The European Securities and Markets Authority (ESMA) published its second risk monitoring report of 2024, setting out the key risk drivers currently facing EU financial markets. External events continue to have a strong impact on the evolution of financial markets, and ESMA also sees high or very high overall risks in the markets within its remit.
Less volatile markets earlier in 2024 and a return of search-for-yield behavior in riskier market segments suggested a general market anticipation of a ‘soft landing’. However, more recent events show how markets remain very sensitive, especially to interest rate developments, deteriorating credit risk and to political and electoral news. There remains a high risk of corrections in a context of fragile market liquidity, in equity and in other markets.
In H1 2024, EU fund performance was positive across categories and funds exposed to fixed income instruments (bond funds and MMFs) recorded inflows. The increase in interest rates has been offset by a broad-based market perception of declining credit risk, reflected in low credit spreads. However, bond fund portfolio credit quality, as measured by credit rating, has continued to deteriorate, raising the risk of a disorderly repricing of risky assets. Risks continue around liquidity risks and potential losses related to interest rate, credit risk and valuation issues. Open-ended real estate funds remain particularly vulnerable given their structural liquidity mismatch and downward pressure on valuations in housing markets.
Verena Ross, ESMA’s chair, said in a statement: “Markets are getting more nervous about the economic outlook and political events, as the dip in equity valuations in early August and market volatility around recent European and French elections shows…We continue to see risks in the fund area linked to liquidity mis-matches, particularly in the real estate sector, and deteriorating quality of assets linked to interest rate, credit risk and valuation issues.”
According to the report: “Commercial and residential real estate continue to be affected by elevated interest rates. This feeds into financial markets and investors through lower equity and debt pricing of real-estate firms, rating downgrades, and declining real-estate fund valuations and elevated liquidity risks. Derivatives and repo exposures are limited but concentrated.”
Looking at market-based finance, ESMA wrote that capital availability for European corporates through capital markets has been broadly stable in 2024 so far. Although the market environment remains very challenging for equity issuance, there were signs of improvement in IPO activity. Corporate bond issuance was high in 1Q24 but fell in the second quarter of the year. The corporate bond outlook continues to show a significant upcoming maturity wall from 2024 until 2028. In this context, corporate debt sustainability remains a considerable risk, especially in lower quality segments.
ESMA also highlighted volatile settlement fail rates volatile, writing: “Settlement fail rates have generally decreased since the introduction of cash penalties under CSDR in February 2022. In H1 2024, asset classes displayed volatile behavior in settlement fail rates. Settlement fail rates for exchange-traded funds (ETFs) continue to show high levels, and there was an increase for UCITS in March, associated with one type of settlement instruction for one securities settlement system.”
However, no noticeable trend on settlement fails has occurred in H1 2024 linked with the shift to T+1 settlement in the US.
“Even though the impact on EU markets seems limited so far, ESMA will monitor for different risks associated with such a change. Specific challenges include mismatches between securities and foreign exchange settlement cycles, which increase costs and risks, especially with less liquid currencies and multiple time zones.
“The shorter cycle also impacts securities financing transactions, like securities lending and repos, requiring efficient collateral management within a tighter timeframe. Additionally, different settlement cycles for multi-listed securities could lead to funding gaps and operational inefficiencies, affecting liquidity and pricing.”
For sustainable finance, ESMA noted that in the last few years, a strong interest in and uptake of sustainable investments has been sending positive signals about investors’ willingness to finance the green transition. However, recent ESG-related market developments have sparked concerns on the ability to mobilize private capital, with green bond issuance slowing and sustainable funds facing outflows for the first time in 2H23. Looking ahead, firms’ ability to announce credible transition plans could steer broader willingness to invest in transitioning firms, supported by transition finance instruments.