Trend Sight 2024

AI
Trend Sight
November 2023
Read more

Contents 2
Contents
Introduction 3
01 Financial Services 11
02 Capital Markets 22
03 Asset Management 30
04 Reporting and Accounting Firms 38

Introduction 3
Introduction
Trend Sight addresses important trends and risks in the financial sector.
Trend Sight provides background, depth, and coherence regarding relevant supervisory topics. Early detection and understanding of changes in the sector contribute to a risk-oriented, forward-looking, and preventive supervisory approach. In this way, we give shape to our mission to strengthen ourselves for fair and transparent financial markets and contribute to sustainable financial well-being. In chapters 1 to 4, the most important trends and risks are outlined for our four supervisory areas – Financial Services, Capital Markets, Asset Management, and Reporting and Accounting Firms – Two in-depth analyses accompany the publication of Trend Sight 2024 on (i) the pricing of climate risks in the housing market and (ii) algorithmic collusion in capital markets. These in-depth analyses are published separately.

Trends
General Developments
Economic growth is slowing, with persistent inflation and rising interest rates as major causes. In 2022, inflation rose sharply due to significant price increases in energy. Central banks worldwide intervened with tight monetary policy to moderate inflation, but core inflation, in particular, has not yet been contained. It is expected that in 2023 and 2024, inflation will remain well above the ECB's target of 2%. Meanwhile, the Netherlands is experiencing a slight recession, as growth figures for the first and second quarters of 2023 were just below zero. The Dutch economy is expected to grow by 0.7% over all of 2023 and by 1.4% in 2024, while the labor market remains tight.1 This modest economic growth, however, is vulnerable to disappointing economic growth in world economies such as the US and China and geopolitical tensions.

Government intervention has so far limited the financial consequences of high inflation and rising interest rates for Dutch households, but vigilance is required. The vulnerability of the economy is reflected in the financial position of households. Households feel the high inflation in their wallets, among other things through more expensive groceries and rising energy costs. The government is taking measures to dampen the consequences of this, especially for low-income households. This is preventing the expected increase in the number of people in poverty for the time being. Concern for the vulnerable remains high and therefore has the attention of supervisors and policymakers. The picture on credit markets is still stable. Mortgage rates are largely fixed for the longer term, and house prices are adjusting to the new interest rate levels without major shocks. Indications of increasing payment problems for consumer or mortgage credit are still non-existent or negligible. Only a severe economic downturn would worsen this picture, but that is not currently anticipated.

Within the financial sector, high inflation and rising interest rates have a significant impact on business models and the financial valuation of assets. The rise in central bank policy rates causes interest rates on government and corporate bonds to rise. The transition to higher interest rates generally means a healthier business model for many financial companies. It also leads to a more robust financial system because it contains fewer incentives to seek returns through risky activities. However, the transition to higher interest rates also leads to a decrease in the value of outstanding debt. As a result, holders of fixed-income securities are particularly affected. The expected value of companies that rely on the promise of their

growth potential (such as startups in the tech sector) decreases, while financing at very low interest rates is no longer possible. With ongoing inflation, rising interest rates, uncertainty in capital markets, and the high speed of news dissemination, it is conceivable that this will lead to abrupt price fluctuations and liquidity problems in the coming period.

Digitalization
Developments in artificial intelligence (AI) are proceeding at breakneck speed and create opportunities and risks for the financial sector. The applications of AI (for example, Large Language Models, such as ChatGPT) will have an increasingly large impact on society and the economy, and thus also on the financial sector. In general, AI can contribute to making the financial sector more efficient by taking over various administrative, data processing tasks, and risk management tasks. Additionally, AI can be used for direct service provision in the form of advisory services, designing and executing trading strategies, personalizing prices for credits and insurance, executing targeted marketing campaigns, and so on. The use of AI can also bring risks, for example when it is unclear how an AI model arrives at a certain outcome. Furthermore, personalization using AI can lead to certain consumers being discriminated against or excluded from the market based on the algorithm used. It is important that financial institutions take sufficient control measures to reduce the risks of the use of algorithms and to be able to explain the outcomes of AI models. The European AI Act, which is under development, will offer more leverage points to channel the potentially large impact of AI in the right direction, but it will most likely lag directly behind the advancing technological possibilities.

The digitalization and platformization2 of the financial sector are continuing at a steady pace. Think primarily of the intertwining of the financial sector with (large) tech companies. The intertwining of large tech companies often leads to lower costs and greater efficiency, but also causes greater dependence and concentration risks, vulnerabilities such as digital crime, and reduced leverage points for supervision. The crypto market also remains in motion. With the advent of new crypto regulation, Markets in Crypto-Assets Regulation (MiCAR), a legitimizing effect may arise, which incorrectly gives the impression that crypto assets are less risky (cryptowashing), leading to renewed interest from consumers (and malicious parties). The development of the underlying technology (distributed ledger technology, DLT) is still trying to fulfill the promise in the form of a shift from the traditionally centralized financial system to a peer-to-peer financial system (decentralized finance, DeFi). For now, DeFi also carries multiple traditional financial risks, and these are further strengthened by the international decentralized nature and the increased complexity of the underlying technology.

Sustainability
Achieving the climate goals of the Paris Agreement is under pressure.3 This leads to the risks of climate change, including extreme weather, sea-level rise, and biodiversity loss, increasing further. In the Netherlands, this means, among other things, increasing financial damage due to drought, flooding, and extreme weather. Much of this type of damage is uninsurable, which can lead to significant financial risks for households and businesses. Societal awareness of this still needs to gain momentum (see also the In-depth Analysis "Pricing Climate Risks in the Housing Market").

The societal and political desire to give momentum to the sustainability transition is growing. The demand for green (investment) products is increasing. This leads to strong incentives in the market to meet this demand. A wave of new sustainability regulation is unfolding. This regulation primarily focuses on improving transparency regarding sustainability risks and impact, and aligning financial products with customers' sustainability wishes. Trust in the 'green' label is crucial for the transition. This also applies to the risks of net-zero claims by issuing entities and new trends such as voluntary carbon markets.4 Early intervention and course correction by policymakers and supervisors prevents ambiguity.5

In response to the increase in cross-border financial services, we see a movement towards further internationalization of supervision and supervisory convergence. A lot of new, extensive European legislation and regulation is coming up for the financial sector in the short term (see Box 1). Cooperation is also being sought more in the area of supervision, for example between the European regulator for the internal market for electricity and gas (ACER) and ESMA, following the volatile gas market last year. Geopolitical tensions play an important role globally, and European strategic autonomy is in the political spotlight.6 For a healthy financial system, both a robust banking system and resilient and diversified capital markets are important. This has led to renewed interest in the European Capital Markets Union (CMU). This is a European project to allow money from investors to move freely across European capital markets. Supervisory convergence is of great importance for this.

Integrity and Criminal Behavior
Criminal behavior undermines the integrity of the financial-economic system. Trust in the financial sector can be damaged if financial companies are consciously or unconsciously involved (affected) in criminal activities. Money laundering enables criminals, among other things, to use illegal income to finance new criminal activities. It also offers the possibility to acquire positions in bona fide companies with criminally acquired wealth. Money laundering is a manifestation of the broader societal problem of undermining, where undermining refers to various forms of crime that blur the boundary between the upper world, including the financial sector, and the underworld. In the accounting sector, fraud in a controlled company that is not detected or reported in the statutory audit can lead to material losses for shareholders and a broader loss of confidence in financial markets.

Digitalization and internationalization increase the possibilities for criminal behavior. Technological developments and the internationalization of financial markets promote access for many new players to financial markets. Criminals are also creative in exploiting opportunities offered by technology, digitalization, and cross-border services. We see this, for example, in the increasing reach of foreign malicious providers of investment products. Such malicious activities have a major impact on (groups of) victims who suffer damage from them. The AFM focuses on cooperation with (inter)national chain partners to combat criminal behavior.

Risks
For the various supervisory areas, we summarize below the risks that arise or accelerate as a result of the above trends and developments.

Financial Services. Within financial services, the pension transition is one of the themes that stands out. The transition leads to a more personal and transparent pension system that better fits the needs of this time. Nevertheless, the system change is complex. It brings impactful and irreversible choices with it. This increases the importance of careful choice guidance. In the area of digitalization, targeted and aggressive advertising via social media and low-threshold accessibility of embedded products and services create risks regarding consumer protection. The rapid rise of AI brings risks due to potentially uncontrolled use, because of the black-box character, and through the use of incorrect or unreliable data. For the housing market, climate risks are having an increasing impact, which can lead to significant financial consequences for (future) homeowners.

Capital Markets. On capital markets, the information processing accelerated by digitalization enables market participants to quickly incorporate new data, such as macroeconomic conditions, geopolitical tensions, and climate change, into their decision-making. This can lead to sudden price shocks that cause liquidity problems and put pressure on the orderly functioning of markets. Additionally, increasing digitalization places high demands on the controlled operation of capital markets. Insufficient control of algorithms can lead to errors in these algorithms or unexpected interference between different algorithms. Capital markets are cross-border, and this also applies to trading activities. Cross-border market abuse therefore requires extra attention. To make well-considered investment decisions, high-quality information remains essential. Due to the fragmentation of European capital markets, there is too little central market and price information. Market dynamics and complex regulation ultimately contribute to concentration in the trading chain through the so-called winner-takes-all effect. Dependence on a few institutions makes markets less robust.

Asset Management. Within the asset management supervisory area, attention is paid, among other things, to the strategic repositioning of parties in the form of (cross-border) mergers and acquisitions, which leads to consolidation and market power. We also see that technological developments are changing the operations of asset managers and the wealth management chain. The increasing outsourcing of (parts of) business processes to (a few large) service providers – including cloud platforms – makes the asset management sector as a whole vulnerable to cyber incidents at such nodes. The important role that asset management parties play in the sustainability transition is also an issue. It is important that asset managers integrate sustainability into their operations, manage the risks of the sustainability transition, and are transparent towards investors about how sustainability is implemented. Due to the high volatility in capital markets, we pay extra attention to liquidity risks in the asset management sector, as these may undermine the financial stability of the system.

Reporting and Accounting Firms. Accounting firms are facing changes due to digitalization and sustainability that affect the controlled company, the statutory audit, and the accounting organization itself, creating new material risks. Therefore, increasingly higher demands are placed on both the company's reporting and the knowledge and expertise of the accounting firm. Additionally, cyber risks are gaining importance, also for accounting firms themselves. Furthermore, sustainability and the economic conjuncture create an increased risk of fraud and discontinuity, which accounting firms must be alert to. Finally, we see pressure on the accessibility of statutory audits, among other things due to personnel shortages. The developments taking place in response to this, such as the influx of private equity into the segment of organizations with a regular license and supervisory arbitrage at Public Interest Entities (PIEs), negatively affect the quality of statutory audits.

Regulation
Box 1 Overview of Important European Regulatory Trajectories Various European regulatory trajectories are ongoing that have an impact on the AFM and/or market participants. This box highlights the most important regulatory trajectories. Some of these trajectories are also addressed elsewhere in Trend Sight.

DORA (Digital Operational Resilience Act). DORA comprises a European directive and regulation with the primary goal of controlling systemic risk and the resulting consumer and investor risk. DORA sets uniform requirements for financial institutions in areas such as ICT risk management, ICT-related incident reporting, control of ICT risks in outsourcing to third parties, and contains a European supervisory framework for critical third-party providers (CTPPs), such as large cloud service providers. DORA will apply to institutions that are regulated in Europe. For example, DORA will apply to trading platforms, central counterparties, credit institutions, investment firms, and investment institutions. DORA entered into force in January 2023. Market participants have until January 2025 to comply with the relevant provisions.

MiCAR (Markets in Crypto-Assets Regulation). This is the first European legislative package that regulates crypto assets and related services. This legislation and regulation applies to both issuers of crypto assets and providers of crypto services and provides uniform rules in the EU. MiCAR was published in June 2023 and will enter into force in Q4 2024 after an implementation phase of 18 months. The implementation phase gives market participants and supervisors the opportunity to prepare.

Revision of MiFID II (Markets in Financial Instruments Directive)/ MiFIR (Markets in Financial Instruments Regulation). The proposal for the revision of MiFIR primarily focuses on adjusting the rules regarding the trading of financial instruments and transparency provisions related to this trading. MiFID is hardly adjusted. In June 2023, a political agreement was reached in the trilogue negotiations between the European Commission, European Parliament, and Council of the EU. The agreement includes, among other things, a consolidated tape (CT) and a European ban on payment-for-order-flow (PFOF). At this moment, only technical points are being worked out. The European Parliament is expected to vote on the revision in December 2023 or January 2024.

SFDR (Sustainable Finance Disclosure Regulation). This regulation has been applicable since 2021. The lower-level regulation has been applicable since January 2023. Based on this regulation, information about the negative sustainability impact of the entity and of products, as well as information about sustainability characteristics and objectives of products, must be provided in a standardized way. The SFDR aims to give investors more insight into sustainability risks and the sustainability aspects of financial products and to make them more comparable. It is also intended to combat greenwashing. For a uniform European definition of which economic activities are sustainable, an EU Taxonomy has been developed. Part of this has been applicable since early 2022. In the SFDR information, it must also be indicated, where applicable, to what extent investments are aligned with this taxonomy. In 2023, an extensive assessment of the SFDR framework started to identify any shortcomings.

CSRD (Corporate Sustainability Reporting Directive). To strengthen transparency regarding sustainability and other non-financial matters, the Non-Financial Reporting Directive (NFRD) has been revised. A new name was chosen for this directive: the Corporate Sustainability Reporting Directive. The CSRD greatly expands the scope of the NFRD by making sustainability reporting mandatory for smaller listed companies and for all large non-listed companies. Additionally, the CSRD stipulates that companies report according to the ESRS, a uniform reporting standard for sustainability reporting established in Europe. The obligations will (for the larger listed companies falling under the CSRD) start in

1 'Macro Economic Exploration', CPB, September 2023.
2 Platformization is the offering of financial products and services via online platforms.
3 See for example: 'AR6 Synthesis Report Climate Change 2023', IPCC, March 2023.
4 See for example: 'Voluntary Carbon Markets', AFM, April 2023.
5 See for example: 'Guideline for Sustainability Claims', AFM, October 2023.
6 'Council adopts conclusions on strategic autonomy of the European economic and financial sector', European Council, April 2022.