Lynn Strongin Dodds looks at the FIA paper’s recommendations on the positive impact derivatives can have in an integrated EU financial landscape
The idea of a Capital Markets Union (CMU) was first mooted in 2015, and the blueprint is still being mulled over by European policymakers. While a finishing line is still not evident, a recent paper – Capital Markets Union at a Critical Juncture – from the Futures Industry Association (FIA) argues derivatives should play a key role in building a strong integrated financial landscape.
One of the main reasons is that exchange traded derivatives (ETD) are a deep and liquid asset class which offer a more efficient price discovery process, less friction and lower trading costs. In addition, the report highlights a study by the Milken Institute that demonstrates the positive impact they have on economic growth when deployed by banks and non-financial firms.
This is because using derivatives enables a larger volume of commercial and industrial loans, which in turn increases business outlays. Moreover, investors assign higher valuations to non-financial firms that employ them which enhances their attractiveness. Finally, their well documented hedging attributes helps firms to manage risk, enabling more loans and investment in capital.
The big question, of course, is when will the CMU become a reality? EU finance ministers have committed to a 2029 deadline, but negotiations have stalled for nearly a decade because members do not want to relinquish control of national financial rules.
Proponents of the CMU are concerned that these issues will derail the project with discussions either fizzling out or focusing on measures that trigger financial instability, reinforcing the bloc’s market fragmentation, according to a policy brief by think tank, the Jacque Delors Centre. This is despite EU leaders’ best efforts in April and June to move the needle substantially forward
If things do not progress, banks will continue to dominate the European financing landscape. They account for a weighty 70% of corporate funding which is in sharp contrast to the US where they comprise only 20%. Currently, only a handful of countries have well-developed capital markets with bonds being the only exception. The result is a wide chasm with the US boasting an aggregate market capitalisation equal to 227% of GDP versus the 81% in the bloc, according to figures from the European Central Bank.
In order to move the needle, the FIA believes several steps need to be taken including “promoting an open, competitive, pragmatic, predictable, safe, well-regulated and fair marketplace for domestic and international financial institutions alike.” This translates into the increasing transparency, public stakeholder engagement and certainty to cut through the often complex and lengthy EU legislative process.
The trade group also calls establishing a fit-for-purpose regulatory environment that benefits both regulated financial institutions and their customers. In addition, the legislation should facilitate client choice on where to clear.
However, the FIA stresses this does not mean a complete overhaul of the frameworks but a finetuning of the existing rules. It also advises engaging in international dialogue with peer regulators and global standard setters to be on the same page to avoid a hodgepodge of legislation that is not only costly but also disincentives investment.
As for the derivatives piece of the CMU specifically, the FIA stresses the need to support clearing and address the many concerns such as margin transparency as well as constraints in accessing central counterparties (CCPs) and liquid and eligible collateral. It believes that appropriate capital requirements and the reduction of other restrictive measures can alleviate clearing capacity for intermediaries.
The FIA paper also underscored the importance of preserving the competitiveness of all EU market participants when further developing the CMU. It highlighted policies such as the active account requirements under EMIR 3 which need to be properly calibrated to ensure the clearing ecosystem is efficient and effective. The proposal for these accounts is part of the long-held ambition of policymakers to encourage clearing within the region’s confines and to reduce reliance on systemic non-EU CCPs, as well as build a more attractive and robust EU clearing market.
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