From Fragmentation to Financial Integration in Europe

Chapter 18. An Assessment of Markets and Credit Rating Agency Regulation

Charles Enoch, Luc Everaert, Thierry Tressel, and Jianping Zhou
Published Date:
December 2013
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Ana Fiorella Carvajal

Within its resource envelope, the European Securities and Markets Authority (ESMA) has performed well during its first two years of operation, especially in connection with the single rulebook and credit rating agency (CRA) supervision. A significant number of technical standards, advice to the European Commission, and opinions were developed. ESMA has also been able to build its expertise in connection with CRAs and has worked on the development of a risk framework to anchor its supervisory program. Results are more modest in connection with other functions. To a large extent, this prioritization was driven by the financial sector regulatory agenda, which imposed regulatory obligations on ESMA under tight deadlines and required it to assume the supervision of CRAs, which until then had not been supervised in Europe.

As it has acknowledged, ESMA needs to step up its role in other areas and in particular on supervisory convergence. The institution has set up strategic directions for each area and in many cases has developed concrete actions to take these priorities forward.

  • Supervisory convergence. Work on reengineering and strengthening peer reviews is essential to achieve convergence, since the direct breach of laws and mediation procedures would be appropriate for only a few cases. The objectives of the reengineering should be: (1) making reviews more rigorous by relying more on on-site work; and (2) sharpening the review outcomes by linking the reports to the development of best practices and/or guidelines, the implementation of which can be monitored and followed up. If necessary, stronger actions (such as a breach of law) could then be taken. These changes might also require a stronger role for ESMA in the peer review groups and in the review panel. It is important that the National Competent Authorities (NCAs) take the steps necessary to ensure the enforceability of ESMA’s opinions and guidelines in their respective jurisdictions.

  • Risk identification and crisis management. Projects under way will allow ESMA to make a qualitative jump in its contribution to financial stability and crisis management. However, it is critical that ESMA have access to data with the granularity and timeliness necessary to conduct in-depth analysis, including stress testing in connection with entities that could pose systemic risk. In this regard, requiring a vote from the ESMA Board of Supervisors to provide data for particular studies that ESMA wants to undertake may hinder ESMA’s ability to be timely in its work. In addition, the ESMA Board of Supervisors should take a more active responsibility in this area. Thus, risk identification should remain a recurrent point in the board’s agenda, and not only in times of crisis. In the second case, in addition to developing a framework for each scenario identified, ESMA should coordinate simulation exercises.

  • Investor protection. The emphasis on product monitoring is warranted, and the consumer trends data project would be key to making a qualitative jump in this area. Effective monitoring of financial innovation should also have a positive effect on financial stability. The granting of product intervention powers to ESMA is welcome, but such powers should be exercised cautiously since ESMA is not a direct supervisor.

Having sufficient expert resources will be key to delivering results. The approved additional staff for 2013 will not be large enough to ensure that these other functions are sufficiently covered. Furthermore, the European Market Infrastructure Regulation will assign additional functions to ESMA for which resources will be critical. Expanded functions will also arise from other initiatives to be implemented in the upcoming years, such as the third reform of the CRA regulation (CRA3) and Markets in Financial Instruments Directive (MiFID) 2.

Finally, reviewing governance arrangements to strengthen ESMA’s independence in relation to the NCAs is advised. Current governance arrangements might negatively affect ESMA’s performance of its functions, in particular supervisory convergence. In addition, ESMA staff should continue to play a stronger role in the standing committees.

ESMA Institutional Arrangements

Mandate and Powers

ESMA was created in 20111 as part of the new European System of Financial Supervision. This system consists of the European Systemic Risk Board (ESRB) and the three European Supervisory Authorities (ESAs), based in Paris; the European Banking Authority (EBA) based in London; and the European Insurance and Occupational Pensions Authority (EIOPA) based in Frankfurt. While new in its current structure and nature, it builds on the work of the Committee of European Securities Regulators.

ESMA’s mission is to enhance the protection of investors and reinforce stable and well-functioning financial markets in the European Union (EU). To achieve these objectives, several tasks are allocated to it, along with the powers to undertake them. Such tasks and powers can be grouped in the following themes:

  • Regulatory work. ESMA has a key role in contributing to the development of a single rulebook by (1) the development of technical standards, (2) the development of guidelines, and (3) the provision of advice to the European Commission on secondary legislation.

  • Supervisory convergence. ESMA has a role in supporting the convergence of supervisory culture and practices, mainly by (1) issuing opinions, (2) conducting peer reviews, and, as a last resort (3) making use of powers to investigate and remedy breaches of European Union laws. By regulation ESMA may develop new instruments to foster convergence.

  • Financial stability and crisis management. ESMA’s obligations include contributing to the assessment of risk and financial stability. To this end, it (1) carries out its own analysis, (2) contributes to the work of the Joint Committee, and (3) cooperates with the ESRB. Regarding crisis management, ESMA’s role is fundamentally one of coordination except in connection with short selling, where direct powers were given to it.

  • Investor protection. ESMA contributes to strengthening the framework of investor protection through different tools, including (1) the issuance of guidelines, and (2) the power to issue warnings in the event that a financial activity poses a threat to investors.

  • Supervision. Since July 2011, ESMA has been responsible for the registration and supervision of CRAs in the European Union.

ESMA Governance

Governance arrangements have involved several bodies, all of them under the direction of the Board of Supervisors.

  • The ESMA Board of Supervisors is the decision-making body of ESMA. It is composed of the heads of the 27 NCAs for the supervision of financial markets in each member state.2 The regulation requires board members to act independently and objectively and in the sole interest of the European Union as a whole, and therefore they should not take instructions from any European body or domestic authority. Decisions are taken by a majority of votes, each member having one vote. However, the adoption of technical standards and guidelines requires a qualified majority whereby voting rights are weighted by population to ensure demographic representativeness.

  • Standing committees, made up of staff from the NCAs, do the preparatory work. There are currently 11 standing committees. Ad hoc task forces can also be constituted. NCAs lead the work of the standing committees, that is, they chair them and in some cases “hold the pen,” while ESMA staff act as rapporteurs.

  • An ESMA Management Board, composed of six members selected from the ESMA Board of Supervisors by its members, focuses on management aspects of ESMA’s work, such as the development of the annual work program, the budget, and resources.

  • ESMA’s chair and the executive director, respectively, prepare the work of the ESMA Board of Supervisors and the ESMA Management Board. They are appointed by the ESMA Board of Supervisors, following an open selection procedure based on merits. Both are required to act independently and are prohibited from taking instructions from any European body or domestic authority. Both are appointed for five-year terms with the possibility of reap-pointment for one more term. ESMA regulation does not require the existence of “due cause” for their early removal.

  • There is one Appeals Board for the three ESAs, composed of two experts from each sector (and their alternates). Decisions of the Appeals Board can be appealed to the European Court of Justice.

  • A Securities and Markets Stakeholder Group facilitates consultation with stakeholders. It has 30 members appointed by ESMA for a period of two and a half years following an open call for candidates. In practice, this group is active and has its own work program. The group has periodic meetings with the ESMA Board of Supervisors, for which an agenda is set up in advance.

Independence is a key source of concern. Thus, in the context of the upcoming review to be conducted by the European Commission,3 governance arrangements should be evaluated and if necessary further enhanced. Stakeholders interviewed concurred that work by majority represents a fundamental change from the Committee of European Securities Regulators’ way of operating, since its decisions were taken by consensus, which in some cases meant agreeing to the lowest denominator. Furthermore, most of the stakeholders indicated that the presence of the board chair in the discussions of the ESMA Board of Supervisors ensures that ESMA’s positions are heard. Thus, there is agreement that ESMA represents a significant evolution from its predecessor, not only from a legal perspective, but also from an operational perspective.

However, the conversations with stakeholders and examples given by them lead to the conclusion that decisions are still dominated by “domestic” views. Furthermore, ESMA’s governance structure as a college of “peers” could be particularly troublesome in the context of supervisory convergence. The fact that there does not appear to be strong follow-up on the conclusions of peer reviews might be in part explained by the current composition of the ESMA Board of Supervisors. Therefore, this issue should be further analyzed during the review of the ESAs, with a view to enhancing ESMA’s independence in relation to the NCAs, while keeping a framework of high accountability to the European authorities. Different alternatives could be considered: from adding more independent members to the board, to moving to a full-time and fully independent board, to delegating more functions to the ESMA Management Board. In addition, the rules for removal of the chair and the executive director should be strengthened by requiring removal only with due cause.

It is important that ESMA staff continue to play a stronger role in the standing committees. There was consensus among the stakeholders interviewed that over time ESMA staff are becoming more active in the discussions at the standing committee level. ESMA staff highlighted that when consensus on a topic has not been reached, reports explicitly state ESMA’s position, in addition to highlighting the different alternatives, more often now than previously. In addition, at the ESMA Board of Supervisors meetings, the chair presents the position of the institution.

From a transparency perspective, more engagement with the stakeholder group in connection with the work plan could be explored. ESMA already operates under a robust framework of accountability and transparency. Accountability has been made operational in two ways: (1) through an annual joint hearing at the European Parliament for the three ESAs, and (2) through ad hoc hearings of a more technical nature with the European Parliament and Council. Concerning transparency, a significant amount of information can be found on ESMA’s website, including the minutes of the meetings of the ESMA Board of Supervisors; ESMA’s annual work program, its budget, and its annual report; the reports of the different standing committees; and the proposals for technical standards and guidelines. One aspect where more engagement may be advisable is in relation to the development of the work plan. ESMA could engage with the Stakeholders Group early on in the process to get their views on priorities.

Funding and Budget Issues

ESMA has three sources of funding: a subsidy from the European Commission, a contribution from the NCAs, and a fee levied on registered firms under its direct supervision. Currently, only CRAs are subject to this levy, but with the approval of European Market Infrastructure Regulation, trade repositories would also have to contribute. For 2013, ESMA’s budget will amount to €28.3 million, of which the European Commission’s contribution would represent roughly 46 percent, the NCAs’ contribution 30 percent, the CRAs’ contribution 20 percent, and the trade repositories’ contribution 4 percent. It was indicated that the contribution of the largest NCAs does not represent a significant proportion of ESMA’s budget. Operationally, the European Commission decides on the budget proposal to be sent to the European Parliament. The European Commission can make changes to ESMA’s proposal, and the European Parliament and Council in turn can make changes to the European Commission proposal.

The upcoming review should look at alternative funding structures, since in the medium term the current structure could become a problem. First, this funding structure could create conflicts of interest in relation to the NCAs—as in some cases there might be a bias against letting ESMA grow in light of views about the centralization of functions. Second, as ESMA grows, the contribution from the NCAs could become a heavy burden for the smaller jurisdictions and a risk of nonpayment could arise. Thus, as stated by the Committee on Economic and Monetary Affairs of the European Parliament,4 additional funding models should be explored, including industry fees; in fact, part of ESMA’s budget is already funded this way. However, it may be difficult in the short term to expand this type of funding mechanism beyond the CRAs. On the one hand, there would be resistance from market participants to a system of “double” charging (to fund the domestic authority and to fund ESMA), while on the other hand a system where the levy that was charged domestically would be offset to compensate for a levy charged at the ESMA level could negatively impact the operation of the domestic regulator. From a strictly technical perspective, the functions assigned to ESMA are not identical to those of the NCAs; furthermore, in many ways they benefit market participants, including for example by ensuring the existence of a level playing field across the European Union. Thus, a system of dual charging could very well be implemented. In addition, given the large number of regulated participants in the European Union, the levy on each could be relatively small. An alternative would be to be funded entirely by the European Union or to increase its share of funding.

It would also be important to review the current role of the European Commission in the approval of the ESAs’ budget. While until now the European Commission has not made changes to ESMA’s proposals, the experience of the other ESAs—whose budget proposals have been cut—leads one to conclude that in times of austerity the European Commission could be under pressure to reduce their budgets, using a mechanistic reduction scheme across the board, without any differentiation for the ESAs in relation to other public agencies (see note 4). It is worth exploring whether ESMA should present and justify its budget directly to the European Parliament and Council.

Organizational Structure and Resources

During ESMA’s two years of existence, its management has worked on the development of its organizational structure and procedures for operation. It currently has three divisions (Markets; Investment and Reporting; and Operations) and three units (Credit Rating Agencies Unit; Economic Research and Financial Stability Unit; and Legal Cooperation and Convergence Unit). It is bound by the same administrative rules that apply to other public agencies of the European Union for purposes of recruitment and procurement.

ESMA’s human resources are growing. It started with 35 staff from the Committee of European Securities Regulators. As of November 2012, it had 85 professionals, who were a mix of roughly 75 percent staff and 25 percent secondees from NCAs and contractors. Staff are hired under a three-year contract, with the possibility of renewal for another three years, after which they can be offered an “indefinite” position. ESMA’s officials indicated that salaries have not hindered recruitment of qualified experts, since European Commission salaries, which also apply to ESMA, are reasonably high—although hiring experts from “the North” is more challenging, since their salaries are relatively higher.

However, ESMA needs more resources to carry out all its functions effectively. Its budget envelope for 2013 would not be enough to allow for the implementation of the different initiatives mentioned in this chapter, which are critical for ESMA to take a more active role in functions beyond the single rulebook and the supervision of CRAs. Furthermore, initiatives in the pipeline—such as European Market Infrastructure Regulation, CRA3, and Markets in Financial Instruments Directive 2—will create new responsibilities for it or expand existing ones.

Recruitment policies should be monitored to determine whether they pose any risk to ESMA’s ability to attract and retain qualified staff. At this stage, recruitment policies, in particular the six-year term to provide an indefinite position to staff, might work to ESMA’s advantage. However, at the outset, the six-year policy does not seem conducive to the stability of the organization, which should be a long-term objective of recruitment policies. Finally, it is important that a high ratio of permanent staff to secondees be kept in order to consolidate institutional knowledge.

ESMA’s Regulatory and Supervisory Convergence Work

Single Rulebook

During its first two years of operation, ESMA has dedicated a significant amount of resources to the single rulebook. Several pieces of legislation require ESMA to either develop technical standards or provide advice to the European Commission for it to develop secondary legislation (level 2). The following is a summary of the policy work conducted by ESMA:

  • Forty technical standards were developed for the implementation of European Market Infrastructure Regulation;

  • Four technical standards were developed for the new CRA supervisory regime;

  • Seven technical standards were developed for the new short-selling and credit defaults swap regime;

  • Five pieces of advice were provided to the European Commission on secondary legislation in areas such as prospectuses, undertakings for collective investment in transferable securities, alternative investment funds, and short-selling; and

  • Six sets of detailed guidance and recommendations were developed in areas such as automated trading, alternative investment fund managers, exchange-traded funds, suitability of advice, and the investment firm compliance function.

In the future, it is important that ESMA be given sufficient time to deliver on its regulatory obligations, since tight deadlines can result in significant reputational risk and can also have a negative impact on the market. ESMA has had to deliver some of the technical standards under very tight deadlines. As a result, in some cases consultation processes have been squeezed. Many stakeholders have expressed concern about such a situation, since market participants did not have the time to conduct a thorough analysis of the proposals, nor ESMA to actively engage with them to discuss their concerns. As a result, neither industry nor ESMA had a comprehensive view of the costs and impact of the proposals.

Finally, the framework of transparency, including in connection with the European Commission role, remains critical. ESMA is required to conduct a public consultation process, as well as to consult the Securities and Markets Stakeholders Group. Technical standards must be endorsed by the European Commission. ESMA’s officials have stated that so far, the European Commission has not made changes to the standards it has proposed. Because ESMA is the technical authority, it is critical that any intervention from the European Commission through its endorsement process be motivated by and grounded in technical reasons. The process devised in the regulation ensures that cases where the European Commission deviates from ESMA’s proposal are visible.

Supervisory Convergence

Peer reviews have been the main tool used for supervisory convergence. Peer reviews are conducted by the review panel, which is a standing committee established for the purposes of fostering supervisory convergence. Currently this unit has two staff directly dedicated to convergence work and three more lawyers that support all of ESMA’s work, including the standing committees’ work. In addition, all the standing committees play a role, since in many cases they conduct mapping exercises and develop opinions and guidelines in connection with sectoral legislation within their remits.

  • Peer reviews. The Committee of European Securities Regulators conducted several peer reviews. Since 2011, ESMA has conducted four peer reviews, and two of them—the review of sanctions under the Market Abuse Directive and the review of prospectus approval—have already been finalized. Three more reviews are planned for 2013. In the past, reviews focused on mapping rather than on assessments. When assessments were done, they were desk-based, which did not allow for thorough contestation of the responses provided by the NCAs. Thus, most countries were usually rated as fully compliant. Even when countries were found to be partially compliant, there was no systematic follow-up nor was any action attached to such noncompliance beyond the publication of the report. ESMA’s chair has highlighted the intention to revamp peer reviews to make them more rigorous and their outcomes sharper. The committee also intends to conduct more peer reviews.

  • Opinions. Two important cases are (1) an opinion on the treatment of sovereign debt under International Financial Reporting Standards, and (2) opinions on consistency with the Markets in Financial Instruments Directive for a large number of pre-trade transparency waivers.

  • Mediation and breach of laws procedures. ESMA has not made used of its powers in connection with mediation and breach of laws procedures. In the first case, no case has been filed by an NCA, which is a requirement of the regulation. As to the latter, part of the reason is that there is no culture of filing complaints by firms or by the NCAs. However, ESMA acknowledged that it could start a procedure at its own initiative, and it stated that its involvement with the stakeholders group as well as having more staff will allow it to take a more proactive stance. There has only been one case brought by an NCA, and it concerned the application of one provision in the Undertakings for Collective Investment in Transferable Securities framework. In this case, the ESMA Board of Supervisors opted to issue an opinion on how such a provision should be interpreted.

As acknowledged by ESMA, supervisory convergence needs to be given priority in the future. Within the ideal of a single market, ensuring consistent transposition of laws—in which the European Commission plays a role—and convergence in supervisory practices is critical to minimize the risk of regulatory arbitrage and an unlevel playing field. The experience from the Financial Sector Assessment Programs, as well as conversations held with different stakeholders during these programs, lead one to the conclusion that the risk of regulatory arbitrage arising from inconsistent supervisory practices and/or interpretations of current regulations must not be overlooked.

To this end, reengineering and strengthening peer reviews would be essential to step up work on supervisory convergence. Breaches of laws and mediation procedures only would be fit for a limited set of cases. This leaves peer reviews as a key mechanism to foster convergence. The main two objectives of the reengineering should be: (1) making reviews more rigorous by, for example, relying more on on-site work; and (2) sharpening their outcomes, by linking the reports to the development of best practices and/or guidelines. Implementation of such guidelines could later be monitored and followed up in a systematic manner, and if necessary, stronger actions (such as a breach of law) could then be taken. Achieving these objectives might also require a stronger role for ESMA in the peer review groups as well as in the review panels. ESMA should draw a comprehensive strategy in this area. As supervisory convergence cuts across the whole organization, the development of the annual plan of peer reviews should consider input from all the standing committees.

As a principle, it is also important that NCAs take the necessary steps to ensure that ESMA’s opinions and guidelines are enforceable in their respective jurisdictions. Some stakeholders have expressed concerns that in some countries the opinions and guidelines of ESMA are not being incorporated into the national framework, which creates uncertainty for them. This is an issue that needs to be addressed, if necessary by changes to the domestic legal frameworks, as appropriate.

ESMA’s Role in Financial Stability

Direct Supervision of CRAs

Since July 2011, all registration and supervisory responsibilities concerning CRAs were transferred from the NCAs to ESMA. ESMA has a dedicated unit for the supervision of CRAs. Currently this unit has 16 staff (15 officers and the head of unit), with a mix of policy, market, and supervisory experience. There is also a Technical Committee chaired by the executive director, composed of NCAs and observers of the European Commission, EBA, and EIOPA, which provide advice to the unit on its policy work and international cooperation.

Since its operation, the CRA Unit has conducted significant supervisory work. This work included:

  • Registration and certification. The unit provided advice and assistance to NCAs with the application process. Since July 2011, it has taken charge of the assessment of new applications, with one new CRA being registered upon application received directly by ESMA. There are currently 18 registered CRAs and one certified CRA. There are five applications pending.

  • Perimeter. ESMA contacted roughly 30 companies whose activities could be considered to fall under the CRA Regulation and requested explanations. It is currently preparing guidance on the scope of the CRA Regulation.

  • Ongoing supervision. ESMA is taking a multidimensional approach, which includes desk reviews and on-site inspections, both horizontal (thematic) and vertical (on individual entities). Last year, it conducted on-site inspections of three global CRAs. As a result of these inspections, ESMA (1) sent individual reports to each CRA with a request for changes and a plan for implementation, and (2) published a report summarizing its main findings, which is available on its website. Based on the findings from these inspections, it is currently conducting a review of banking rating methodologies. In addition, based on its risk analysis, it has decided to conduct a vertical, individual on-site inspection on the internal controls of another CRA. Following the CRA Regulation, the CRA Unit must conduct inspections on all CRAs by 2014.

  • Development of a central repository. This is a data repository that makes available information on the past performance of ratings (with a six-month lag) through the ESMA web page. CRA3 will require such data to be available in real time. Another information technology tool, the Supervision of Credit Rating Agencies Tool, will facilitate the processing of ratings data in a standardized and automatic manner to support ESMA’s supervisory activities.

  • Coordination with non-European Union regulators. ESMA has finalized memorandums of understanding (MoUs) with a number of jurisdictions. In addition, it has been actively involved in the International Organization of Securities Commissions’ consultation on the establishment of a global “college” for CRAs.

Over the next couple of years, ESMA needs to finalize the implementation of its risk-based supervisory approach for CRAs. The CRA Unit has made significant progress in the development of a CRA Risk Assessment Framework to anchor its supervisory program. It is estimated that roughly 70 percent of the supervisory resources would be spent on the large CRAs; however, the approach of the unit is to ensure some minimum engagement with all CRAs, even the small ones. Thus, each CRA has been assigned a relationship manager who is in charge of continuously monitoring it. Feedback from the relationship managers would be one of the inputs for the risk assessment framework. Such minimum engagement would include also annual meetings with the compliance officers of the CRAs.

Once the inspections on all CRAs are concluded, it is estimated that on an ongoing basis the unit will conduct two thematic reviews and two vertical reviews a year, in addition to other supervisory work (registrations, handling of complaints, etc). It would be important, however, that after the initial on-site inspections required by regulation for all CRAs, small CRAs are at least included from time to time in the samples for thematic on-site inspections. In addition, meetings with senior management of the CRAs should be considered. A key challenge in supervision would continue to be striking a right balance between the need to supervise the methodologies used by the CRAs to ensure that they are “rigorous, systematic, continuous and subject to validation” and the need to not interfere with their content, as required by the regulation.

It is also important that ESMA keeps close coordination with the NCAs. Due to their functions—in particular concerning market surveillance and the monitoring of issuers—the NCAs could provide valuable information to feed ESMA’s risk-based approach.

Oversight mechanisms should continue to strike the right balance in the role that the ESMA Board of Supervisors should play in connection with CRA supervision. CRAs represent the first case where an ESA has direct supervisory powers. Therefore, it is critical that the exercise of this role is structured well from the start. Furthermore, since ESMA will get supervisory powers in connection with trade repositories, current oversight arrangements for CRAs should also serve as a blueprint. In this regard, as currently developed, the monitoring of specific and supervisory work should remain at the level of the ESMA Management Board, while the role of the ESMA Board of Supervisors should be one of oversight. This oversight should be exercised through the discussion and approval of the work plan and the risk-based supervisory approach that the CRA unit is developing, as well as through periodic reporting on the accomplishment of the work plan, as currently appears to be the case. Engagement in connection with individual supervisory work (for example, conduct of individual on-site inspections) should remain at management level.

Finally, as part of the review of the ESAs, the enforcement framework for CRAs should be reviewed. Recently, through secondary legislation, the European Commission established the amount of the fines that can be imposed.5 The framework requires disclosure of the sanctions after their imposition by the ESMA Board of Supervisors. However, the sanctions that ESMA can actually impose appear to be rigid, since the approach seems very mechanistic. Moreover, depending on the size of the CRA, in practice the sanctions could be too low to have a deterrent effect—although it is early to predict whether the publication of the sanction would suffice to alter behavior.

Identification and Monitoring of Risks

Risk identification and monitoring is the responsibility of the Economic Research and Stability Unit. As of November of 2012, this unit was composed of six staff. In addition, there is a standing Committee for Economics and Market Analysis.

Projects underway will allow ESMA to make a qualitative jump in its contribution to financial stability and crisis management. Projects include work in four areas:

  • Periodic reports. Risk identification is mainly based on the continuous monitoring of a set of indicators. This then feeds into two periodic reports6 that must be approved by the ESMA Board of Supervisors. Currently this analysis is done based on publicly available data. The two reports are:

    • A quarterly risk dashboard. ESMA has produced seven risk dashboards. This publication is a market trends analysis divided into four categories: liquidity risk, market risk, contagion risk, and credit risk. The content of these reports is similar to that in reports produced by central banks. ESMA acknowledges that a key challenge is to adjust the categories/indicators in the risk dashboards to securities markets. A recent improvement, for example, was the inclusion in the most recent report (2012:Q2) of an indicator of stress in securities markets. A second challenge is to develop a set of early warning indicators, based on risks that originate in securities markets.

    • Biannual report of trends, risks, and vulnerabilities. ESMA produced its first such report last year. The first section aims at providing a systematic analysis of markets; the second is a replica of the dashboard(s), and the third contains a thematic analysis of risks that deserve attention. ESMA acknowledges the need to further improve this report by having a more systemic analysis of the markets within its remit, which also requires improvements in the indicators to be followed, as discussed above.

  • Thematic work. Two reports have been completed, on the risks associated with the current industry trends toward structured and complex retail products and an assessment of the size of shadow banking. Ongoing thematic work includes the following analyses: (1) the credit default swaps market, (2) the contribution of the hedge fund sector to systemic risk, (3) high frequency trading in European equity markets, and (4) bank funding issues and securities financing transactions.

  • Techniques for stress testing securities firms. ESMA is focusing on three types of firms: trading venues, hedge funds, and central counterparties. However, at least in the first case, its informal request for data from the NCAs met with opposition, and the NCAs requested a strategic discussion at the level of the ESMA Board of Supervisors on ESMA’s stress-testing strategy.

  • Building a full set of relevant data. A data warehouse would incorporate publicly available data as well as the incoming regulatory data. In addition to the operational challenges described above, there are areas where data is not collected at the NCA level, and these gaps will need to be filled.

However, it is critical that ESMA have access to data with the granularity necessary to conduct in-depth analysis, including stress testing. ESMA Regulation provides it with the power to request information from the NCAs as long as such information is necessary to fulfill its mandate.7 However, the recent experience of ESMA indicates the existence of practical challenges. In this regard, requiring a vote from the ESMA Board of Supervisors to provide data to ESMA might hinder its ability to be timely in its work.

It is important that the ESMA Board of Supervisors take a more active responsibility in risk identification and monitoring. The board has had discussions on risk in the context of the current crisis. What is key is that risk identification remain a recurrent agenda item for all meetings of the board and that input from those discussions be given to the corresponding unit (Economic Research and Financial Stability Unit). The same applies to the Committee for Economics and Market Analysis.

Crisis Management

ESMA’s role and its powers in crisis management generally focus on coordination. Pursuant to its regulation, it only has direct powers where sectoral legislation provides it with such power—which is the case in the short-selling regulation—or when an emergency has been declared by the European Council.

The short-selling regulation provides ESMA with direct but exceptional intervention powers. This regulation grants temporary intervention powers to NCAs. Measures available include (1) increased transparency requirements; (2) prohibiting or restricting natural and legal persons from engaging in short sales on a trading venue or otherwise limiting transactions on a specific financial instrument in such a trading venue for a maximum of three days in certain circumstances; (3) an outright prohibition on short-selling for a period of time; and (4) imposition of conditions on a short sale or transactions that indirectly create short positions. If an NCA intervenes, it is required to notify ESMA, which has to issue an opinion within 24 hours on whether it considers the measure necessary to address the exceptional circumstance faced by the NCA. If ESMA considers that there is a threat to financial stability that is not adequately addressed by the NCA’s actions, it has the power to take any of the measures available to NCAs.

The use of these powers is a source of concern, although ESMA itself has not made use of them. In November 2012, two NCAs issued bans on short selling. There were concerns in the market that the bans were not identical, creating challenges for their implementation. ESMA did not use its direct intervention powers in this case, but it was required to issue an opinion on the measures of the NCAs.8 While it could be argued that in the short term a restriction on short selling can slow down a downward spiral, in the medium term restrictions on short selling affect liquidity and price formation. Second, if such measures are to be used by NCAs, it is critical that NCAs aim at implementing nonconflicting and preferably identical measures, unless differences in domestic market structures do warrant the differences.

The development of a framework to deal with crisis management is a welcome priority. ESMA has recently started work on crisis management, with the goal of identifying the potential crisis scenarios where it would need to be involved and establish a framework to deal with such events. The starting point was the development of a definition of “crisis” for securities markets (i.e., one that seriously affects orderly trading or financial stability, with cross-border implications and an urgency element). Such a definition led to the identification of six types of events that would fit into it: (1) an EU-wide trading suspension; (2) an EU-wide ban on short selling; (3) EU-wide suspensions of redemptions of units in Undertakings for Collective Investment in Transferable Securities; (4) if a settlement fails on a pan-European basis; (5) EU-wide product intervention measures; and (6) failure of clearing members and central counterparties.

A first output from such work is a protocol for exchanging information in connection with central counterparties that (1) identifies the potential emergency situations faced by central counterparties; (2) establishes principles for the exchange of information; (3) sets mechanisms for such exchange; and (4) identifies the information to be exchanged. It would be important that in addition to developing a framework for each type of crisis identified, ESMA coordinates simulation exercises.

Investor Protection

Investor protection issues are within the remit of the Investment and Reporting Unit. This unit currently has 17 staff, but it covers a wide array of issues in addition to investor protection. In addition, the Financial Innovation Standing Committee was recently established to assist ESMA in fulfilling its investor protection responsibilities. Its main function is to identify risks to investor protection and to financial stability in the financial innovation area and then to produce a risk mitigation strategy. There is also an Investor Protection and Financial Intermediaries Standing Committee.

Although it is still at an early stage, the emphasis on product monitoring is a very positive development. The objective is to monitor products sold to retail investors mainly to determine whether appropriate disclosure exists. Effective monitoring of financial innovation should also have a positive effect on financial stability. Currently, the main tools for monitoring are market intelligence, received through a network of regulators as well as industry participants, and data from private vendors. Through the Joint Committee, the ESAs have embarked on a project to determine the type of information that is critical for the authorities to have in order to make risk assessments (including, for example, complaints and information on products sold), as well as the format for that information. Other areas of emphasis are investor education and guidelines on information distribution and suitability obligations.

Granting product intervention powers to ESMA would strengthen its role. Currently, the main tools at its disposal to address risks to investor protection are warnings. It is expected that the second Markets in Financial Instruments Directive will give it product intervention powers, which is a good development. However, it is critical that such powers be exercised cautiously, since ESMA is not a direct supervisor, and that a clear and transparent protocol for their exercise be developed. On the other hand, the proposal to provide it with preapproval powers should be carefully evaluated, since the proposal seems to pose more risks than benefits. Such risks include slowing down innovation and the potential moral hazard brought by a supervisory body’s giving early approval.

Cross-Sectoral Arrangements

According to the ESMA Regulation, the Joint Committee serves as a forum for cooperation and exchange of information among the ESAs, as well as for fostering cross-sectoral consistency. The chairs of the three ESAs sit on the committee. In addition, the executive directors, a representative from the European Commission and the ESRB, and the chairs of any of the subcommittees of the Joint Committee all participate as observers. The Joint Committee does not have a permanent secretariat, but each ESA has committed one staff person to it (these are the rapporteurs). The chairperson rotates on an annual basis. Each year the rapporteur from the ESA that is chairing the Joint Committee takes the lead on producing the committee’s different documents, as well as setting the agenda for the meetings. The agenda for the Joint Committee meetings is set up taking into consideration requests from the three ESAs. A work plan is developed on an annual basis, based on feedback from the three ESAs. The bulk of the technical work is conducted by subcommittees, composed of the staff of the ESAs, who then report to the Joint Committee. There are currently four subcommittees.

The Joint Committee needs to adapt to the changing role of the different ESAs. As the authorities acknowledge, the Joint Committee had a slow start, since the first year was devoted to setting up the rules of engagement. However, the subcommittees have started to work on important projects, following their 2012 plan, such as their work on packaged retail investment products and on the harmonization of data on consumer trends. Thus the authorities should continue to commit resources for this cross-sectoral work. The establishment of a single website for the Joint Committee should add transparency to its work.

Cross-sectoral work on risk assessment has proven challenging. To some extent this is reasonable, since risk identification is a new focus for some of the ESAs (including ESMA). It is key that this work be closely coordinated with the ESRB to avoid overlap.

Looking Ahead

It is important that the authorities develop a framework for ECB cooperation with ESMA in the context of the proposed Banking Union and the ECB’s new supervisory role. The banking union will primarily affect the authorities involved in the prudential supervision of banks, but it will also have an influence on ESMA’s work. National banking supervisors and securities supervisors presently cooperate extensively on a day-to-day basis regarding the supervision of specific banks. An important question is how day-to-day coordination will be arranged when the prudential supervision of banks moves to the ECB. The current proposal already includes the duty of the ECB to cooperate with the ESAs, but the scope of such operations would need to be defined.

In the short term, it is not desirable to assign additional direct supervisory functions to ESMA beyond those already in the European Market Infrastructure Regulation. The institution needs first to acquire certain stability in connection with its current mandate and deliver in the areas mentioned above. In particular, in connection with the central counterparties, ESMA will benefit from the experience of the other ESAs regarding its own role and the work of colleges of supervisors.

In the medium term, it would be worth exploring whether further centralization of supervisory functions in ESMA is desirable. There are a few areas where such centralization would be desirable, as listed below. However, it should be acknowledged that in many of the cases listed there are challenges (fiscal, legal, and/or operational) that would need to be addressed first.

  • Facilitating cooperation in connection with third-country regimes. Given the global nature of financial services, global regulatory convergence is key. Regulatory convergence does not necessarily mean that all countries should have the same regulation, but rather that the trend is to move more and more toward mutual reliance. In this context, ESMA could play a role in helping to set up these systems of mutual reliance—for example, through a determination as to whether the frameworks are “equivalent” enough or to facilitate the execution of MoUs.

  • Direct supervisory activities where “domestic” presence is not critical, and/or where synergies and expertise would benefit from a centralized approach. This category could include (1) supervisory responsibilities in connection with issuers’ information, from the approval of the prospectus to the review of all the periodic and ongoing information that issuers are required to submit; and (2) market surveillance.

  • Direct supervisory responsibilities in connection with firms with pan-European reach or where a home regulator is not clear. The list here could include (1) central counterparties (for which European Market Infrastructure Regulation already provides ESMA with some role), (2) trading venues, and, potentially, (3) auditors.

Regulation 1095/2010 of the European Parliament and of the Council of November 24, 2010, establishing a European Supervisory Authority (European Securities and Markets Authority).

In addition, there are observers from the European Commission, ESRB, EBA, and EIOPA. Norway, Iceland, and Liechtenstein also attend as permanent observers.

Article 81 of ESMA Regulation requires the European Commission to conduct a review of the performance of the ESMA by January 2, 2014 and every three years thereafter. The same obligation exists in connection with EBA and EIOPA.

Committee on Economic and Monetary Affairs, European Parliament, “Opinion, for the Committee on Budgets, on the General Budget of the European Union for the financial year 2013—all sections, 2012/2092.”

Infringements are grouped in categories, and a minimum and maximum fine is assigned to each category. For example, the “lowest” category contemplates sanctions ranging from €10,000 to €50,000 and the “highest” category from €500,000 to €750,000. Aggravating and mitigating factors trigger increases or decreases, respectively, whose amounts are also specifically prescribed in the regulation.

There is also a weekly Financial Monitor.

Only when the information is not made available in a timely fashion and after following certain steps can ESMA request it directly from market participants.

Recently, the United Kingdom brought a suit against the European Parliament and the Council of the European Union for granting such powers to ESMA. The suit is pending (C-270/12).

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