectors. The benefits of data sharing In our increasingly digital world, the interactions of data sets and the products built using newly available data will shape and define human interaction for the years to come. Hence, it is critical to build a leading EU “data economy” that is both sustainable and competitive. A data economy is an ecosystem in which data can be gathered, organised, and exchanged while delivering valuable information to the ecosystem’s participants. Open Finance in the EU’s data economy will shake up the way banks share data with each other, and also with third-party providers, such as fintech companies. For financial services this could mean that access to new, broader data sets could improve the way banks operate, encourage innovation across sectors, and mitigate risks to corporate and retail customers. Certainly, enhancements in data sharing have a huge transformative potential, providing the tools and information needed to achieve common goals, such as contributing to better ESG data and ratings which would support the EU’s Green transition goals. What are the risks? Some of the risks arising from this innovation may be unintended. For instance, sharing data with participants in other sectors who may already have a dominant share of both individual and corporate data could lead to monopolies and the exploitation of data. Concerns also exist about the oversight of data sharing and the regulatory requirements needed for the responsible use of large data sets. This is particularly pertinent where data is transferred from the financial services sector to other sectors – the financial services sector is subject to stringent regulation regarding how it collects, stores, analyses and shares data, whereas another sector may have less oversight resulting in data misuse, skewed analyses, and potential harm to markets and customers. These are just two examples of the risks that may occur and why it is essential for data recipients to be responsible with the data entrusted to them. To overcome these risks responsibility should be evidenced with adherence to appropriate regulatory requirements and guidance. Given that data is the digital fingerprint of a company or individual, in the ever expanding digital world, compliance and consistency are key to maintaining trust. Level playing field crucial to developing Open Finance As a first step towards addressing these risks a ‘level playing field’ is needed with when data is shared across sectors. If participants in the data economy are conducting similar activities and offering similar products compared to regulated financial entities, then the same risks will still exist, making it imperative that these providers are subject to the same regulations. Not only is a level playing field necessary to mitigate risks (such as those discussed above) and ensure that data is fit for purpose, but it also supports competition and prevents smaller market players from being at a disadvantage. The Bank for International Settlements (BIS) notes the growing risk of big techs’ dominance in their recent paper, stating that “If data collected from non-financial businesses (e.g. social media, search, online commerce etc) can be used for financial services provision, there is a risk that a few big techs would quickly come to dominate (some) markets.” Duty of care must be consistent across sectors There could also be unintended consequences if a ‘duty of care’ is not consistent across sectors. Each data recipient has a duty of care for the data set, which means they have the responsibility to conduct a robust assessment of any data used to ensure that it is of a high quality and fit for purpose. Quality control is important as it ensures data reliability, which means that data can be used consistently across multiple records, programmes, or platforms and allows for trust to be maintained within the ecosystem. Consistent oversight is key to ensure that these robust assessments are being carried out and to mitigate risks. The EU has a significant opportunity to unlock the potential of a modern and globally leading data economy. However, to enable this, it is vital to safeguard data from misuse and mitigate the risk of monopolies, while also encouraging responsible innovation. Regulators must be mindful of potential unintended consequences that could arise if a level playing field and the duty of care for data are not consistent across sectors. It is crucial that both the EU and global regulators continue to work towards a balanced and future-proof data economy, where market participants from all sectors can share high quality data with consistent regulatory oversight.
Pablo Garcia
Should Europe join the race to shorten settlement cycles?
29 Sep 2022
Significant technological advances have changed the way we work, live and interact. This is no different for securities markets, where the industry continues to seek opportunities to improve efficiency through advancements in technology and standardisation. For example, recently, the US, Canada and India announced their intention to shorten settlement cycles to one business day (T+1), while most securities transactions are currently settled within two business days. The US and Canada plan to adopt T+1 in what is understood to be a “big bang” implementation in late 2024. The move to accelerated settlement cycles is seen as a way to lower risks to financial systems and drive greater efficiencies in post-trade processes. The question arises on whether Europe should also follow suit. The European region is characterised by a multitude of currencies, market infrastructures, and distinct legal frameworks. Compared to the US, Canada or India, which are single national markets, Europe’s capital markets are notable for their diversity, the complexity of their legal, fiscal and regulatory frameworks, and for the large number of regulatory, supervisory and infrastructure bodies. These structural differences have historically brought challenges when it comes to harmonisation and efficiency of post-trading in European financial markets, making the adoption of T+1 in Europe a more complex proposition. The case for and against settlement cycles in Europe is not straightforward. While many of the benefits of the US adapting T+1 stand for Europe, there is simply more complexity to consider. What is a settlement cycle? Simply explained, a settlement cycle is the time period between when a transaction is agreed and executed by a buyer and a seller (i.e. the trade date) and when the transaction is completed and the securities and cash are exchanged (i.e. the settlement date). This process is not much different to that of any other commercial transactions that happen across a shop counter. However, while the transfer of cash and goods happens simultaneously in a shop, the settlement process of securities transactions occurs at a different time than the execution of the trade. There is a time window between trading and settlement which allows for several important processing steps to take place, ensuring a high degree of control and efficiency, as required for processing high volumes and values of securities transactions. European markets were operating on a three business-day settlement cycle (T+3) until 2014, when a majority of European markets adopted a two business-day approach (T+2) in preparation for the direct application of Article 5 of the Central Securities Depositories Regulation (CSDR). The US followed suit in 2017 and adopted a similar move to T+2. Over the years, advancements in technology and standardisation have allowed for this window to be reduced. More efficient and competitive capital markets There are immediate benefits of Europe moving to T+1, reducing risk is a notable example, which the US has set as one of its main reasons of moving to T+1. In recent years, capital markets have been characterised by periods of significant increases in trading volume and volatility, increasing levels of counterparty risk. Reducing the number of days between trade execution and settlement could lead to a reduction of risk across the settlement ecosystem, especially during periods of market volatility. By reducing firms’ open exposures over the settlement period, there will also be a reduction in costs. Decreasing the margin requirements could lead to market participants better managing capital and liquidity risk. Modern capital markets are becoming more accessible than ever, with much of the transactional world moving towards real-time operations, and many emerging asset classes – such as crypto-currencies – offer investors instant settlement. Against this background, T+1 settlement may contribute towards the continued attractiveness and relevance of traditional financial markets. Settlement cycles have gradually reduced over time, at each stage driving further advancement in post-trade efficiency. The adoption of T+1 would necessitate renewed industry focus on opportunities to automate manual processes, create and adopt industry standards. Significant challenges for Europe A transition from T+2 to T+1 would represent a significant time constraint and model shift, because there would be significantly fewer hours between trading and the beginning of the settlement cycle for post-trade operational processes. There are many post-trade activities that need to take place between the close of trading and the beginning of settlement. Being able to modify systems and processes to accomplish all of these activities during a shorter time frame will be a significant undertaking. The compressed timeline for the completion of operational processes, as well as the reduced opportunity to complete securities lending transactions to cover short positions, could potentially lead to an increase in the number of settlement fails in the market. At a regulatory level, these fails could incur cash penalties under CSDR rules, as well as having Risk Weighted Assets implications under Basel III requirements. Moreover, a compression of the settlement cycle would create operational complexities for all firms transacting in European securities markets, but in particular for investors from other regions, for whom time zone differences will impact the possibility of same-day matching processes, and vastly reducing the time available to communicate and resolve any breaks or exceptions. Industry collaboration is the next step Before making any decisions on the future of settlement cycles, Europe needs to do some preparation. One of the first steps should be to conduct an industry-wide consultation to identify and quantify the potential challenges, followed by a robust cost-benefit analysis. It will also be crucial for global market participants to give their feedback to ensure that a migration to T+1 will not hurt the competitiveness of European markets or diminish their attractiveness to global investors. The interconnected and complex nature of European capital markets shows how challenging it might be to implement a shorter settlement cycle in Europe. The barriers to timely settlement today on a T+2 basis need to be fully understood and overcome before moving to T+1 in order to avoid exacerbating existing issues. Successful implementation will depend on a high degree of coordination and agreement across all stakeholders. Ideally, a cross-industry taskforce, with representation from all market participants, should be established to drive forward the initiatives. A rushed or uncoordinated approach could result in increased risks, costs and inefficiencies in European capital markets.
Elisabeth Mauguy
European Financial Integration not yet in sight
1 Jul 2022
The EUis dealing with many challenges: war on its borders, rising inflation and persisting financial fragmentation across the Eurozone are all cause for concern. These issues were at the heart of discussions among leading policymakers and banks at AFME and OMFIF’s 2nd Annual European Financial Integration (EFI) Conference last week in Frankfurt. Most speakers agreed that Europe needs to strive for more competitive and integrated capital and banking markets and that there is a key role for technological innovation to help overcome fragmentation in European markets. Panellists also found that there were considerably sharper trade-offs now than during the pandemic, but that these were political rather than economic. Nonetheless, on a European scale there needs to be scope for better policy coordination to fight inflation and build a robust and competitive banking system. Competition, speakers found, needed to be interpreted in a nuanced way. While the single market in the EU is still incomplete, regulatory action needs to embed competition, so that enforcement and regulation can be complementary. Philipp Hartmann, Deputy Director General Research at the European Central Bank (ECB), presented the ECB’s bi-annual report on financial integration and structure. Previous crisis, Mr Hartmann reflected, were able to teach us a lesson and prompt monetary policy measures and agreement on the EU recovery fund had made a fundamental difference in supporting financial integration, although this has still not returned to pre-GFC levels. Commenting on the structure of the EU’s financial system, Mr Hartmann, considered how European equity markets can be made fit for green & digital transformation. In its report, the ECB points to Next Generation EU (NGEU), initiative having large public investments in digital and green projects that firms can benefit from. However, this is still far from the EUR 650bn investment per year, which the European Commission estimates is needed. Substantial private investment will be necessary to finance these transitions and equity finance is well suited for innovation-oriented investment. The 2020 CMU action plan could produce tangible progress for developing and integrating European equity and risk capital markets, yet efficiency and harmonisation of regulatory frameworks still need to be enhanced. Unicredit’s CEO, Andrea Orcel, reflected on how the geographical footprint and scale of European banks is key for competitiveness. Mr Orcel pointed out that the EU has more or less the same GDP as the USA, yet, leading banks in the States spend 10 times more on technological innovation. Over time, this leads to a lack of level playing field, to the detriment of European competitiveness. Scaling up would bring about a more unified pan-European market and for this technology is paramount. In terms of regulation, Mr Orcel said that the prudential framework and profitability need to be balanced against each other. If there is an excessive focus on prudence, it can make entire sections of banking unprofitable. Furthermore, rules differ from country to country and capital and liquidity can remain trapped locally. In contrast to the US, Europe is not one market. In light of such fragmentation, which limits scale, but also as a result of a likely conscious choice from policy-makers post-GFC, European banks do not feature highly on the league tables of the worlds’ investment banks and global market players. Edouard Fernandez-Bollo, Member of the Supervisory Board at The European Central Bank (ECB), gave a supervisory perspective on the European banking industry. He noted that one of the ECB’s aims is to help banks realise their M&A projects if these have a valid basis. The ECB is also focused on assisting firms in operationalising and integrating ESG policy into their risk management. When it comes to leveraged finance and industry concerns surrounding supervisory expectations rendering banks uncompetitive compared to international peers, Mr Fernandez-Bollo responded that the ECB is concentrating on outliers to create a safer market. Profitability of the sector has returned to pre-pandemic levels, but remains structurally low. While the ECB has seen progress in the areas of diversification and harnessing technology to reduce cost base, it is not enough. The ECB has been encouraging banks to look at their cost and revenue structures, while investment in technology is something that needs to be monitored more closely. The CFOs of Société Générale, Claire Dumas, and Santander, José Antonio García Cantera, spoke about the key driving factors behind lower evaluations of European banks compared to international peers, reiterating the problem of Europe’s fragmentation and issues deriving from this, such as fewer opportunities to streamline their businesses and higher costs. Regulatory issues and differences in requirements between European countries are also a cause for concern. Both speakers noted that banks themselves can improve their profitability and efficiency, through partnerships, as well as focusing on diversifying their business mix, such as insurance and leasing. Digitalisation and disruption is another area that banks should focus on, as operational efficiency and new business models become increasingly important. Other panels delved into the regulatory environment for the banking industry, with speakers debating the impacts of Basel 3 implementation on the sector’s ability to continue financing the real economy. The real need to address deficiencies in the securitisation framework was flagged as being key in this respect, while providing a bridge between bank and market-based financing. Following this, the conference examined the listing, trading and post-trading landscape in the EU, with panellists querying why many EU firms continue to go public outside of the EU. Panellists commented on the fragmented market structure for trading and complexities of post-trade organisation compared notably to the US as being part of the reason behind this. They noted that differences in tax processes and insolvency laws across Member States continue to be high amongst barriers to achieving more efficient capital markets in the EU. Overall, AFME and OMFIF’s EFI conference brought renewed attention to how fragmentation in European banking and capital markets is impacting the financial sector’s ability to serve the economy and what can be done to combat it. Given the size of our investment needs, deeper, more liquid and competitive markets will be necessary to allow the financing of the green and digital transition to be supported in addition to ensuring that banks continue to have capacity.
Pablo Portugal
The EU Must Strengthen the Competitiveness of Its Financial Markets
20 Jun 2022
Europe’s economy is on another unpredictable course. The outbreak and resurgence of the COVID-19 pandemic over the last two years and now the economic impact of the war in Ukraine underscore why the European Union (EU) needs a resilient and diversified financial system able to withstand sudden economic shocks. Meanwhile, the financing needs associated with the green and digital transitions remain as urgent as ever: Europe’s financial system needs to be geared towards channelling the significant scale of investment required to enable these transformations. Capital-market financing will need to play a central role in meeting these challenges. Yet, the EU’s capital markets remain fragmented and under-sized. Deepening integration and expanding the international reach of EU capital markets are, therefore, paramount to Europe’s economic prospects and overall strategic goals. European capital markets and regulatory frameworks continue to evolve in the post-Brexit environment. Major legislative proposals that may have far-reaching impacts on the European banking sector, capital-markets ecosystem and sustainable-finance advancement are under consideration. In light of such changes, the EU needs to pursue regulatory outcomes that not only preserve and reinforce financial stability and investor protection but, crucially, encourage increased participation in EU capital markets from both local and international players. A strong focus on this principle will be essential to further developing the EU’s capacity in primary and secondary capital markets. Increasing markets’ competitiveness will be vital for Europe’s economic strength. Financial markets in the EU—or any other jurisdiction—do not function in isolation. They are interconnected, and financial centres across the globe compete with each other. This is especially true for wholesale markets in which sophisticated investors and market participants are themselves active in multiple jurisdictions and have choices to make regarding deploying their capital and accessing liquidity pools. This is why policymaking should contribute, where possible, to strengthening the attractiveness and competitiveness of EU capital markets. In turn, this will support current efforts to scale up the Union’s market ecosystem, promote the international use of the euro and achieve greater strategic autonomy in financial services. Promoting international cooperation and regulation supporting market development The major successful global financial centres are characterised by their high regulatory standards, quality of their legal frameworks, openness to global pools of capital and scale of their underlying financial ecosystems. Maintaining openness and connectivity with non-EU markets is essential in continuing to build the EU’s capital-market capacity. The EU should continue to champion open capital markets that allow EU participants access to international capital pools and funding opportunities while ensuring market integrity and fair treatment between EU firms and third-country entities. Furthermore, greater importance needs to be placed on supporting global regulatory cooperation, particularly in the areas of digitalisation and sustainability, as jurisdictions grapple with common objectives and challenges. It is in the interests of European companies and investors to have globally aligned standards while maintaining the EU’s strong and ambitious leadership role in these areas. Strengthening Europe’s primary and secondary markets The EU is at a critical juncture in its decision-making around the future of its capital markets. The next two years will see the advancement and completion of major policy debates in areas such as market structure, prudential requirements for banks, sustainable finance and digitalisation, which will have the potential for significant change. For example, as the EU competes with other global markets to attract company listings, attractive and harmonised listing rules on European public markets will be vital to support crucial access to market finance for EU companies. The EU is, therefore, undertaking a comprehensive review of company listing rules to encourage more companies to list on EU public markets, particularly small and medium-sized enterprises (SMEs). This should ensure that strong levels of legal certainty, transparency and investor protection are retained. Meanwhile, legislators are currently debating a set of major, potentially transformational proposals for Europe’s secondary markets in the ongoing review of the Markets in Financial Instruments Regulation (MiFIR), which governs how markets function. This work is critical to promoting globally competitive capital markets in the EU. An attractive, well-regulated trading ecosystem can nurture innovative, world-leading market infrastructures and promote enlarged liquidity pools within the EU. The promotion of market efficiency, competition among service providers and strong outcomes for investors and corporate and SME issuers should be at the forefront of the debate around these proposals for Europe’s market structure. In this respect, proposals for establishing a consolidated tape—similar to a price-comparison tool for investors—should be particularly supported. A well-designed tape will promote more attractive and competitive capital markets and reduce home-country bias (where an investor tends to prefer companies or investments from his or her own country) in the Union. As these debates progress, it is important to consider the wider international context—including, for instance, the United Kingdom’s parallel review of its wholesale-market architecture. As the EU reviews its own market legislation, if there is a shift towards a market structure that is ultimately less supportive of investor choice and prevents investors from accessing the most optimal trading conditions, this will not only result in additional costs for pensioners and savers, it also risks discouraging global market players from participating in EU capital markets, thus undermining their competitiveness in relation to other jurisdictions. Now is the time to complete CMU. To conclude, EU capital markets have many strengths enabling them to thrive in today’s global environment—among them, the scale of the EU single market, the euro as a leading international currency and global leadership in ESG (environmental, social and corporate governance) financing. In the recent Versailles declaration, the EU Heads of State agreed to create an environment that facilitates and attracts private investment by “creating more integrated, attractive and competitive European financial markets, enabling the financing of innovation and safeguarding financial stability, by deepening the Capital Markets Union (CMU) and completing the Banking Union.” These objectives are achievable and within reach, but the EU must find the political momentum to deliver policies that will foster a globally competitive CMU that can support sustainable long-term growth in the coming years.