By April Day, Head of Equities, Association for Financial Markets in Europe (AFME)
European equity markets are facing a worrying problem. Liquidity is leaving Europe, and if the current state of affairs remains unchanged, this trend is probably set to continue.
The European Union’s (EU’s) market capitalisation (or the total market value of shares for listed companies) was only EUR 10.4 trillion at the end of 2022, compared to EUR 38 trillion in the United States—in other words, it was less than one-third of US market capitalisation. Furthermore, turnover of EU shares (a measure of liquidity) remained completely flat from 2016 to 2022, while this measure increased by 40 percent in the United States over the same period.
There are, of course, multiple contributing factors to this crisis, but two initiatives are underway that may help to reverse the decline. For example, completing the Markets in Financial Instruments Regulation (MiFIR) review with the right focus could help boost secondary-market liquidity. This review is an important moment for Europe’s capital markets as policymakers consider how to enhance the competitiveness and attractiveness of EU capital markets at the international level.
Europe also aims to improve primary-market issuance through the EU Listing Act, which, once implemented, can simplify access to European capital markets and streamline the listing process as well as post-listing requirements.
Navigating the complexities of the EU’s regulatory framework
Part of the EU’s equity problem is the complex regulatory framework governing how its markets function, including certain restrictions that do not apply in other markets. For banks, explaining this complex regulatory framework to international clients and persuading them to still want to transact in the EU is a long, involved process.
In the EU, rules on share trading require investment firms to ensure that trades occur only on an EU-regulated market or multilateral trading facility. The trading amounts on certain trading venues are capped in favour of so-called public venues. Originally, this requirement was meant to increase transparency, yet it has led to firms being unable to trade in the most liquid markets or pursue the best execution for their clients. Ultimately, this can limit competition and deter investment.
In addition, the costs of complying with regulations and administrative burdens can also disincentivise investment. European issuers face higher capital costs as investors require liquidity premiums for investing in securities that cannot easily be converted into cash. Over time, this impacts where businesses list, making the US more attractive in the long run.
The role of MiFIR
To enable equity markets to thrive, Europe needs a well-developed equities consolidated tape. This tape will provide a window into liquidity across Europe and be accessible to investors. An example is the fund manager in Singapore, who wants to look at Europe as one single market and have the ability to invest in the most liquid markets to construct a deeper and more varied portfolio.
By implementing such a tape, Europe can bring visibility to its true scale, making it a more attractive place in which to invest and creating further opportunities for both investors and companies seeking to list in the EU. This is a major objective of the MiFIR review, with negotiations currently underway on how the tape should be constructed.
The deeper the tape, the deeper the use cases across market participants, and the more viable the tape will become. After years of real progress failing to materialise, a consolidated tape is in tangible reach, so negotiators must now focus on implementing a tape that benefits the whole EU.
In addition to a consolidated tape, the outcome of the MiFIR review should also ensure that a variety of trading mechanisms are offered to investors. Investors want choices in how they execute transactions so they can get the best possible results for their clients. Under MiFID, stocks can be bought and sold on trading venues and through systematic internalisers (SIs).
SIs are important components of the European trading ecosystem as they provide investors with a service similar to how banks provide loans to businesses. When firms act as SIs, they use their own capital and balance sheets to facilitate more efficient and often better-priced executions for clients. In turn, they also benefit end investors, such as pensioners and savers, who entrust their monies to asset managers who trade with SIs to obtain the best possible results. Data shows that SIs contribute an additional EUR 3 trillion annually to European equity-market liquidity that would be lost if the provision of this type of trading were curtailed.
The MiFIR review currently introduces some ill-founded restrictions on trading via SIs. By limiting the investor’s ability to choose the type of execution mechanism that is most suitable for his or her investment needs, the overall global attractiveness of European markets could be negatively impacted.
Increasing liquidity through the EU Listing Act
Equity markets not only rely on secondary-market liquidity but also on the health of the primary market. As more companies enter the market, the greater the number of growing companies, which will capture investors’ interest and increase trading.
Here, the EU also lags behind other markets. For example, the gap between EU and US equity primary issuances has widened significantly over the last five years. From 2018 to 2022, equity issuance in the EU represented 27 percent, or less than one-third of that in the US.
Seeking to improve the EU’s standing, the European Commission (EC) launched a set of proposals known as the EU Listing Act in December 2022. The EU Listing Act aims to increase the appeal of public markets to EU companies by easing the complexities and costs of accessing capital for small and medium-sized enterprises (SMEs).
While this is a promising first step towards increasing Europe’s attractiveness as a desirable location for companies to list, the proposals are not perfect. The European Commission’s blanket proposals to cap prospectus length and remove any requirements for prospectuses for secondary-capital raises under 40 percent in size reduce flexibility and may create material risks for issuance stakeholders. The Listing Act proposals must be revised to ensure that market participants can continue providing the best possible disclosures to protect quality listings.
Putting liquidity first
Europe is at an important juncture to establish itself as a leading equity market. The opportunity to address some structural issues and revise key capital-market regulations, which govern how markets function in the EU, now rests with policymakers.
The US offers deep and broad pools of capital, leading to a market with attractive listed companies and higher activity levels from retail investors. Investors want choices in how they execute transactions to achieve the best executions of regulatory requirements.
The EU now has the chance to step up: first, by establishing a meaningful consolidated tape, which will draw investment focus to Europe as a whole, and second, by ensuring there are sufficient choices in trading mechanisms, which will help to attract investment within and into Europe.
To reverse the deteriorating trends in equity-market liquidity, policymakers must ensure that Europe’s attractiveness and competitiveness as an investment destination are at the forefront of their decision-making.