EU regulators issue market risk warnings on Brexit and cyber-security

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European Union regulators have issued a series of warnings on the key risks facing markets, highlighting risk premia reversal, Brexit, cyber-security and climate change.

In a report issued on Thursday (12 April), the European Supervisory Authorities (ESAs) – encompassing securities and markets regulator ESMA, banking regulator the EBA and insurance and pensions regulator EIOPA – reiterated concerns about the risks posed to retail investors by the rise of cryptocurrencies.

It said: “virtual currencies can raise significant consumer protection issues [such as] extreme volatility and bubble risk, the lack of a robust secondary market, operational disruptions as well as the lack of price transparency.”

The ESAs issued a similar joint statement on 12 February, which focused on the risks of buying and trading virtual currencies, and financial products exposing consumers directly to virtual currencies.

In addition, the 12 February warning highlighted the specific risks associated with the un-regulated status of cryptocurrencies.

The joint committee report on Risks and vulnerabilities in the EU financial system focuses on the second half of 2017, over which time despite “the overall EU macroeconomic environment continued to improve” key risks persisted.

Despite the improved economic outlook, the potential for sudden risk premia reversals, whereby abruptly increasing yields could lead to losses across asset classes and generate substantive volatility in asset prices, remain “imminent”, according to the report.

ECB data shows retail consumers are affected by a repricing of risk premia through their portfolio holdings, with EU households’ exposure to globally listed equities amounted to €950bn in the third quarter of 2017, while they held €1,890trn in investment fund shares.

The report said: “Significant market turmoil resulting in negative portfolio returns can reduce household consumption, via wealth effects or realised losses”.

The ESAs said national regulators must continue to use stress testing as a crucial tool for the management of systematic risk”, focusing on banks, CCPs, insurance and pensions, and, in the future, asset managers.

In 2017 equity prices rose by 10%, after remaining flat in 2016, supported by the improved macroeconomic environment and “accommodative monetary policies”, the report said.

The ESAs believe these conditions “fuelled concerns of possible asset overvaluation, while low volatility “reflects to some extent expectations of continued monetary policy support” and, as a result, the “relative absence of market reaction to adverse events” has also potentially increased investor complacency and “the probability of sudden risk repricing”.

The report added this may have contributed to sudden return of global equity market volatility in February 2018, where the S&P 500 lost 4.1% in one day and the VIX jumped to around 40%, its highest level in several years.

It warned this kind of volatility “may increase in the future”.

The ESAs also reiterated concerns about the risks associated with the UK’s departure from the EU, which have “the potential to expose the EU27 and the UK to economic instability and to weaken market confidence, in particular if negotiations end in a disorderly fashion”.

For regulated firms, counterparties, investors and consumers, the report said it is essential they “prepare appropriate mitigating actions in a timely manner, to prepare for the UK’s withdrawal from the EU”.

The report also noted concerns about Brexit-driven relocations, adding “common EU efforts to ensure a consistent EU supervisory approach to potential relocations of financial institutions are necessary to protect the integrity of the Single Market”.

It added: “A range of further issues may arise, including the restructuring of legal entities and possible portfolio transfers.

“In the short term, UK’s withdrawal from the EU may also affect access of EU 27 households and corporates to financial services provided in the UK and it may affect market confidence.

“This has potential implications on market liquidity and risk premia, and the risk of further adverse feedback loops.”

Cyber threats

The report also warned cyber risks have “become a significant and increasingly escalating threat to investor protection, the financial markets and institutions and financial stability worldwide”, with increased outsourcing creating further challenges.

Specifically, the CSAs said cyber risks “threaten data integrity, data confidentiality, data protection and business continuity”, and the risk is particularly significant because of possible “multiplier effects, leading to further business risks, such as supply chain risk and reputational risk”.

It added: “Moreover, it can trigger high legal costs, for example in cases of data breaches with notifications, litigation and solution, as well as in case of fraud.

“Insufficient protection against cyber incidents and a disruption in the availability of critical IT infrastructures could lead to major damages for financial institutions concerned, and potentially to the wider financial system.

“Consequently, cyber risk is receiving increased attention from all the ESAs.”

The ESAs said financial institutions must work to “improve fragile IT systems, explore inherent risks to information security, connectivity, and outsourcing”.

Going forward, the ESAs will continue to assess cyber risks for securities, banking and insurance markets and monitor firms’ use of cloud computing and potential build-up of cyber risks.

Climate change

Over the longer term, the ESAs said climate change and the transition to a lower-carbon economy have become emerging risks for large parts of the financial sector.

European financial authorities, as well as the Financial Stability Board and the G20, have issued warnings in the last two years about the potentially destabilising effects of climate change.

While acknowledging their knowledge on the impact of climate risk on the financial sector is “still relatively limited”, the ESAs highlighted the potential for “severe weather events” to hit insurers and reinsurers as a key problem.

It added: “If losses are uninsured, the burden to cover damages might fall on governments, households and corporates, which could impair their ability to repay loans and bonds, or pay out dividends.

“This in turn affects the value of financial assets, which can harm the solvency position of financial institutions and can lead to losses for investors.”

However, the regulators were also keen to acknowledge the “opportunities” on offer to the financial sector as a result of the move to a lower-carbon economy.

It said financial institutions should be “encouraged to take a more forward-looking approach to include sustainability risk in their governance and risk management frameworks, and to develop responsible, sustainable financial products”.

For national regulators, the ESA said it was essential they “enhance their analysis of potential risks related to climate change for the financial sector and financial stability”.

“This also involves a stronger engagement of the ESA’s in the area of climate change risks,” the report added.