17 March 2021

ESMA Report on Trends, Risks and Vulnerabilities

EU financial markets recovered from the significant COVID-19 related market stress in 2H20, in the light of notable public policy interventions, the announcement of new vaccines available in the short term and the reduction of Brexit-related uncertainty at the end of the reporting period in the EU.

Risk summary

 However, risks in markets under ESMA’s remit remained very high. The significant rebound of equity markets and the valuation of debt indices, which reached pre-crisis levels across all segments, contrast with the weak economic fundamentals.

The main risk we see for EU financial markets is that this ongoing decoupling leads to a reversal in investor risk assessment and a sudden market correction in a context where investors remain sensitive to events, exposing less-liquid markets to disorderly sell-off episodes. Prices of non-regulated cryptoassets at all-time highs imply significant risks for investors. Credit risk is likely to increase further because of significant corporate and public debt overhang. The extent to which these risks will further materialise will critically depend on three drivers: the economic impact of the pandemic, market expectations of monetary and fiscal support measures, and any occurrence of additional external events in an already fragile global environment.


Market environment: Macroeconomic conditions improved in 2H20, which was reflected by improved GDP forecasts amid continued very high uncertainty related to the future economic impact of the COVID-19 pandemic. Despite this uncertainty, asset prices – with the exception of commodities – recovered close to or above pre-crisis levels, thus highlighting a continued risk of decoupling from economic fundamentals. Concerns around the profitability of banks and insurers resurfaced and contributed to the underperformance of financial sector stocks. Central banks maintained their accommodative policy stance and asset purchase programmes, while government support measures continued to help mitigate the impact of the crisis. The December Brexit deal agreement has avoided the risk of cliff-edge effects and reduced political risks in the short term.

Securities markets: During 2H20, equity and fixed income markets continued their recovery from the massive market corrections in 1Q20. Equity valuations in the EU increased by 10% during 2H20, remaining slightly below pre-COVID-19 levels amid significant divergence between Member States and between sectors. If the end of the UK transition period had no discernible stability impact on securities markets, the implementation of the EU share-trading obligation is changing the European trading landscape. Linked to major monetary policy support, valuations in fixed income markets continued to increase across all sectors and ratings, especially during 3Q20. Riskier segments such as high-yield corporate bonds and emerging markets debt now have valuations above pre-COVID-19 levels, reflecting investors’ renewed search for yield. Higher sovereign and corporate debt levels point to sustainability issues in the medium to long term.

Infrastructures and services: Equity-trading volumes stabilised to pre-crisis levels in 2H20, and the distribution of volumes across trading types remained broadly unchanged, with the share of lit trading stable at 46 % for 3Q20. Outages on European venues raise concern about over-reliance on third-party services. The launch of several new EU-based entities from UK groups in 4Q20, and the planning of an important merger are modifying the trading venue landscape in the aftermath of Brexit. EU and UK CCP initial margins decreased slowly but consistently throughout 2H20 following the sharp increase in March and April amid the COVID-19-related market stress. Settlement fails receded from their March peak although they remained above their pre-crisis level for equities. Rating downgrade numbers continued their post-April downward trend, but corporates and structured finance products exposed to corporates continued to be more affected by negative rating actions, with fallen angel vulnerabilities remaining. Benchmark reform is still under way, with large exposures to legacy benchmarks on derivatives markets remaining, and the potential impact of credit downgrades on fixed income indices.

Asset management: The fund industry continued to expand in 2H20, reflecting strong flows and valuation effects. Following the significant outflows experienced during the COVID-19-related market stress, bond funds recorded the highest inflows, partly reflecting higher performance than equity funds. As stress receded, bond funds have reduced their cash holdings, while the credit risk profile of investment-grade bond funds has slightly deteriorated. The size and composition of EU MMFs remained stable, while liquidity buffers plateaued at high levels, substantially above regulatory requirements. The size of alternative investment funds remained stable in 3Q20, while EU-domiciled hedge funds reduced their leverage through derivatives but increased their financial leverage through borrowings.

Consumers: Following the market stress linked to the first wave of the COVID-19 pandemic, investor sentiment ameliorated amid continuing uncertainty, and the performance of retail investor instruments, such as EU UCITS funds, improved. Analysis of retail investor behaviour during the COVID-19-related market stress showed that new retail investors invested in equity markets during this period. The extent to which the phenomenon of increased retail equity trading is positive or negative from the perspective of investor protection depends on the situation of the individual investor and whether the investment is driven by long-term investment or speculative motives.

Market-based finance: During 2H20, primary markets mostly recovered from the COVID-19-related market stress earlier in 2020. The share of capital markets financing for non-financial corporates improved from its lowest point in the first phase of the crisis. Primary equity markets reopened but showed signs of differentiation between incumbent firms and new entrants. Corporate fixed income market issuance remained at high levels, but slowed down after touching record highs in 2Q20, with issuance quality slightly deteriorating towards BBB-rated bonds. Increasing corporate indebtedness raises concerns of debt overhang in the medium to long term. Access to capital markets for SMEs continues to be limited. Nevertheless, SME share trading improved in the second half of the year, especially on SME growth markets. Market-based credit intermediation decreased owing to valuation losses. On the other hand, wholesale funding increased thanks to bank deposits motivated by precautionary savings.

Sustainable finance: Against the backdrop of new pledges from the largest greenhouse gas-emitting countries to aim for future carbon neutrality, EU sustainable debt markets continued to expand at a brisk pace in 2H20 (+ 32 % from 1H20, EUR 508 bn), linked to robust supply from the corporate sector and massive public-sector financing needs to support the EU’s economic recovery. The performance of environmental, social and governance (ESG) equity benchmarks was mixed. This mainly reflected the negative (positive) impact of COVID-19-related vaccine announcements on sectors that had performed well (poorly) during the crisis, such as healthcare (transport), and are overweight (underweight) in ESG portfolios. ESG equity funds attracted high net flows again, as ESG-related communication by asset managers paid off.

Financial innovation: The wider COVID-19 impacts continue to fuel digitalisation, with positive outcomes for consumers and firms but at the same time challenges and risks, especially related to cyber-resilience. In the crypto space, Bitcoin price is at all-time highs, fuelled by strong investor demand, positive news reports and the expectation that cryptoassets will ultimately achieve mainstream acceptance. Developments around global stablecoins continue to be under regulatory scrutiny, while sentiment towards central bank digital currencies is shifting positively.

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