By Elizabeth Howcroft and Phoebe Seers
PARIS, Sept 10 (Reuters) - A disconnect between deteriorating macroeconomic conditions and upbeat valuations risks triggering a market drop, the European Union's financial watchdog said on Thursday, citing conflict in the Middle East and rising energy prices.
"Investor optimism continues to support elevated valuations despite rising geopolitical tensions and a weakening economic outlook. The wider this gap becomes, the greater the risk of an abrupt market correction,"
ESMA Chair Verena Ross said.
The European Securities and Markets Authority also said operational risks across financial markets were at a very high level and rising, driven by growing cyber threats and advances in AI which can discover and exploit cyber vulnerabilities.
In addition, ESMA reiterated its long-standing concern that shocks in crypto markets could spread into the rest of the wider financial system due to their growing links.
ESMA said that while tokenised equities, a kind of crypto product based on equity derivatives, are currently "negligible" relative to the global stock market, adoption was increasing and could affect market structure.
The regulator also highlighted the risks of growing institutional interest in fast-growing prediction markets, as market infrastructure providers, such as exchanges and investment funds, seek partners in the industry.
"Market manipulation and insider trading risks reach new levels in the context of prediction markets," ESMA said.
The ability of users betting on the outcome of real-world events, including sports, wars and elections, to use crypto "hinders the detection and prevention of insider trading, wash trading and coordinated market manipulation", ESMA said.
"A growing number of incidents illustrates that prediction markets are rife with insider trading," it added in the report.
(Reporting by Elizabeth Howcroft in PARIS and Phoebe Seers in LONDON; Editing by Kirstin Ridley and Alexander Smith)
