Conference Report: ‘The Future Framework for European Capital Markets – Law and Finance’

When European banks were hit by financial calamity, a lack of alternative funding arrangements deepened the crisis. Stronger European capital markets would have changed that picture, because savers and borrowers could have sidestepped frail banks. This rationale has given momentum to the European Commission’s push to create a European Capital Markets Union ('CMU'). The CMU should unlock funding for small and medium-sized enterprises ('SME's) and infrastructure projects, boost economic growth, and diversify the economy’s funding sources to increase financial stability. Now, the question is how to best achieve these objectives.

In January 2017, at an event jointly organised by the University of Oxford, Columbia University and the European Corporate Governance Institute, scholars and policymakers met at the University of Oxford to bring expertise in law, economics and finance to bear on this issue. This conference report covers three themes: rules for effective capital markets, institutional design, and the implications of Brexit for further development of the CMU. Because Chatham House rules applied, discussions and comments are anonymised.

1. Rules for Effective Capital Markets

Equity Markets and Entrepreneurial Finance

Because of their fixed-costs aspects, capital regulations place disproportionate burdens on smaller firms. Merritt Fox argued that calls to alleviate these regulatory burdens, especially in the case of ‘truly new securities’, can be counterproductive. The first time securities are offered to the market, information asymmetries between the issuer and potential investors are particularly large, creating adverse-selection problems that can cause the market to unravel. This problem will not be solved by market-based alone, which implies a role for regulation. That is why Fox views many reforms meant to ease the ‘regulatory burden’ on SMEs with scepticism; they ignore the fact that ‘burdensome’ regulatory processes play an essential role in countering these adverse-selection problems. Instead of abolishing such regulation, he proposes to review the questions that must be answered under the traditional registration process. Questions that add more cost to the process for smaller issuers than they reduce adverse selection should be eliminated. This approach can only be taken so far. Ultimately, Fox concluded, the reality is that, for firms below a certain size, the cost of what is still required will make a public offering an impractical form of finance.

Such firms could, instead, turn to various forms of crowdfunding. In Fox’ view, allowing these forms of funding can be compared to legalising space for certain kinds of gambling notwithstanding that the odds are always against the gamblers. To the European Commission, however, crowdfunding is a cornerstone of the CMU framework. Lars Klöhn outlined the regulation of crowdfunding in Europe. There is currently no specific crowdfunding regulation at the European Union ('EU') level, and more general capital markets regulation, such as the Prospectus Directive or MiFID, allows for a great variety of national regulatory regimes in the area of crowdfunding. Klöhn proceeds to discuss the British and German regimes, two very different models. He argues that both create functional markets, where crowdfunding platforms compete on the quality of their investor protection. This suggests, according to Klöhn, that the ‘hands-off approach’ currently adopted by the European Commission is appropriate for now.

However, when a hands-off approach turns to neglect the start-up environment is at risk. Thomas Hellmann warned that, for all the attention on the early-stage start-up financing, European ‘scale-ups’ – entrepreneurial companies that are past their initial exploratory phase and are aiming for fast growth – lack the access to finance their peers in the United States enjoy. He argued that scale-up investors need to satisfy four criteria (financial muscle, expertise, networks and long horizons), and analysed the funding conditions in the US, Europe and Canada. Europe and Canada, he argued, face six challenges in terms of catching up to the US, related to the overall market size of scale-up funding, the creation of larger venture funds, the challenge of avoiding selling companies too early, the creation of a venture debt market, finding ways of reinvigorating tech IPOs, and designing better markets for secondary shares.

Debt Markets

Securitisations, once considered symptomatic for discredited pre-crisis financial engineering, are about to make a comeback. The problem with securitisation was not the tool itself, but the moral hazard that was generated because issuers had too little ‘skin-in-the-game’. Jan-Pieter Krahnen argued that post-crisis reforms fail to align the incentives of originators and investors. He constructed a new risk-retention metric and found that even though the nominal retention is always five percent, the true level of loss retention across available retention options can vary between zero and full loss retention. By requiring disclosure of this new metric for all ABS-transactions, the real levels of risk-retention can be made more transparent, which allows investors to adjust their prices accordingly.

For debt capital markets to be truly European in scope, the European Commission believes that insolvency law should be, too. Horst Eidenmüller, argued that, because this is currently politically inconceivable, the European Commission focuses on preventive corporate restructuring frameworks that can be accessed pre-insolvency. He criticised the Commission’s proposal on the basis that it will lead to a rise in financing costs. First, it will create a refuge for failing firms that should be liquidated. Second, it rules out going concern sales for viable firms. Instead, Eidenmüller proposed a regulation allowing European firms to opt into a ‘European Insolvency Regime’ in their charter. By providing companies with an additional option, rather than replacing old ones, horizontal regulatory competition between Member States for the most attractive insolvency law is preserved, whilst also introducing vertical regulatory competition between the Member States and the EU. Such a proposal, he argues, does not contravene regulatory traditions of the Member States, nor does it restrict their freedom to experiment. If the proposal is flawed, market participants will simply not use it.

Regulating Financial Innovation

Regulating a rapidly changing financial sector poses challenges for regulators, especially if the innovation that drives such change takes place outside the conventional regulatory perimeter. Dan Awrey unpacked one such set of financial innovations related to ‘shadow payment systems’. Legally and operationally, payment systems have traditionally been part of the conventional banking system and benefited from the regulatory regime that covered it. Liquidity support from central banks, for example, relaxed the application of traditional insolvency law so that the banks, and the payment systems within them, could continue to operate even during periods of stress.

However, because the rapidly developing shadow payment system resides outside the perimeter of regulated banks general corporate insolvency law is not relaxed under periods of stress. Awrey examined the risks this creates for customers of such shadow payment systems. Two risks, delayed conversion or transfer (illiquidity) and a potential write-down of customers’ claims wherever they are characterised as unsecured liabilities in the context of an insolvency proceeding (loss of value), stand out. Awrey then evaluated the effectiveness of various strategies that might be employed to address these risks, but found them wanting. The broader contribution of the paper, he concluded, is to highlight the important role of the law and legal institutions in supporting liquidity and stability within the financial system.

Financial innovation can also be a, sometimes unintended, consequence of financial regulation. When regulators, after the financial crisis of 2007-2009, imposed heightened capital and liquidity requirements, their aim was to improve the resilience of the affected institutions. But, as Kathryn Judge outlined, these same regulatory initiatives may in fact have contributed to the fragility of the financial system as a whole. She proposed a framework for understanding the relationship between financial regulation, investor preferences, and financial innovation. A new legal intervention, here the introduction of capital and liquidity regulation, can act as a source of constrained capital. That is, to meet the new regulatory requirement, investors’ demand for a particular type of financial product grows. When the ‘natural supply’ of this type of asset is outstripped by that demand, such assets might be synthetically produced. That process of financial innovation, in turn, can lead to increased complexity, interconnectivity, and rigidity in financial markets, which can increase financial fragility.

2. Institutional Design

Designing a Capital Markets Union also entails the creation of a new institutional architecture that covers the entire EU. But harmonizing conditions in previously fragmented markets comes with challenges. Luzi Hail studied the implementation of two EU directives, the Market Abuse Directive (MAD) and the Transparency Directive ('TPD'), and assessed their effect on market liquidity. Both directives were designed to give investors more and better information, which increased market liquidity and led to more efficient capital markets. But these benefits are not uniformly distributed. Countries with a history of higher regulatory quality and stronger track records of implementing and enforcing rules saw liquidity rise by about twice the average, whereas countries with a weaker track record saw virtually no benefits. Counterintuitively, harmonization actually led to larger differences between countries. The result that prior conditions matter poses a challenge to regulatory harmonization initiatives, because those differences are not easily overcome by isolated regulatory initiatives. Instead, Hail argues, it may require coordinated institutional change of the kind that can be politically complex to achieve.

As regulatory reforms are designed and ultimately implemented, it is critical to remain aware of their interactions. Veerle Colaert examined the multitude of post-crisis reforms in the area of investor protection, and identified three pervasive trends. First, in the area of information, the paradigm of rational investment decisions remains central to investor protection regulation, but has been fine-tuned in light of behavioural insights. Second, conduct of business rules have been enhanced, and their scope of application has been broadened. MiFID II, for example, now applies such rules to structured deposits (banking products), in addition to the traditional financial instruments (investment products). Third, in a departure from a liberal approach towards retail investor protection, product regulation has been revolutionised. Product quality requirements, for example, form an important part of the directives that apply to the management of investment funds (the UCITS Directive and the AIFMD). These three trends frequently interact, sometimes in ways that are not fully understood. Accordingly, Colaert concludes that, as EU capital market regulation becomes more comprehensive, the key challenge will be to knit the various rules relating to investor protection together to create one well-functioning investor-protection scheme.

3. Brexit, and New Proposals for the Capital Markets Union

The impending Brexit will affect the development of the CMU project. Unconventionally, Georg Ringe argued that Brexit is irrelevant for European financial markets. Opposing those who fear an ‘almost Apocalypse-like’ scenario, his optimism is grounded in the substantial economic stakes for the United Kingdom ('UK') and the twenty-seven remaining EU Member States in retaining the benefits of the European Single Market for financial services. Given these joint economic interests, and based on past examples in EU financial market integration, Ringe argued that the outcome will satisfy the referendum result but still keep Britain closely involved in the EU’s financial markets. The broader point, he concluded, is that there is a strong tradition of politics or economics trumping law. Brexit will inevitably come, but more in form than in substance.

In the discussion that followed, Ringe’s account was questioned on three fronts. First, it was noted that the politicians in charge of the negotiations vastly underestimate what is at stake. In the UK the value of reciprocal access is overestimated (the UK is far more reliant on access to the EU than vice-versa), and in the EU politicians have no experience with being cut off from the Union’s major financial centre. Any threat from London that the City would no longer be accessible for European firms will be too easily dismissed. Second, the misalignment of objectives – returning sovereignty on the one hand, and retaining market access on the other – runs deep, especially because the EU aims to retain control over its financial system. Paradoxically, the one deal that sustainably resolved this tension, membership of the EU, has just been rejected. Third, any deal will be complicated and will likely take too long to conclude. In response to the protracted uncertainty generated by these negotiations, firms will move out of the City. Understanding these dynamics ex ante will undermine incentives to conclude a deal in the first place, especially in the EU. As one discussant grimly concluded: ‘it is likely that what none of us wants to happen will happen anyway’.

European Union officials have publicly stated that Brexit does not invalidate the CMU project, but rather underscores its importance. Discussants concurred, but also noted that the plans for the CMU will have to change dramatically. Currently, the EU’s capital market activity overwhelmingly takes place in the UK, and this has strongly influenced the initial CMU plans. The UK particularly objected to any changes to the division of power, and refused to cede authority to the Paris-based European Securities and Markets Authority ('ESMA'). That meant market oversight remained fragmented, although in practice most of it was carried out in the UK. Once the UK leaves the EU it leaves a regulatory void that ESMA is neither authorised nor equipped to fill. It operates more as a technical body that coordinates national regulators than as a strong regulator in its own right. New CMU proposals should, therefore, not only include a new mandate for ESMA, but also reform its governance and expand its funding. If implemented, a single regulator would allow the CMU to integrate beyond what was possible prior to Brexit.

Thom Wetzer is a DPhil Candidate in Law and Finance at the University of Oxford.