CMU and the Investment Firm Review: strengthening European capital markets through proportionality

10 December 2018


Hands up if you want up-and-coming European companies to have sufficient access to the money they need to grow and to drive prosperity across the EU? It’s a no brainer – and one of the reasons why European politicians and regulators are keen to push forward the Capital Markets Union (CMU).

Here’s a couple of details to flesh out the argument: equity finance in Europe is 67% of the eurozone GDP versus 125% in the US. More than two-thirds of lending to small and medium (SME) sized business in the EU comes from banks.

So, a simple analysis suggests it’s a lot harder for companies to raise money on the capital markets in the EU than in the US, leading to lower levels of investment and growth for the businesses and the EU as whole.

The Capital Markets Union is essential for building up a stronger equity culture in Europe and for opening up or expanding other sources of capital for financing. And of course, a more diversified financial system is also more resilient and stable. All market participants have their role to play in helping to reach this goal of a stronger and more diverse European capital market – from long-term investors such as pension funds and asset managers, to independent market makers like the principal trading firms who make up FIA EPTA.

FIA EPTA members help to ensure end-investors get a better deal when they execute their investment decisions; they are estimated to provide up to 45% of the on-exchange liquidity in EU capital markets. By improving the quality of the secondary markets, principal trading firms help to create the conditions that are key for companies looking to raise the capital that funds innovation, jobs, and growth for the European economy.

Principal trading firms enthusiastically support the CMU. FIA EPTA members strongly believe proportionate regulation of the financial markets is key to achieving the twin goals of strengthening economic growth and ensuring financial stability. Currently, there’s a very important piece of regulation going through the policy-making process: The New Prudential Regime for Investment Firms, also known as the Investment Firm Review (IFR). It’s a proposal that could have a big impact on the Capital Markets Union project.

The Investment Firm Review and the CMU share some common objectives:

  • Crafting a simpler, more proportionate prudential regime for investment firms
  • Removing cross-border market barriers within the EU
  • Creating a single market for capital
  • Removing barriers to entry to the markets
  • Creating a healthy business environment for entrepreneurs to raise capital.

If the Investment Firm Review can help deliver on these aims, it will support the CMU plan by encouraging greater diversity and growth among investment firms whilst making the EU’s capital markets easier and more predictable for end-investors.

Diversifying EU capital markets more widely than their current strongholds will also be important - there are plenty of places within Europe waiting to be ignited. Our members are playing their part in this; we’re seeing firms run successful trading teams in Prague or running graduate recruitment programmes in Poland, as well as seeing start-ups (often spinning out from existing firms) in many locations elsewhere. These bring innovation and greater competition to the table, along with increased choice, liquidity and diversity - and their resulting benefits.

So, principal traders can play an important role in developing the CMU if the regulatory playing field allows and encourages this.

However, there are concerns with the Investment Firm Review that may prevent or even undo the positive contributions that independent market makers bring to European capital markets:

  • Most notably on the details of the capital requirements methodology being proposed
  • And in the way the IFR intends to classify firms, which will create a serious regulatory and financial burden.

Both may have serious unintended consequences on the activities of independent market making firms in Europe and their ability to provide diverse and high-quality liquidity to end-investors.

On capital requirements, the large diversity amongst independent market making firms, along with the wide range of products they trade, makes allowing multiple alternatives the most effective and proportionate approach. The Investment Firm Review proposal recognises - on paper at least - four ways to calculate market risk. But the detail of the practical implementation doesn’t yet match the vision, unless some limited but important changes are made so that all four methods can be used in practice. The ability to use all four models is key to prevent principal trading firms being priced out of certain areas of the market, particularly in important niche asset classes or markets.

Importantly, in addition to the existing market risk rules for banks, firms should be allowed to use methods based on the margin models of clearing firms. Clearing firms and their margin models are subject to strong regulatory oversight and they continuously monitor compliance with requirements throughout the day. Importantly, these firms have a deep knowledge of the market making activities of FIA EPTA members and the associated risks of their portfolios, so their models ensure prudent capitalisation. Building on these highly robust and effective margin models will ensure that resulting capital requirements are risk-sensitive, sound, and simple - exactly as intended by the CMU and Investment Firm Review.

The IFR will also apply daily trading limits on the volumes that firms can trade, which are linked again to their capital reserves. Modelling indicates that on days when markets are most volatile and in need of liquidity, all but the biggest principal trading firms will quickly reach their daily trading limits and have to withdraw from the market, taking their liquidity with them. Note, this will force them into a conflict with their MiFID II market-making obligations.

These rules will apply to all investment firms categorised as Class 1 or Class 2, but not Class 3 (reserved for the smallest). Currently the threshold between Class 2 and Class 3 is crossed the moment a firm trades a single euro – placing all principal trading firms in the Class 2 box with all the ensuing demands highlighted. This will be an unfortunate disincentive to any firms looking to start-up or enter European markets, limiting choice and competition by raising barriers to entry.

To achieve a strong and vibrant equity culture in Europe, we should amend the Investment Firm Review draft on a limited number of key points to avoid any contradictions with the CMU goals. This will help to ensure a healthy, safe, competitive and diverse European capital market in which end-investors can continue to rely on high-quality liquidity from principal trading firms. A more diverse market is a more stable market, since it is less reliant on traditional banking models and it encourages an environment where innovation can flourish. This should be one of the keystones of the CMU and the Investment Firm Review.  Let’s keep improving the good draft we have already achieved – it’s been a long race so far but let’s go the final few metres to get it right.

Piebe Teeboom
Secretary General of FIA EPTA

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