Consultation document on post-trade in a Capital Market Union: dismantling barriers and strategy for the future

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1 15 November 2017 European Commission DG Financial Stability, Financial Services and Capital Markets Union Rue de Spa Brussels Belgium Submitted via to: fisma-post-trade@ec.europa.eu RE: Consultation document on post-trade in a Capital Market Union: dismantling barriers and strategy for the future Dear Sirs, BlackRock, Inc. (BlackRock) [1] is pleased to have the opportunity to respond to the consultation document on post-trade in a Capital Market Union, issued by the European Commission. BlackRock supports a regulatory regime that increases transparency, protects investors, and facilitates responsible growth of capital markets while preserving consumer choice and assessing benefits versus implementation costs. We welcome the opportunity to comment on the issues raised by this consultation paper and will continue to contribute to the thinking of the Commission on any issues that may assist in the final outcome. Delivering Capital Markets Union While definitions of what specific components might constitute a Capital Markets Union still vary, first and foremost, Europe must create a single capital market that works in the interest of its main beneficiaries: asset owners. Asset owners are the end-investors from individual savers to institutions such as pension funds, insurers, and corporates, all investing in the Europe s real economy. On this premise, we urge the European Commission to look at how both investors and companies currently interact with the market and assess whether improvements can be made to allow each greater ease of entry, and to create new opportunities to connect investors capital and real economy sectors that need investment. More broadly, policymakers need to incentivise both savers, investors, and companies to participate in a reformed capital market. For a company, the greatest incentive is generally a lower cost of funding. The picture is more complex for savers and investors as they have varying liabilities, investment objectives, and regulatory constraints. Generally, however, they have to feel confident to commit their savings in the capital markets. The more investor-centric the regulation, the greater the potential flows of capital that savers will be willing to invest to both their own and the economy s benefit. This should be the starting point for policymakers: putting Capital into the Capital Markets Union. Dismantling the barriers to Europe s post-trade arrangements will be a fundamentally important element of a successful delivery of the CMU. [1] BlackRock is one of the world s leading asset management firms. We manage assets on behalf of institutional and individual clients worldwide, across equity, fixed income, liquidity, real estate, alternatives, and multi-asset strategies. Our client base includes pension plans, endowments, foundations, charities, official institutions, insurers and other financial institutions, as well as individuals around the world. i

2 Key post-trade issues for end-investors The European Commission s consultation paper covers a range of issues which vary in relevance for the asset management value chain and the end-investors experience of European capital markets. In this letter we focus on the more relevant themes and points for policy makers to consider. 1. Post-trade market organisation The most important issue, in our view, is that disclosure requirements across products and jurisdictions are far from being harmonised. This needs to be addressed in the context of CMU. The optimal conditions for investment are created by regulatory regimes that protect investors and facilitate responsible growth of capital markets. They also maintain consumer choice and properly balance benefits versus implementation costs. Financial market transparency, delivered through appropriately detailed and timely reporting, underpins well-regulated and robust markets where risks are monitored and properly understood. The 2008 global financial crisis laid bare that financial markets were at that time lacking the regulatory framework that protects investors today. Enhanced reporting to regulators and disclosure to investors subsequently became a cornerstone of the global regulatory reform following the global financial crisis. Today, regulators around the world continue to introduce reporting regimes in line with the objectives of the Pittsburgh Declaration. These initiatives are generally laudable in aim and sensible in their conception. The initiatives are manageable in isolation, however, due to different reporting requirements, regulators cannot assess and compare the information they receive, particularly at the global level. In its review of the cumulative impact of post-2008 regulation, the European Commission has acknowledged the concerns raised by stakeholders regarding the usefulness of multiple and often duplicative data requests. By addressing the following issues, regulators would be in a position to strike a better balance between stimulating economic growth and adequately monitoring concentrations of risk in the financial system. Over the short term we encourage regulators to focus on: Clarity of purpose: It is important to understand how data that regulators gather would be analysed and used, and how the data could be leveraged to provide feedback to the broader market. Standardisation of requested information: We encourage regulators to move towards standardisation of data requests. This ranges from reaching globally agreed measures and definitions of key terms through to a common approach on the detail and the frequency of requests. Standardisation on how information is reported: Electronic data delivery whenever and wherever possible should be the objective. This would substantially improve the accuracy and quality of data as well as the timeliness of reporting. At the global level we propose that the International Organization of Securities Commissions (IOSCO) expands upon its recently announced data gaps in asset management study by undertaking an assessment of how substantially similar data requests vary across their member jurisdictions and second, establish a working group tasked with agreeing on a common transaction reporting template for relevant capital market products and activities. Over the medium term we encourage migration to uniform reporting platforms. Major jurisdictions as EU and US each have multiple reporting platforms. A significant step, given the questions that need to be addressed around regulatory remit and data sharing, would be for each jurisdiction to commit to a single internal reporting platform. Over the longer term, a single global data repository should be the goal. Subject to robust reassurances regarding cyber security and the protection of data, a single global data repository could be set as a long term ii

3 objective. Short of that, reporting identical data to multiple databases would mark a significant improvement over the current framework. 2. Technological developments and their implications for post-trade Technological developments may provide solutions to current post-trade issues, but expectations need to be calibrated regarding the extent to which processes can benefit from, for example, distributed ledger technology (DLT). Currently, the primary use of DLT is as a cryptographic ledger for Bitcoin/Crypto transactions. Other uses include storing digital records, exchanging digital assets, and executing smart contracts. What take-up there has been of DLT in the financial services industry has been very much concentrated in the banks, which have invested in a number of start-ups and engaged in number of partnerships. We have seen sell-side (bank) involvement in blockchain solutions for: repo; corporate bonds; bank loans; settlement; clearing; issuance; derivatives; payments and remittances; collateral management and syndicated loans. DLT represents a shift in software development and maintenance models, but significant progress must be made to address outstanding issues before wider industry take-up is possible. In the future, a secure shared ledger could bring issuers and asset owners closer together. However, there are a number of barriers to widespread adoption by the financial services industry, including: Latency: transactions can take up to 10 minutes to process. Privacy: all transactions are disclosed to the entire network. Unclear legality: currently, the regulatory environment means regulation and contract validity is uncertain. Consensus: the transaction approval mechanism is at odds with the demands of financial markets 3. Exchange Traded Funds Index investing has profoundly changed the way investors seek returns, manage risk, and build portfolios. For nearly 50 years, index investment vehicles have lowered costs and simplified access to diversified investments for all investors, from sophisticated institutions to individuals. Technology and data have also transformed the range of investments that can be tracked by an index. Choice now extends beyond traditional equity indexes - which include stocks in proportion to their market-capitalization - to a whole array of more dynamic indexes compiled according to other methodologies. These can be used to create investment products that serve a wide variety of needs for example, products that track indexes with exposure to specific investment styles such as value or quality stocks, and other asset classes such as fixed income and commodities. Although the benefits of index investing are widely recognized, concerns and media commentary have focused on its market impact. We recently addressed a range of these concerns in our ViewPoint: Index Investing Supports Vibrant Capital Markets 1. The Commission s consultation document raises the potential for Exchange Traded Funds (ETFs) to experience liquidity disruptions, with implications for financial stability. It is useful to clarify a number of details around the trading and liquidity of ETFs versus that of the underlying securities they hold. Given that this question is concerned about financial stability, it will be helpful to focus on fixed income (bond) ETFs. We have seen a deterioration in bond market liquidity since the Global Financial Crisis (GFC). Pre-crisis, liquidity in bond markets was underpinned by banks and broker-dealers (market-makers) warehousing inventories of bonds. 1 BlackRock (2017) Index Investing Supports Vibrant Capital Markets, available at: iii

4 The events of the GFC and subsequent wave of regulation mean we have seen a reduction in the balance sheet size of firms acting as market makers. The consequence has been a drop in inventories and repo financing, in turn leading to the observed drop in bond market liquidity. Turning now to the mechanics of ETFs, it is critical to understand that there are two levels of ETF trading and liquidity. One level is the intraday buying and selling of ETF shares on an exchange, at a market-determined price. These transactions provide liquidity to ETF shareholders without requiring the ETF provider to transact in the underlying securities. The vast majority of ETF investors can only trade shares on an exchange. This is referred to as secondary market liquidity. The other level consists of Authorised Participants (APs) a small group of sophisticated investors who trade directly with ETF providers, based on rules underpinning the creation and redemption of ETF shares. APs create or redeem shares in ETFs in exchange for the appropriate basket of securities when it is in their interest to do so. When increased demand or supply for ETFs shares causes their price to diverge with the net asset value (NAV) of the ETF s holdings, APs are heavily incentivised, but not required, to create or redeem ETF shares to benefit from this discrepancy. This is referred to as primary market liquidity. Primary market liquidity of an ETF will normally reflect the liquidity of the underlying assets. The reason for this is the pass-through nature of an ETF and the creation/redemption mechanism inherent in the ETF structure. APs will react to increased demand for an ETF by creating new ETF shares. In order to fulfil that obligation, the AP or their agent will generally buy the assets relevant to the ETF in question. In the same way, decreased demand will generally result in ETF shares being redeemed and the underlying securities sold by the AP or its agent. Secondary market trading in ETF shares does not require transaction activity in the underlying securities. The secondary market (exchange-traded) trading volume for most ETFs is typically a multiple of the volume of creation/redemption activity. By facilitating demand from buyers and sellers through a transparent, exchangetraded instrument, ETFs may in fact provide incremental exchange liquidity beyond that of the underlying assets. Given this, we would question the notion that ETFs may experience liquidity disruptions, and that ETF activity could have implications for financial stability. It does not hold that trading activity or liquidity conditions in the secondary market necessarily has implications for that of trading activity or liquidity conditions in the primary market. Indeed, there are a number of examples of periods of market volatility where ETFs were beneficial to liquidity conditions. The volume of exchange trading in fixed income ETFs tends to spike when markets reprice fixed income assets. For example, during the Financial Crisis, as liquidity in corporate bonds traded over-the-counter deteriorated in June 2008, the ishares iboxx $ Investment Grade Corporate Bond ETF (LQD) continuously traded on exchanges in an orderly manner and more than quadrupled volume. Similarly, the so-called Taper Tantrum in the summer of 2013 followed an unexpected announcement by the Federal Reserve that it intended to cut back its ongoing program of repurchasing bonds, sparking widespread fear of rising interest rates. Bond prices fell steeply during June, followed by a rebound the following week. During the selloff, volume in the ishares iboxx $ High Yield Corporate Bond ETF (HYG), the largest U.S. high yield bond ETF, rose to as high as 25% of the underlying high yield bond market. iv 4. Collateral re-hypothecation The consultation document also suggests the potential for re-hypothecation of collateral to be systemically risky, and raises the possibility that thin margins on certain types of financial instruments [could lead to] excessive securities lending, with implications for financial stability. BlackRock does not believe that lenders of securities or their appointed lending agents contribute to systemic risk, as there is no opportunity for the introduction of leverage. When contracting with a potential borrower, both parties specify collateral guidelines which will govern all transactions with that borrower, including the types of

5 eligible collateral and the overcollateralization level (or haircut) for each type. Collateral is marked to market daily to ensure that the total amount of collateral posted by that borrower for that fund matches the requirements set out in the collateral schedule. While the lender has access to the collateral in the event of a counterparty default, borrowers typically retain the right to substitute any collateral posted for other eligible collateral at their discretion. To balance the needs of borrowers and lenders, a common operational practice in the securities lending market is the appointment of tri-party agents for handling non-cash collateral. This allows the collateral to be held for the benefit of the clients and therefore accessible in the event of a borrower default while also allowing the borrower to manage which collateral is posted. In Europe, collateral posted to BlackRock s lending clients for securities lending transactions is cannot be re-hypothecated by agent lenders or beneficial owners, eliminating the possibility of that collateral being used in subsequent transactions or introducing systemic risks. BlackRock s European lending clients all use tri-party agents. Unlike lenders and lending agents, the borrowers have the ability to use the securities they receive through lending transactions in subsequent transactions. Typically, the borrowers that BlackRock lends to are full-service broker-dealers which are likely to on-deliver any securities borrowed to an end client. 5. Access to market infrastructure BlackRock is supportive of efforts to ensure effective supervision of critical financial market infrastructures and of close cooperation between supervisory authorities for the benefit of global financial stability. However, we would emphasise the importance of ensuring that end-investors - the ultimate beneficiaries and users of financial markets are able to access to the post-trade infrastructure they require, regardless of where that infrastructure is located. An efficient, open, multi-currency clearing environment benefits the wider European economy. For more a more detailed discussion of this issue, refer to BlackRock s response to the Commission s proposal on more robust supervision of central counterparties Tax barriers We fully support both the Code of Conduct and the OECD s renewed interest in the TRACE project, to facilitate the administration of withholding taxes generally. We believe the European Union should be a supportive participant in the TRACE discussion. But we further believe that the strength and depth of capital markets in Europe is supported by having sizeable and efficient collective investment schemes that are able to draw in investment from across the Union and around the world. European investors in such funds get to benefit from the economies of scale. However, the difficulties such funds face in obtaining practical access to tax treaty relief, which is important to their commercial success, are not purely administrative. There remains considerable uncertainty, after the BEPS Action 6 process, about whether individual governments worldwide continue to be committed to the principle (set out in the OECD 2010 report) that funds should be entitled to claim treaty relief in their own name. We view the action of the German government (in unilaterally granting all genuine, regulated collective investment funds access to the concessionary 15% rate of withholding on German equities) as a positive example. Conversely, we view any use of the Limitation of Benefit approach (allowed as an option in the Action 6 report) as problematic for European UCITS funds given these are often successfully marketed to investors from 30 or more countries. The TRACE implementation package is designed around an unstated assumption that mass market funds will be allowed by source countries to claim treaty relief in the own name, without look through to the underlying investors. We believe there is a real opportunity for European governments to take a coordinated leadership position, by declaring clearly that i) of the two approaches in the BEPS Action 6 report, they prefer the Principal Purpose 2 BlackRock (2017) European Market Infrastructure Regulation 2.0 (CCP Location Policy) Key issues for end-investors, available at: v

6 Test over the Limitation of Benefit and that ii) genuine, regulated, widely held funds should be presumed to meet the Principal Purpose Test in the absence of evidence to the contrary. This would give welcome clarity to European UCITS and other funds, allowing their continued successful development, to the benefit of the European capital markets. We welcome further discussion on any of the points that we have raised. Yours faithfully, Stephen Fisher Global Public Policy Group vi