The European Union's markets watchdog said on Thursday it was on red alert for contagion after inflation stoked by Russia's invasion of Ukraine has threatened markets' ability to function in an orderly way.

The European Securities and Markets Authority (ESMA) in its latest risk monitor report gave an overall red risk rating for markets, with only credit risks and environmental risks flashing amber, and none green.

Contagion and operational risks, such as liquidity, were very high, it said.

Against a backdrop of already increasing inflation, the Ukraine war has profoundly impacted financial markets, leading to rapid price rises and volatility, especially in commodities.

"These present liquidity risks for exposed counterparties and show the continued importance of close monitoring to ensure orderly markets, a core objective for ESMA," Verena Ross, the watchdog's chair, said in a statement.

As European Union states revert to more polluting sources of energy, such as coal to cut dependence on Russian energy, EU investment funds, which tout their environment, social and governance (ESG) credentials saw net outflows for the first time in two years in March.

But the fundamental shift into ESG investments continues overall, with ESG assets averaging 27% of the total in the second quarter of 2022, compared with under 10% in the first half of 2020.

Russia's invasion of Ukraine raised questions over the compatibility of sustainable investment practices with the financing of non-democratic regimes or weak democracies, ESMA added.

"The Russian invasion highlights the importance of the 'S' (social) pillar in ESG investing and its clear link to 'E' pillar," ESMA said.

During the first half of 2022, there was also big drop in crypto-asset prices and liquidity, meaning investors with big positions have limited options to exit, ESMA said.