ESMA's report on trends and risks in EU financial markets

On 9 February 2023, ESMA published its Report on Trends, Risks and Vulnerabilities No. 1, 2023 (the Report), in which it assesses the current state of the EU financial markets.

The Report warns that, overall, risks in the sectors covered by ESMA “remain at the highest level” and investors should be prepared for further market corrections.

Its key findings include

Risk summary and outlook
Amid a volatile environment which has included high inflation, geopolitical uncertainty and peripheral risks linked to leverage and liquidity, financial markets remained remarkably stable in H2 2022 and economic sentiment has become more positive in early 2023.

However, high levels of uncertainty and fragile market liquidity limit the financial system’s resilience against further shocks and, overall risks to ESMA’s remit remain at the highest level.

Contagion, operational liquidity and market risks are considered 'very high', while credit risk is 'high' and expected to rise. Risks remain ‘very high’ in securities markets and for asset management. while environmental risks remain 'elevated'.

Market environment
Energy market volatility remained elevated despite a general decline in prices, while structural vulnerabilities continue to expose markets to the risk of shocks being amplified by liquidity supply and demand imbalances.

Securities markets
Equity prices were volatile in H2 2022 while EU price earning ratios fell below their ten-year average – this suggests that uncertainty over the economic outlook is now being priced in by market participants. Fixed-income liquidity broadly deteriorated with higher bid-ask spreads across bond types as volatility increased.

Asset management
H2 2022 saw outflows and low performance across most fund types in the EU fund sector. AuM experienced the sharpest decline since the Global Financial Crisis. Meanwhile, maturity mismatches in Commercial Real Estate Funds persist and the impact of the UK Gilt market turmoil on leveraged Liability-Driven Investment Funds in H2 2022 confirmed existing concerns over fund liquidity risk management and excessive leverage.

Consumers
Investor sentiment remains weak - inflation acts as a drag on real investment returns and contributes to falling household savings. Retail investment in UCITS continued to decline but consumer complaints have returned to historical levels after having spiked in early 2021.

Infrastructures and services
In 2H22 volumes traded in EU equity markets remained stable, while the relative composition showed a slightly decreasing share of lit trading. Central clearing volumes grew further, as margins collected by EU central counterparties (CCPs) for interest rate and commodity derivatives rose with rises in prices and volatility in underlying instruments, while some migration from exchange-traded derivatives (ETD) to over the counter (OTC) energy derivatives was observed. Margins collected for energy derivatives are concentrated in a few large clearing members who clear at only a few EU and non-EU CCPs. CRA views on credit risk generally became more negative, except for sovereigns, with downgrades increasing relative to upgrades.

Market-based finance
Capital market financing decreased sharply in 2022 - the drop in activity is linked to high investor uncertainty, tighter credit standards for firms, high corporate debt levels and a rapid increase in the overall cost of external financing in the Euro area. Global private markets have grown to EUR 8.6 trillion – this includes a EUR 1.2 trillion exposure to EU AIFs.

Sustainable finance
Net-zero pledges have come under growing scrutiny, with the energy crisis jeopardising decarbonisation objectives. Despite this, ESG markets continued to grow, with this trend showing resilience to broader market developments.

Crypto-assets and financial innovation
Crypto-asset valuations have now fallen by almost 70% year-on-year, driven by macro-economic factors and several high-level collapses in 2022. The failure of FTX triggered some large market corrections across crypto-assets while contagion within the crypto sector has been substantial. This has been reflected in further price drops of key crypto instruments and knock-on bankruptcies among service providers.