Market and Liquidity Risks Remain Elevated, According to ESMA

Building on similar concerns in past TRV reports, ESMA explained that ‘the risk outlook is stable, however risk [remains] high, particularly in securities markets and for retail investors,’ as geopolitical and macro drivers worsen. ‘Macroeconomic conditions deteriorated in the second half of 2019, with EU and global growth forecasts being cut,’ the regulator added. Continuing uncertainty over ongoing trade tensions, Brexit, and wider political uncertainty weighed on the outlook. More recently the coronavirus outbreak has also increased uncertainty and could dampen short-run economic activity.’

Big Tech’s disruption of financial markets also caught the attention of ESMA, as the regulator concluded that, ‘the entry of BigTech into financial services may pose risks to financial stability and investor protection… The cross-sectoral and global nature of the business strengthens the case for comprehensive cooperation among relevant regulators.’ How this plays out remains to be seen. Yet despite all of these issues, risk assets remain elevated and credit spreads historically tight, keeping market risks high as the year goes on. Although interest rate risk has dissipated as central banks have turned more dovish, ‘corporate bond spreads remained tight in a worrying sign of continued search for yield,’ ESMA cautioned. Meanwhile, ‘credit risk… remains elevated, with deteriorating corporate debt quality. Liquidity and credit risks [are] concentrated in high yield.’ That search for yield remains a key concern for ESMA, as many funds push into ever more exotic and less liquid parts of the market.

For example, in a 2019 simulation ESMA found that 40% of European high-yield bond funds could experience a liquidity shortfall under ‘severe but plausible assumptions.’ In its recent survey of the AIF market, it noted that real estate and fund of funds could come under similar strain during the market tumult. With these risks in mind, UCITS and AIF funds will be subject to more stringent stress tests starting this September. ESMA has also launched a supervisory action looking at fund liquidity, while liquidity risk management will remain a key focus of regulators in the months ahead.