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The COVID-19 pandemic, in combination with the valuation risks we had highlighted in ESMA’s previous risk assessments, led to massive equity market corrections in 1Q20. We provided an updated Risk Dashboard on 2 April to inform about the new risk landscape. Since this risk update, markets have seen a remarkable rebound, not least in the light of notable public policy interventions in the EU and elsewhere. However, as the market environment remains fragile, we maintain our risk assessment: going forward, we see a prolonged period of risk to institutional and retail investors of further – possibly significant – market corrections and see very high risks across the whole of the ESMA remit. The extent to which these risks will further materialise will critically depend on two drivers: the economic impact of the pandemic, and any occurrence of additional external events in an already fragile global environment. The impact on EU corporates and their credit quality, and on credit institutions, are of particular concern, as are growing corporate and public indebtedness, and the sustainability of the recent market rebound.
Market environment: As a result of the COVID-19 pandemic, financial markets have been hit by an external shock of unprecedented size. During the initial stage of the crisis in 1Q20, markets experienced one of the fastest declines in recent history, including surges in volatility and liquidity contractions. Massive policy responses – containment, fiscal, monetary and regulatory – in the EU and elsewhere aimed to mitigate the economic impact of the pandemic. While markets have seen a remarkable rebound in 2Q20, the resilience of the recovery critically depends on the economic impact of the pandemic. In particular, the effect on EU corporates and their credit quality, and on credit institutions are of particular concern, as is growing corporate and public indebtedness. Beyond the risks related to second waves of infections, any occurrence of additional external events, such as trade tensions between the US and China, could further destabilise fragile market conditions.
Securities markets: In 1Q20, EU equity markets plunged amid liquidity shortages and upticks in extreme volatility triggered by rising infections across Europe against the backdrop of a deteriorating global economic outlook. Corporate bond spreads surged as a result of signs of rapid credit risk repricing, as flight-to-safety strategies took off. Government bond spreads widened, reflecting the damage of the virus and the associated containment measures implemented by sovereign countries. Markets have seen a remarkable rebound, albeit with differentiation across economic sectors since end-March, not least in light of massive public policy interventions in the EU and elsewhere. The potential decoupling of financial market performance and underlying economic activity raises the question of the sustainability of the market rebound looking forward.
Infrastructures and services: Market infrastructures faced heightened activity during the sell-off, as volumes and volatility soared. Trading venues coped with increased trading volumes amid a higher share of lit trading, as investors sought certainty of execution during the time of liquidity stress. Central Counterparties (CCPs) proved resilient throughout the period, despite the surge in clearing activity coupled with the sharp rise in initial and variation margins. Similarly, clearing members met heightened liquidity demands despite some margin breaches that were covered by excess margins. Credit Rating Agencies (CRAs) responded to the sharp economic deterioration by downgrading affected issuers, particularly non-financials. The risks of “fallen angels” remain high as a result, and securitised products (e.g. Collateralised Loan Obligations (CLOs)) may be affected, too, going forward.
Asset management: In the wake of the initial impact of the COVID-19 outbreak on markets, the EU investment fund industry faced a significant deterioration in liquidity in some segments of the fixed income markets combined with large-scale investment outflows from investors. Redemptions from bond funds reached record highs in March, resulting in outflows of 4% of their net asset value (NAV) in 1Q20. Some asset managers decided to suspend the redemption of their funds, mainly because of valuation uncertainty but in some cases also because of outflows. Between the second half of March and May around 200 EU and UK funds (out of 60,000 funds) had to suspend redemptions temporarily. Some corporate bond exchange traded funds (ETFs) traded with unusually large discounts compared with the reference basket, reflecting liquidity issues in underlying assets in March and April. Some money market funds (MMFs) were particularly affected end-March owing to their exposure to the USD money market, especially low volatility net asset value MMFs. Since early April, the liquidity profile of funds has improved across fund types, with a surge in inflows and a general improvement in performance.
Consumers: The strong negative impact of the COVID-19 pandemic on both the real economy and financial markets has affected retail and institutional investors. Investor confidence fell sharply from March 2020 onwards owing to the pandemic, and the performance of typical retail investor instruments, such as EU UCITS funds, declined to historical lows. Despite improvements in 2Q20, annual performance remained close to zero at the end of the reporting period . Complaints in relation to financial instruments remained steady.
Market-based finance: The COVID-19 turmoil has also had a strong impact on primary markets. During the period of acute market stress, primary issuance practically came to a standstill for equity and bonds. In the equity space, only incumbent firms were able to tap markets through follow-on issuance in March. Bond issuance rebounded from early April onwards, first in the investment-grade segment, followed in May by lower-rated issuers. However, small and medium-sized enterprises (SMEs) remain at risk of facing financing gaps.
Sustainable finance: Environmental, Social and Governance (ESG)-oriented assets such as benchmark equity indices and funds have outperformed their non-ESG peers again in the first half of 2020 (1H20). Investor appetite for ESG funds remained high with net inflows in 1H20 compared with large net outflows for the rest of the equity fund industry. The green bond market continued to expand even as some agency and supranational issuers shifted their focus to social bonds to tackle the socio-economic consequences of COVID-19. Green bond liquidity is improving despite a deterioration in corporate bid-ask spreads in March and April, in line with broader bond market developments.
Financial innovation: COVID-19 lockdowns are expected to accelerate digitalisation of financial services. While positive from an efficiency perspective, this may accentuate risks, such as cyber risk, high market concentrations among data service providers and fragilities in the FinTech sector. Crypto assets were not spared from the COVID-19 turmoil. So-called “global stablecoins” continue to be under close scrutiny by central banks and regulators.