Europe’s top financial supervisory authority seems surprised to find “remarkable resilience” in the EU’s financial markets in the light of the higher-for-longer interest rate environment. Going forward, it warned investors of a high risk of corrections, especially in difficult-to-value private markets such as real estate.
The European Securities and Markets Authority, Esma, said markets will remain “very sensitive” given the potential market impact of high interest rates, the macroeconomic outlook and geopolitical risks. Esma sees a “high risk” of corrections in the context of “fragile market liquidity” in equity, bond and crypto markets, with “special concerns” relating to real estate exposures.
Against that backdrop, Esma chair Verena Ross said the authority is focused on ”maintaining trust” in financial markets. “Maintaining trust in financial markets is of particular concern to ESMA, and key to achieving our mission to protect investors,” Ross said when presenting Esma’s latest quarterly report on trends, risks and vulnerabilities.
Risk categories
Financial stability and investors will be impacted by increased interest rates which are expected to remain higher for longer. Last week’s Federal Reserve comments on inflation suggest that rates won’t be lowered as soon as markets may have expected. This environment has a negative impact on credit quality and real estate valuations, Esma said.
In the current interest rate context, supervisors pay special attention to the leverage of investment funds, which can act as a risk amplifier, as happened to the British funds in 2022. Esma calculated that leverage for alternative investment funds declined to 123 percent of their net asset value in 2023 from 127 percent a year earlier.
Esma noted a wide range of leverage between different types of funds. Hedge funds stood at 265 percent last year while the average of other alternative funds was below 140 percent. Esma found “anecdotal evidence” that leverage is building up especially in the US Treasury market which “will need to be closely monitored”.
High leverage for hedge funds
Esma remains concerned about valuation of real-estate funds. Especially in the Luxembourg private markets community, home to many of Europe’s alternative investment funds that invest in real assets such as real estate, valuations have garnered more and more attention in the last years.
Producing reliable valuations of unlisted private funds is complex. Not all market participants have access to the comprehensive data required to assess values. “It is extremely difficult to produce an objectively perfect valuation,” acknowledged Brian Slattery, senior vice president and head of Northern Europe at Clearwater Analytics. “The important thing for firms is to empower their valuations teams by ensuring they have access to as much data as possible.”
Private credit lacks transparency
In regards to private credit markets, another unlisted segment in which Luxembourg structures play a major European role, Esma noted “a lack of visibility on the crystallisation of risk”. It said that the lack of transparency in this market can trigger “a sudden credit risk deterioration” that could have “wider impacts that are difficult to anticipate”.
On a positive note, Esma noted that the availability of ESG data has started to improve. The 1,500 largest non-financial companies last year began reporting on their alignment with the EU taxonomy, which means they are not providing more insights on the “greenness” of their activities and investments efforts to transition to low-carbon.
Yann Bloch, head of product at investment software specialist NeoXam, said this development offers hope to investors but that it can become problematic for investment managers that need to process this deluge of additional information. “If they are relying on legacy systems or data scattered across the business in Excel spreadsheets, they are going to struggle,” he said.
Decrease in systemic stress
