Germany assumed the rotating presidency of the Council of the EU, i.e., the EU legislature’s upper chamber on July 1, 2020, before handing over to Portugal in January 2021. Germany has held this position many times before and this is Chancellor Merkel’s second rotation in the presidency, her first being in 2007. However, 2020 is already quite different. Challenges posed by COVID-19 in terms of the ongoing health situation, the economic outlook, and the financing of the recovery have all flown into its program of priorities.
In face of the worsening economic outlook, the introduction of previously unthinkable reforms, such as common EU instruments to mitigate unemployment risks in an emergency (SURE), are welcome baby steps (€100 billion in a common backstop is still a baby) but nevertheless decisive. Germany’s change in tune on common debt instruments that have formed part of the EU Commission’s proposed package of measures, and its suggestion that it might take on domestic debt to assist other EU Member States marks what many are calling a “Hamiltonian moment”.
The ECB, which has issued stark warnings on the economic outlook and risk to the EU’s unity, has even stated that it would begin to offer repos of euro-denominated loans against collateral to central banks outside the euro area to backstop funding markets. These will run until at least the end of June 2021, and will complement bilateral repo and swap facilities. This newest support measures come in addition to the June increases to the ECB’s Pandemic Emergency Purchase Programme.
These COVID-19 focused actions have also translated into renewed energy to complete the European Banking Union (through EDIS and other institutional reforms) and grant more powers to the European Supervisory Authorities (EBA, ESMA and EIOPA) (ESAs). The EU is getting serious on transforming its underdeveloped domestic and cross-border capital markets infrastructure of relative to Europe’s economic weight by pushing for action on its Capital Markets Union project in a “2.0” phase as well as to brace for new waves of NPLs.
Brexit is also back in fervor. In June the UK rejected any extension to the transition period and it will enter its final six months of preferential access during the German presidency. As we go to press, regardless of intensified talks, a No Deal outcome is again looking increasingly likely. The EU confirmed late on June 30 that the UK had missed the month-end deadline on assessing equivalence of their respective regulatory rules, which is the basis for finalizing future cross-border trade arrangements in financial services. EU Chief Negotiator Michel Barnier has made it clear that the UK’s proposal for financial services firms to do business across the EU-27 from January 2021 would not be accepted. Firms will need to pick up the pace on preparations and special coverage will be available on our Eurozone Hub. COVID-19 is certainly not wholly to blame for this breakdown in discussions. It may well be that the UK’s attention has been perhaps focused elsewhere, including with respect to on June 30, the UK and Swiss Finance Minister issuing a joint statement on plans to negotiate an ambitious bilateral agreement on financial services. The EU is currently reassessing how Swiss firms can access the EU’s Single Market (as discussed here). It is quite conceivable that the EU may look to take its own action to ensure that the Single Market’s competitive advantages are safeguarded and that the Single Rulebook is strengthened.
The UK also announced in June that it would not be adopting a raft of post-financial crisis reforms affecting trading and settlement in securities. Instead, and it will “tailor” a range of existing rules such as Solvency II in the insurance sector, retail customer disclosure rules such as the PRIIPs regulation, as well as rules on securities settlement discipline. In a stark warning, German Chancellor Merkel stated that the UK will have to “live with the consequences” of ditching Theresa May’s plans for close alignment with the EU after Brexit, and that the German presidency would instead focus on COVID-19 and strengthening the EU rather than rushing through a last-minute deal.
Without equivalence, financial firms in Britain wishing to access the EU’s Single Market for financial services will have to step up plans to open in the EU to continue to service existing, and more importantly, new counterparties and customers. The question will remain whether the EU will be inclined (at some point beyond the immediate divorce) to follow some of this British tailoring. Even if a Saville Row suit is viewed as the epitome of style, for counterparties and clients in the EU, the question whether financial products and services purchased from UK issuers under a lighter-touch regime are of much use - in particular where these repeal existing and/or reject new EU principles or otherwise engage in cherry-picking. Such a risk is much more akin of trying to plug a British three-pronged plug into an EU plug socket. In some EU-27 Member States, it might work but in most, it will most likely not.
Equally, as an alternative to equivalence, reverse solicitation - i.e. where EU based counterparties and customers approach UK domiciled firms and enter into arrangements of their own volition - are increasingly in scope of scrutiny by EU and UK regulatory authorities. There are possible rule changes ahead to complement the EU’s Supervisory Principles on Relocation (see coverage on our Eurozone Hub) (SPoRs). Furthermore, such arrangements are not necessarily, certainly in the eyes of the ESAs, as well as the ECB-SSM, considered longer-term viable solutions for business activity on a larger scale. These statements have been reiterated since 2017 with increasing fervor. While some other compliant and viable structural solutions do exist, the current direction of travel on both sides may mean certain firms (on both sides) might nevertheless need to revisit some of the assumptions made in earlier Brexit-planning. At the very least, they will need to ensure that various policies, procedures and processes are “fit for purpose” so as to meet the much more stringent supervisory expectations set in the SPoRs. All of this poses additional pressures for financial services firms, their counterparties and clients irrespective of where they are based.
Consequently, the next six months will likely be a watershed moment for what the EU may be able to achieve and how they achieve it. Germany, however, takes over the helm of the EU from Croatia with “Europe’s Enron Moment” on its doorstep.
The Wirecard fallout continues to gather pace for the now insolvent firm following the admission that €1.9 billion of cash was missing let alone may not have existed. The pending investigations, insolvency, and international intrigue are also impacting a number of lenders, counterparties and customers with exposure to various parts of the group. The unfolding situation has even attracted coverage from the European Parliament’s own Think Tank, itself a relative first and the “Implications” section makes for interesting reading.
Wirecard Bank in Germany and Wirecard Solutions Limited in the UK, while both not insolvent, have been placed under emergency management by the national authorities so as to continue to carry out its payment services to merchants, credit card service providers, etc. While this points to EU rules on continuity of “critical economic functions” working, policymakers have already hinted at areas in need of improvement.
In particular, as publicly reported, investor protection concerns are emerging following substantiated reports that an accomplished portfolio manager of a leading asset manager, which counts a large base of pension and retail client investors and which is supervised by both the BaFin and ECB-SSM directly, may have breached EU and German risk exposure rules. Specific concern has arisen that asset allocation restrictions, which ordinarily limit a fund holding more than 10% of assets in a single stock, were circumvented. Concern has also arisen around derivatives exposure to Wirecard and the quality of the underlying collateral for those trades, including Wirecard stock. If true, this may also mean that control functions i.e., compliance, legal and risk rather than just rogue actors in the front office might be facing questions.
These publically reported details are of course raising alarm bells directly at the European Supervisory Authorities (notably ESMA) which have already announced a number of common supervisory actions (CSA) putting firms under the microscope for suspected MiFID shortcomings across the EU-27. It is very conceivable, as we have been warning, that despite ongoing restrictions and COVID-19 constraints that have been limiting EU authorities from carrying out on-site inspections, that the use of the CSA tool, coupled with direct powers to request documentation and statements, will continue to gather pace albeit in a more remote and data driven format. The authorities will likely wish to demonstrate they are taking swift action to address any shortcomings that may have occurred at the relevant supervisory authority and/or auditors.
Crucially, despite an open and frank admission from the current head of the BaFin, this respected regulator and erstwhile champion of the importance of national authorities and their proximity to supervised institutions, will itself have to answer tough questions from ESMA, the EBA and possibly the ECB-SSM. The question posed by Germany’s finance minister and others is if the rules are largely fit for purpose, then is the same true of the body that is supposed to be policing compliance? The EU Commission has also indicated, that it could, depending on the results of the preliminary investigations, launch its own enquiry on whether BaFin broke EU law on financial reporting and push for reforms of the EU’s Transparency Directive and how it is implemented in respective national law. Irrespective of these immediate reactions and announcements, the calls from industry but also from former ECB board members, for more Europeanisation of financial services supervision were quick to follow the BaFin’s admission of its failings, which have come even ahead a possible reorganization. In contrast, the relatively unknown German Accounting & Audit Regulator has been relatively quiet.
In addition to pointing at the public authorities, the first “collective actions” i.e., new EU terminology for “class actions”, have been announced as pending against the German and possibly European partnerships of the relevant audit firms. The auditors are at risk of being sued for dropping the ball despite having expressed reservations and questioning the accounts. These pending actions come relatively rapidly after entry into force of new EU rules creating a harmonized framework for collective actions. It remains to be seen whether this perfect storm was a coincidence or a coordinated set of leaked communications possibly of inside information. Certain commentators have pointed to the fact that Wirecard’s collapse, in just one week, came much faster than Worldcom’s (2001) period of four and in the case of Enron (2002) five weeks between accounting issues and insolvency. The pace of developments is causing policymakers to question whether more could or should have been done earlier to intervene (even if legally those powers would not exist beyond the banking arm or where they do, the toolkit is more limited). Some argue this could have facilitated a recovery and restructuring plan, and possibly mitigated the amount of investor losses.
In addition to lawsuits, the auditors may be required to answer a range of questions posed by national authorities across EU Member States, as well as in the UK, where a parliamentary enquiry had during 2019 explored how to redress conflicts of interest between the audit and accounting parts of firms and their consulting arms. Shareholders, short sellers and supervisors are also likely to be interested as to whether these weaknesses at supervisors and auditors emerging in relation to Wirecard may exist at other financial services and fintech firms.
Lastly, German authorities have also taken strides forward to defuse the German Federal Constitutional Court’s recent decision on the Bundesbank’s involvement in the ECB’s PSPP. The German Bundestag is on July 1, set to vote on a motion to confirm the PSPP fulfills the requirements set by the Constitutional Court, which would allow the Bundesbank to continue to conduct PSPP activity. We will keep you posted on the developments following our initial Client Alert on the decision and the outcome of the Bundestag’s vote.
In summary, one can perhaps draw solace in the fact that change is coming to prevent future failings and rout out rogue actors. Reforming financial reporting rules, the BaFin and “Europeanizing” non-Banking Union financial supervision further may take comparably longer but that path is now seemingly cemented into place. In many ways, Germany’s assumption of the rotating presidency, is likely to continue to observe the adage of never letting a good crisis go to waste.