Centralising Fund Supervision: Draghi Reform Proposal Faces Headwinds

Overview

The former ECB President, Mario Draghi, warns that Europe needs to become more competitive. For the capital market, he proposes a kind of super regulatory authority. Jochen Kindermann sheds light on the Europe-wide discussion, which has so far been hardly held in Germany.

The future of European Competitiveness

On September 9, 2024, Mario Draghi, the former Italian Prime Minister and President of the European Central Bank (ECB), published his report "The future of European competitiveness". It is the result of a request by the EU Commission, in which Draghi presents his view on enhancing the EU's competitiveness. A core thesis of the report indicates that the EU has less of a problem with innovative ideas, but rather a lack of commercializing these ideas. One weakness which persists is the fragmentation of the capital market. One reason for this is the excessive and costly bureaucracy and the resulting slow development of a unified and thus more efficient EU market. This is regularly driven by national interests aimed at cementing the status quo. To counter this, Draghi proposes a change in the current supervisory structure. The role of the European Securities and Markets Authority (ESMA) should be based on the example of the American Securities and Exchange Commission (SEC), and ESMA or the "European Security Exchange Commission" should be transformed into the sole regulatory authority for the European securities market.

ESMA: on its way to becoming a 'super-supervisor'?

One particular aspect of the Draghi report is his medium-term proposal to concentrate the supervision of investment funds with ESMA and thus remove it from national supervision. In terms of its governance and decision-making processes, ESMA is to be structured similarly to the ECB Governing Council in order to act as independently as possible from the national interests of the EU member states.

Since Draghi expects significant resistance in this regard, the plan is to be implemented gradually and in a risk-adjusted manner. His proposal is for ESMA to initially take over the supervision of (i) "multinational" issuers, (ii) major regulated markets with trading platforms in various jurisdictions, such as EuroNext or Clearstream, and (iii) central counterparties. Criteria such as fixed thresholds or the existence of subsidiaries in different EU member states can be defined in order to classify issuers. Furthermore, part of the supervision is to remain with the national regulatory authorities. Thus, issuers operating on a purely national level would continue to be subject to national supervision. In a second step, the supervision of investment funds would then be carried out by ESMA.

Fund locations Luxembourg and Ireland react critically

Draghi is fully aware that his recommendations are a "challenging topic": The report makes it clear that there will be significant resistance turning national regulatory authorities into "subsidiaries" of a single, EU-wide authority. According to Draghi, this resistance will not only come from national authorities who feel threatened in their role but also from trading platforms and market participants who benefit significantly from the current fragmented structure.

Therefore, it is not surprising that the major fund locations Luxembourg and Ireland have immediately criticised the plans. A key point of criticism is the fear that centralization will not increase the efficiency and competitiveness of European financial hubs and will merely cover up the underlying problems of market integration. The experiences with banking supervision in the EU show that centralization does not necessarily lead to a strengthening of the market.

Instead, it is feared that the greater distance of a European regulatory authority could also endanger the efficiency and competitiveness of the various European financial hubs.

Germany: Is Frankfurt Losing Its Relevance as a Financial Hub?

In Germany, the discussion about a European "super-supervisor" has interestingly not yet fully taken off, although in the long term, consolidating supervision to the extent described could also have significant impact on the German market. This raises the question of whether the goal of strengthening the Capital Markets Union, with a focus on investing more money into European industry, is truly desirable for an export-oriented country like Germany, which relies on the influx of non-European capital. It is also unclear whether the current fund locations, Luxembourg and Ireland, might ultimately benefit from further efficiency gains at the expense of other EU countries. Thus, the financial hub of Frankfurt could lose its relevance if, for example, clearing and settlement were to be consolidated into one organization.

The fact is that the establishment of a super-supervisor would be another consistent step towards a complete Capital Markets Union. It would continue what was essentially the goal of the first major financial market directive in 1993, the Investment Services Directive, namely to create a globally competitive EU capital market characterized by uniform competitive conditions across Europe. This path was continued with MiFID I and II, and in 2017, in the wake of Brexit, the ECB expressed its intention to strengthen ESMA and ultimately establish a central European Capital Markets Authority. Vítor Constâncio, former Vice-President of the ECB, highlighted the need for centralized supervision to ensure the stability of the financial system and to better monitor risks.

Conformity with Objectives, Implementation Remains Controversial

While the Draghi report's objectives --- strengthening competitiveness and reducing regulatory fragmentation --- are fundamentally shared by many, the method of their implementation is controversial and requires careful consideration of various interests. As with many visionary approaches, critical reactions are not only completely normal but also important because they can reveal weaknesses. Balancing interests among the current 27 EU member states is challenging, but ultimately just another item on the agenda like many other regulatory initiatives at the EU level. The grand goal of a Capital Markets Union, in which the role of ESMA must also be defined, has long been targeted. Thus, the topic of ESMA will sooner or later become even more of a focus. The asset management industry should therefore engage with the topic early on. Centralized supervision across Europe would result in considerable cost savings due to the elimination of national gold plating, i.e. national regulatory specifics. This could especially result in cheaper products for consumers. However, this would likely lead to greater concentration, which in turn could harm competitiveness. Moreover, Draghi's approach also carries the risk that market participants might even be subject to dual oversight by national and Europe-wide authorities, as we have already seen in other industries. This could only be prevented by combining centralized supervision with the elimination of national rules.