The European Securities and Markets Authority, the EU’s financial markets regulator and supervisor known as Esma, on Thursday warned investors that they should prepare for further market corrections, given a “confluence of high risks”.
Publishing its first Trends, Risks and Vulnerabilities Report for 2023, Esma said risks in its remit “remain high”. The factors that dominated the second half of 2022 remain the defining drivers of risk in EU financial markets, Esma said, referring to the slowdown of economic activity, high inflation, global tightening of financial conditions, the geopolitical environment and the materialisation of peripheral risks linked to leverage and liquidity, together with growing concerns over business practices in the crypto space.
“Financial markets remained remarkably stable in 2H22, despite the general volatile environment,” said its chair Verena Ross, in a statement. “Although economic sentiment has become more positive in early 2023, there is no room for complacency. Esma is keeping the overall risk assessment across its remit at the highest level.”
Resilience may be tested
”The confluence of high risks across the Esma remit and fragile market liquidity may test the resilience of the financial system against possible future shocks,” Ross said.
In its overall risk assessment, Esma said that contagion and operational risks are considered very high, as are liquidity and market risks. “Credit risk stays high and is expected to rise, reflecting the growing concerns over public and corporate indebtedness. Risks remain very high in securities markets and for asset management. Risks to infrastructures and to consumers both remain high, though now with a worsening outlook, while environmental risks remain elevated.”
Structural vulnerabilities
Addressing the market environment, the tightening of financial conditions globally has weighed on economic activity, while inflation remains very high, Esma said. Volatility in energy markets stayed elevated despite a general decline in prices. “Structural vulnerabilities expose markets and participants to the risk that shocks to markets could be amplified by liquidity supply and demand imbalances.”
On securities markets, the supervisor said that equity prices were volatile during the second half of 2022 with markets partially recovering third-quarter losses based on news flow around relatively stable inflation and positive corporate earnings.
Concerns over fund liquidity risk management
On asset management, Esma noted that the EU fund sector has seen outflows and low performance across most fund types in the second half, as assets under management experienced their sharpest decline since the Global Financial Crisis. It said that maturity mismatches in Commercial Real Estate Funds persist, while the impact of the UK Gilt market turmoil confirmed existing concerns over fund liquidity risk management and excessive leverage, as well as contagion risks given strong systemic interconnections.
Investor sentiment remains weak against the backdrop of economic uncertainty, Esma said. Inflation acts as a drag on real investment returns and contributes to falling household savings.
Focus on greenwashing increased
In sustainable finance, net-zero pledges have come under growing scrutiny, with the energy crisis jeopardising decarbonisation objectives. More broadly, the focus on greenwashing has increased while investors increasingly appear to differentiate between products based on their sustainability credentials, as reflected in steady net flows into SFDR Article 9 funds. Despite this, ESG markets continued to grow, with this trend showing resilience to broader market developments.