| 10-11-2016 | Carlo de Meijer |
The European Commission recently launched an update report on the state of the Capital Markets Union (CMU) project. A comprehensive program of actions set out a year ago to put in place the building blocks for this CMU by 2019. Aim is to create deeper, and more integrated capital markets across the EU to lower costs and make the market more resilient. One year later this project is still “lacking an organic and coherent set of actions to bring down cross-border barriers and create a single market for capital, which could support the effectiveness of monetary policies”, according to the Commission.
It however is important that the CMU project moves forward with greater speed. A financial market infrastructure that would permit more funding via the capital market is however not yet in place. Besides under CMU categorisation, post trade issues are considered long(er) term actions.
An intriguing question is: Could blockchain play a role in bringing the EU Capital Market Union forward?
Existing inefficiencies
But first, why a European Capital Market Union? The free movement of capital across the EU is one of the three key freedoms enshrined in the Treaty of Rome. This however is still far from its realization.
Over-reliance on bank financing
Europe’s businesses cannot fully exploit the opportunities of an efficient EU capital market. They are over-reliant on bank financing such as bank loans. Many small and medium enterprises (SME) have limited access to the financial markets, especially to venture capital and capital markets. Access to capital markets in Europe is unequal and varies significantly across member states. Investments in shares and corporate bonds occur mainly domestically, where different rules and standards apply.
“The proportion of European company finance that comes from banks is high, around 80 per cent. Less than 20 per cent comes from investors. Figures from the US are the opposite. While the European economy is as big as America’s, bank loans in the US account for less than 30% of total funding for businesses, Europe’s equity markets are less than half the size, its debt markets less than a third”, according to Deutsche Bank Research.
Fragmented market infrastructure
In Europe, we have a very fragmented capital market infrastructure (unlike in countries such as US and Japan). Though there has been some moves towards consolidation, mainly at the exchange level, there is even more fragmentation now despite the efforts taken by the industry since 2000.
At present there are 102 regulated markets, 151 multilateral trading facilities, 20 central counterparties (CCPs), 42 central securities depositories (CSDs) or securities settlement systems (SSSs) and 6 trade depositories.
Insufficient regulation
In the post-crisis environment European financial authorities have recognized the importance of efficient market infrastructures at the trading and post-trading levels. They have introduced regulations providing guidelines targeting CSDs and CCPs, and aiming to organise their activities in a harmonised way such as CSDR and EMIR. These regulations should bring further harmonisation in the fragmented post-trade area. And there was the launch of T2S, which aims to eliminate cross-border settlement among participant CSDs.
However: this is a very long process that is still ongoing. These pieces of legislation are either still in planning phase or have only partially been rolled out. Others – namely on settlement discipline – have not yet been proposed. The experience with T2S demonstrates how difficult and lengthy the creation of single market infrastructures is. T2S has gone live, but three more migration waves are needed before implementation is complete. Although T2S only concerns settlement, it should create harmonisation in the custody industry.
Capital Markets Union: the goals
On 30 September 2015 the European Commission launched an action plan setting out key measures to achieve a true single market for capital in Europe. With many obstacles to domestic and cross-border capital movements as well as underdeveloped and fragmented capital markets – especially compared to the US – leading to lower levels of diversified funding for the economy, there is a need for action. In the current political and economic context developing stronger capital markets in the EU is seen as even more important.
An EU Capital Market Union is seen as the logical next step in the integration of European financial markets. The idea thereby is to transform European finance from a primarily bank-based financial system into a system wherein most of the funding is channelled directly to firms and households through non-bank financial institutions and securities markets.
The CMU has three pillars …..
- Unlocking investment for companies, including SMEs and infrastructure projects
- Attracting investments from outside the EU from
- Opening up the EU’s real economy to new investment sources
…… and six goals
- Financing for innovation, start-ups and non-listed companies
- Making it easier for companies to enter and raise capital on public markets
- Investing in long-term infrastructure and sustainable investment
- Fostering retail and institutional investment
- Leveraging banking capacity to rapport the wider economy
- And, facilitating cross border investment
The vision
Through a Capital Markets Union (CMU), the Commission is striving to increase the benefits that capital markets and non-bank financial intermediaries can provide to the economy. By improving the effectiveness of these markets, where barriers and fragmentation will be replaced by deeper and more integrated capital markets. This should contribute to improved stability, capital allocation, business growth and innovation. A single capital market would facilitate improved cross-border risk sharing, more liquid markets and a wider variety of sources of funding.
“This is done by unlocking the capital around Europe, by removing obstacles to the free flow of capital across borders and providing savers cross-border investment opportunities and offering business a greater choice of funding options at lower price” (European Commission, 2016).
The effectiveness of the market could thereby be enhanced with a single rulebook approach, enforcement and competition; supervisory convergence; data and reporting; market infrastructure and securities law; company law, corporate governance, insolvency and taxation; as well as technology.
Challenges
One year after the launch of the CMU Action Plan, the EU faces a number of important challenges that could impact the Capital Markets Union.
Political
The EU is confronted with a number of political issues. According to the head of ESMA, one of these that could really hurt the plans for this Capital Markets Union is Brexit, the upcoming British exit from the European Union. Being the European biggest financial center, London was supposed to play a central role in the CMU and be one of its biggest beneficiaries.
Regulatory
But there are also serious regulatory challenges. Work towards a CMU seems even more complex and politically difficult than the building of the European Banking Union. This given the extremely diverse legislative and regulatory setting of non-bank finance in EU countries, and the resistance of national authorities to release powers to Europe. It is therefore important to progress quickly towards the adoption of forthcoming legislative/regulatory proposals.
Technology
And last – but maybe the most important – there are the technological challenges. The capital markets are currently witnessing a remarkable wave of disruption and innovation, driven by new technologies. Technology has the power to increase the role of capital markets, and bring them closer to companies and investors. It is a driver of competition and helps to create a more diverse financial landscape.
Nasdaq: the wrong focus?
In a report by Nasdaq “Capital Markets Union: The Road to Sustainable Growth in Europe” , the US exchange stated that the concrete measures in the CMU Action Plan mainly focus on making it easier for large institutions to invest more and extend their product and service offerings, rather than improving the capital markets themselves.
For Nasdaq that is the wrong focus. Instead, the Action Plan should focus on increasing transparency, making the capital markets more accessible to smaller businesses, incentivizing long-term private investment in listed equities, and above all encouraging the development and use of disruptive technology to improve the post-trade environment.
An independent report by Systemic Risk Centre, co-hosted at the London School of Economics and University College London, also states that a successful CMU must embrace disruptive technologies.
“The EU and national authorities must alter existing regulatory structures if the CMU is to be achieved, encouraging disruptive technologies and allowing market forces to match savings to investment opportunities more efficiently”, according to the report.
Fintech and blockchain
One area that lies in the center of the technology revolution is the Fintech sector. Next to upcoming regulation, the booming FinTech industry is set to be a strong influencing factor on the planned Capital Market Union. They have the power to seriously disrupt EU capital markets. The technological advances they bring are accelerating, creating new business propositions and revolutionizing the way the financial industry operates. New technologies including blockchain may bring new asset classes to capital markets, but also create inroads for new and currently underserved investors as well as SMEs to access and use traditional financial services.
Blockchain: “el Salvador”?
Of all Fintech trends the most discussed and promising is blockchain– which enables transactions to take place on a distributed ledger that is maintained by a network of computers. This technology is attracting industry-wide interest. The financial industry is now actively looking into opportunities this blockchain technology could bring. They thereby are increasingly engaging with industry bodies as well as clients and blockchain providers to bring more efficiency to the financial industry. Nasdaq is a “big believer” in the ability of blockchain technology to effect fundamental change in the infrastructure of the financial services industry.
“Changes are afoot that hold the potential to revolutionize the way we think about and interact with the world of finance as businesses, investors and consumers,” states the report, while cautioning that “more needs to be done within the scope of the CMU to explore the opportunities offered by this (blockchain) technology.”
CMU and blockchain applications
The role that blockchain could play in a CMU environment is intriguing. According to a growing group blockchain technology could be a catalyst for greater integration of Europe’s financial markets by helping break down some of the long-standing barriers to cross-border investment. This technology brings both opportunities and challenges. Blockchain technology promises to bring financial markets into the XXI century with real-time settlement, corporate actions and risk management.
There is little doubt about the potential gains this technology could deliver in terms of lower transaction costs, shorter delays and greater convenience. The existing market infrastructure is being challenged by blockchain applications that have the potential to render contracting and settlement between market participants cheaper and faster. It may allow full-fledged real-time settlement, corporate actions and risk management services.
In line with the CMU, the potential of a blockchain/DLT venture capital platform could facilitate the supply and demand for SMEs with regards to funding. Either by debt issuing, turning savers into investors and providing more capital access options to companies.
Or by shares issuing – against a light prospectus regime – turning savers into owners. This could be a type of regulated crowd funding by issuing existing financial market products like shares and bonds, but without the burden of legacy systems and infrastructures.
Transforming market infrastructures
Blockchain could prove to be a perfect use case for a complete reform of the securities post-trade value chain, transforming the market infrastructures. This technology has the potential to wipe out traditional post-trading players. As blockchain removes the need for a number of intermediaries in the securities lifecycle, this may lead to substantial shifts in the role of the different market participants and in the organisation of the post-trade landscape. Large central bodies such as clearing houses (CCPs) and central securities depositories (CSDs) would not be needed in a world where the settlement of transactions is completely reorganized and executed real-time and those activities are greatly taken over bij the distributed ledger.
No complete disintermediation
It however is not expected that there will be a complete disintermediation of service providers. While the role of custodians would greatly disappear and those of clearinghouses and CSDs will drastically change in a blockchain environment, the rest of the value chain in the securities industry may remain largely intact. The functions associated with tracking, reconciling, and auditing enormous amounts of data are not going to be disintermediated away. They have to continue to exist, but just need to be done more efficiently, at lower cost and with fewer errors. And also the bulk of financial infrastructures dominated by financial institutions will largely remain. As most of their activities in this area are related with the provision of intermediated capital funding.
European Commission and Fintech
But how is the attitude of the European Commission towards Fintech in general and blockchain particularly?
“Fintech has the power to increase the role of capital markets, bringing them closer to companies and investors” says the European Commission.
As it bids to push the CMU, the Commission is increasingly backing fintech in capital markets. The Commission is thereby highlighting the role that technology including blockchain could play as a driver of competition that helps to create a more diverse financial landscape bringing more choices to consumers, companies and investors.
However, “at the same time, the rapid development of fintech poses new challenges in managing risks and ensuring consumers have adequate information and safeguards,” warns the Commission
They agree that this innovative potential should be harnessed. In a number of EU Member States, regulatory authorities are already developing new approaches to support the development of FinTech firms, including hubs providing regulatory guidance or teams focusing on policy implications of FinTech. The European Commission supports this development and will continue to promote the development of the FinTech sector and work “to ensure the regulatory environment strikes an appropriate balance between building confidence in companies and investors, protecting consumers and providing the FinTech industry the space to develop”.
The Commission will work with the European Supervisory Authorities (ESAs), the European Central Bank, other standard setting bodies, and the Member States to develop a co-ordinated policy approach that supports the development of FinTech in an appropriate regulatory environment.
Buts!!
There are however still a number of buts!!! The directions that these blockchain related developments will take in the end are not (yet) entirely clear. For example, it will most likely take some years before blockchain will have a real, potentially disruptive, impact on parts of the financial services industry. And what those really will be?
And it is also far from certain whether there is a reason to assume that this blockchain technology would, on the whole, eliminate the prevailing risks of the capital markets. While it is certainly true that the opportunities blockchain are promising, digital finance is not immune to errors, manipulations, hackings and other dishonest practices.
The self-regulation of blockchain technology is no panacea either: legal issues have already arisen and any application involving risks to the financial sector will still require supervision. The Commission has the vision that one therefore should not attempt to create an artificial separation in financial regulation, but should instead treat technology neutrally.
Carlo de Meijer
Economist and researcher
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