Derivatives markets have functioned well under severe pressure during the pandemic, but the potential risk for future volatility continues, said a top European regulator at FIA's virtual IDX-V conference.
Verena Ross, executive director of Europe's markets regulator, the European Securities and Markets Authority, participated in a keynote Q&A session with FIA President and CEO Walt Lukken at IDX-V. Ross said, "We saw an unprecedented market reaction to the spread of the virus and the extraordinary government measures of closing down business, which in March led to not only huge market volume, but also heavy volatility. Overall, the market infrastructure managed to handle that very well."
She added, "Where we saw more problems was on the funds side, so we saw a number of funds facing redemption pressures and with that liquidity problems…it was certainly a period where there was tension in that market and we observed that with a very close eye."
Speaking about the current state of the financial markets, Ross said, "What we've seen since is a big recovery in April, and relative stability…but what is interesting now is this disconnect between what looks like a pretty dire end-prospect of the real economy and a very slow recovery, and the way the markets seem to be disregarding that picture and...have recovered strongly," she said.
"For us it still means there is a lot of potential risk there for future volatility, particularly given the uncertain environment with the virus potentially spreading again through a second wave and how the market will react to that."
Ross also discussed the temporary short-selling bans that were introduced in several European countries earlier this year. In March, ESMA issued a decision temporarily requiring the holders of net short positions in shares traded on an EU regulated market to notify their relevant national competent authority (NCA) if the position reached or exceeded 0.1% of the issued share capital. On 17 June, it extended that measure by another three months.
"This is in light of our view that market volatility and the risks are still there," Ross said.
Speaking about the decisions by several national regulators to issue short-selling bans, Ross said: "A number of NCAs decided that it was correct and relevant in their particular market…We spent a lot of time with those NCAs to coordinate what they put in place to make sure there was reasonable consistency between the measures. We also managed to get the NCAs to end their specific short selling bans on the same day, which has been useful in creating a more common framework across Europe."
Ross also talked about the lessons learned from the crisis and areas that ESMA will be focusing on over the coming months.
"We will look at the liquidity management tools that funds have at their disposal. This is something that the European Systemic Risk Board has picked up on and it's an area of focus for us for the next few months," she said.
ESMA has already called for increased consistency across national regulators in Europe in the authorisation of liquidity management tools, such as restrictions on fund withdrawals.
"We are also working hand-in-hand with the European Commission to look at particular areas of legislation that should be adjusted to support the recovery from the significant economic effects that we've seen and to help companies to get through the crisis," Ross said.
Earlier this month ESMA announced a revised work programme for 2020 that will allow it to concentrate on helping financial institutions and regulators weather the risks and challenges posed by COVID-19.
"We've really prioritised the COVID-19 response and the issues arising from market volatility, as well as some of the big priorities that were there for 2020 – such as establishing some of ESMA's new responsibilities and focusing supervision on some of key players, in particular the rating business. Ratings are reacting now to increased credit risk, the enhanced indebtedness of some companies, and that is something that we are looking at closely."
Supervision of third-country CCPs
Earlier this month, the European Commission published consultations on its long-awaited draft delegated acts on tiering and comparable compliance in EMIR 2.2. These acts will determine if a CCP located outside the European Union falls into a Tier 1 or Tier 2 category. Tier 2 means a CCP is, or is likely to become, systemically important to the EU’s financial stability, and is subject to more detailed oversight and supervision by ESMA.
"The proposed tiering related delegated act is pretty straightforward," Ross said. "It proposes a number of key thresholds that determine whether an entity could be a Tier 2 and systemically important for the EU financial markets."
These thresholds focus on open interest, securities and exchange traded derivatives, the national outstanding of OTC derivative transactions, the aggregated margin requirement and default fund contributions of clearing members established in the EU, and the largest payment obligations. Ross said it is likely that only a few CCPs will fall into the Tier 2 category.
"Clearly these specific thresholds which have been put into the proposed delegated act are pretty high and from that perspective it looks like it would be a very small number of third country CCPs that would cross one of these thresholds. At ESMA we have always believed that and expected few CCPs to be systemically relevant for the EU, but we were also always clear that we couldn't predetermine that when we provided our advice to the European Commission," she said.
"I think with the delegated acts, the proposals are a lot clearer and I suspect a number of CCPs are crunching their numbers at the moment and looking at whether they are crossing those particular thresholds or not."
Another topic that came under discussion was commodity derivative position limits.
"The MiFID II framework for commodity derivative position limits here is quite different to the approach that, for example, the CFTC has introduced in the US because it applies to all commodity derivatives traded on a trading venue, whatever the liquidity or the underlining commodity is. This may be too all-encompassing and potentially injuring the development of new contracts or illiquid contracts," Ross said.
"In a report that we provided to the European Commission in March, we made a number of proposals looking at how to make that framework more efficient and effective, and one of those is to narrow down the number of commodity derivatives that will be subject to the position limit regime and focus on those where we believe it is essential to have that type of framework and regime in place," she added, "The likelihood is that this is an area that will change going forward."
Ross also said sustainability is a big part of ESMA's agenda and highlighted some of the work it is doing across several areas. "This is starting with ESG disclosure and the type of advice and support brokers and advisors give to their clients. We are also making sure that we avoid the green washing risk that is clearly there, and we are working with various stakeholders on green bond standards and taxonomy."
She added, "I think the markets can and should play a role to change the mindset and create an environment in which investors, whether professional or retail, can express their wishes to go into a direction of favoring investment in a more sustainable agenda. The recent crisis has given us a wake-up call with what we will need to do to make that shift. It's not an easy shift to make, but if we go back to the old normal than we will have lost a good opportunity to move forward into a different future."
- Position Limits