COVID-19 | Market Liquidity | Short Selling Bans | UCITS | CSDR | Renewed Sustainable Finance Strategy
Whilst many of us continue to find ourselves in the midst of dealing with the day to day ramifications of the COVID-19 pandemic, the reaction of governments and their major institutions of power is already providing clear lessons for the future. The reliance on cheap sources of supply of almost everything has allowed the so-called developed economies to prosper under the banner of globalisation. That works well until those fundamental supply chains are disrupted by something quite unexpected and generally not planned for. Governments around the world have realised that globalisation can lead to an over reliance on what are suddenly fragile networks, leading to heated political debates as to why things like face masks are all made elsewhere. As anyone one who has looked at Amazon recently will tell you, they are out of stock and are likely to be so for some time. What we are seeing before us is a true global financial and economic crisis, and although it has not come from the financial community as it did in 2007/8, the implications are no less severe.
The nature of the current emergency does raise some important questions, especially for the financial services sector. Crises tend to drive clear patterns of behaviour, and inevitably, we are drawn to the most recent global financial crisis to understand how we might respond this time. Immediately following those events, we saw the rapid development of regulatory agencies to address the perceived gaps in both prudential and markets-based regulation. In 2014, Mark Carney, the then Governor of the Bank of England and Chairman of the Financial Stability Board pledged that taxpayer money should never be used to prop up banks again. It could be argued that this objective has been achieved, as banks are better capitalised than ever and able to withstand the type of shocks to the financial system that we have just seen. However, some commentators might proclaim that the increasingly tight prudential regime has effectively disincentivised banks to assume market risk and therefore provide essential market liquidity. As we have seen extreme volatility across debt and equity markets, the traditional role of banks to act as a cushion or counter to market extremes through their own trading desks, has been largely absent during the current crisis.
Markets more generally are better policed and regulated than ever before. Regulations like MiFID drive transparency and conduct to ensure that investors are duly protected, with highly regulated investment vehicles built around the UCITS brand in Europe for example, providing further comfort for retail investors. Transparency and trading disciplines in the form of SFTR and CSDR respectively, will provide greater oversight and settlement rigour.
Notwithstanding the importance of some of the regulatory voids that had to be filled post-2007/8, there are two questions that I think we need to ask. First, have we gone too far with some of the current regulatory agenda? and second, do regulatory solutions for yesterday’s problems provide answers for those of today?
Taking each of these in turn, I have already highlighted earlier in this piece how elements of the prudential regulatory agenda appear to create an environment where banks avoid risk. Widely reported events in the North American repo market during 2019 reinforce the view that regulation needs to work to support deep and liquid markets, not constrain them. Aligned to this point is the much discussed temporary bans on short selling, that were a feature of the financial crisis and have been imposed once again by a number of regulators in recent weeks. In terms of the current plight, I believe that it is vitally important that financial markets remain open and fully functional. It is crucial that during a period of such stress, investors have confidence in their ability to trade on behalf of their retail clients. In our view, banning short selling removes an important outlet for investors to express sentiment, hedge positions and add to efficient price discovery.
The final point I would like to make is on UCITS funds and the engagement of retail investors. UCITS have traditionally provided a safe and consistent framework for retail participation in the broader capital markets. There is no doubt that this brand has been a success, however we have advocated for some time that there needs to be some sort of revision to the UCITS guidelines to allow them, within specific parameters, to engage more fully in and around securities lending. Here, the absence of market liquidity that could come from UCITS funds through securities lending, will in our view be a material factor in limiting the success of the renewed efforts to develop a wider Capital Markets Union across Europe.
So in an attempt to answer the first question, there is some evidence to suggest that in order to meet today’s policy and economic aims, notably in a post-Brexit world, certain rules and regulations will need to be revisited.
On the second consideration about yesterday’s regulatory solutions providing answers for today’s problems, the feeling is probably yes and no. As I mentioned earlier, there is no doubt that banks are better capitalised and able to withstand the on-going yet unprecedented events. However, examined through a different lens, I believe aspects of the current regulatory agenda potentially look out of step with the needs of today’s markets. Let’s consider CSDR for a moment. Many of the key aspects of the legislation impacting our markets, will be in relation to legal constructs that span decades. The proposed buy-in procedures and application of fail costs/fines up and down chains of trades, look clunky at best. Furthermore, if we were looking to better understand how settlement infrastructures work, we have just seen our markets tested to the extreme when equity markets went into free fall during March. During this period of exceptional volatility, when we saw exponential increases in both loan and collateral movements, feedback from our members was that their in-house systems and broader market infrastructures proved to be robust and able to manage these additional volumes. Developed over many years, and in many cases reflecting best in class business and operational frameworks. Whilst I note the aspirational direction of CSDR, and understand the implementation of fines for failed trades as prudent and appropriate steps, I don’t necessarily see other significant and incremental benefits for our markets.
Turning attention back to the wider topic, we need to recognise the part that financial markets can play to support economies, companies and individuals through this period. At one level, we see governments providing significant stimulus packages to aid small businesses, and on another, direct intervention to provide broader market support. The various packages are in my view all about one thing, liquidity. Earlier this week, I attended a cross-market call with a key European regulator, where participants were asked what they needed to see over the near term. Unanimously, keeping markets open with access to appropriate liquidity was expressed as the top priority.
Whilst understandably global health issues will dominate much of our thinking over the next few months, we should also turn our attention to other on-going priorities that will move back to the fore over time. The most obvious of these is the broader ESG debate, and most pertinently to our markets, the sustainable finance agenda. In that regard, it was encouraging to see that on 8 April, the European Commission (EC) launched a new consultation on the renewed sustainable finance strategy. Building on the 2018 Action Plan on financing sustainable growth, the renewed sustainable finance strategy will provide a roadmap with new ways to increase private investment in sustainable projects, activities to support the different actions set out in the European Green Deal, as well as manage and integrate climate and environmental risks into our financial system. The initiative will also provide additional enabling frameworks for the European Green Deal Investment Plan.
ISLA will be formulating a detailed response to this consultation over the coming weeks, as the sustainable finance agenda will shape much of the EC’s work over the coming term of this European Parliament. If you are part of an ISLA member firm, and would like to participate in a small working group to review this consultation as well as discuss other sustainable finance issues, please email Farrah Mahmood at regtech@islaemea.org.
As ever during these difficult times, I hope that you and your families remain safe and well.
Andrew Dyson, CEO
