To some, the final instalment of The Godfather trilogy was derided as an abject travesty and a desultory conclusion to what had been one of the finest film sagas in living memory. In contrast, other critics were more restrained, accepting that while the motion picture did not live up to expectations, it was entirely watchable and by no stretches ‘awful’. The EU’s heavily publicised Capital Markets Union (CMU) is now entering its fourth year and elicits a similar response. The initiative pitches industry experts who think the entire programme should be jettisoned against those who see it as a perfectly manageable albeit slightly flawed legislative initiative.
“That CMU was established in the first place is an achievement in itself. Europe is heavily reliant on bank financing and it is positive that policymakers recognise the need to diversify funding sources and promote deeper and more integrated capital markets within the EU. Our view of CMU is that there have been successes in areas like sustainable finance, but also limited progress in addressing structural impediments to cross-border integration, most notably around inconsistent tax practices and legal systems” says Pablo Portugal, managing director at the Association for Financial Markets in Europe (AFME).
Is CMU launching at possibly the worst time ever in EU history?
Policymakers behind CMU are operating in a stressful European political environment punctuated by ongoing Brexit discussions and the systemic risks posed by fragilities in the Italian banking system. Experts concede the tricky headwinds have undermined CMU. Portugal acknowledges that while Brexit creates challenges, the EU 27 should use it as a catalyst to get CMU right. “From a strategic point of view, the biggest financial centre in Europe is leaving the EU. Now more than ever the EU 27 needs to increase the capacity of its capital markets.” Despite this, cracks – partly inflamed by Brexit – are emerging in CMU.
For instance, CMU proposes to better regulate third-country central counterparty clearing houses (CCPs) by creating a two-tiered supervisory mechanism comprising tier one, non-systemically important CCPs and tier two systemically important CCPs, have divided the industry in equal measure. While providers accept that tighter supervision of third country, SIFI (systemically important financial institutions) CCPs is a perfectly acceptable policy objective, there is consternation that the proposals could result in European Securities and Markets Authority (ESMA) demanding that tier two CCPs relocate into the EU in extremis, thereby increasing fragmentation and margining costs for derivative users. As a leading clearing destination for euro denominated swaps, this could hit the UK badly.
Fund managers pull back on CMU
Along with market infrastructures, asset managers have also been left nonplussed at CMU, angered by how the EU has sought to streamline the bloc’s fragmented cross-border distribution rules. Despite the provisions having the right intentions, they have been criticised for being uninspired. Asset managers have also voiced disapproval about CMU’s revisions to the pre-marketing rules under the Alternative Investment Fund Managers Directive (AIFMD) for being highly constrictive. Another CMU invention – the European Long Term Infrastructure Fund– aimed at drawing more capital into illiquid assets – also bombed, mainly because the product is badly structured and appeals to a very narrow target market.
ESG: Good progress so far but caution is still needed
Moving forward, the CMU has its sights set on promoting sustainable finance, principally encouraging more asset managers and asset owners to incorporate sustainability measurables into their investments. This is already happening organically evidenced by a recent BNP Paribas Securities Services (BP2S) survey, which found that 75% of asset owners and 62% of asset managers hold 25% or more of their investments in funds incorporating ESG (environment, social, governance), a massive rise from 2017 when that figure stood at 48% and 53% respectively. In addition, 65% of respondents told the BP2S study that they align their investment frameworks with the UN Sustainable Development Goals (SDGs).
Very few people would dispute the benefits of stimulating sustainability in financial services, particularly as there are growing concerns about greenwashing, namely asset managers misrepresenting their funds to investors as being ESG compliant. Just as MiFID II (Markets in Financial Instruments Directive II) tightened up product governance rules by imposing strict target market requirements on fund manufacturers and distributors, the EC is looking – as part of CMU – to create an ESG taxonomy or benchmark to stop managers from greenwashing their products. In theory, this is not a bad idea as it will help investors compare and contrast the ESG policies and practices of underlying or prospective managers.
Managing the taxonomy
“We support the establishment of an effective taxonomy as we believe it will help provide better standards for the industry. However, we also believe the taxonomy needs to be flexible, adjustable and proportionate. We also accept that the taxonomy is something where international alignment is desirable,” said Portugal. If the taxonomy is unwieldy, asset managers may find it harder to develop dynamic ESG products. With the EC working to an ambitious time-line and growing industry concerns about ESG data quality, there is nervousness that a badly structured ESG taxonomy risks becoming counterproductive.
What happens next?
The catalogue of CMU let-downs is growing, and it needs to be sorted, otherwise the financial services industry will become increasingly disillusioned. What began as a promising and bold endeavour has not met industry expectations. With the UK potentially exiting the EU in late 2019, the scale and ambition of the CMU could be slashed even further. This cannot be allowed to happen, otherwise it will provide further ammunition to the CMU’s loudest critics, many of whom have repeatedly argued that the scheme be totally shelved.