The last four years have seen unprecedented reform and regulation in the financial benchmark industry. Regulators, who uncovered widespread manipulation at numerous financial institutions have been left with no option but to legislate. The aim of the new regulations is to promote high standards of design and governance, and to improve the integrity of benchmarks to sustain confidence in the financial markets they support.
With the most substantial draft of legislation nearing ratification – The Regulation of the European Parliament and of the Council on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (the Regulation), – firms involved in benchmark activities should now formulate their strategy to regulatory compliance.
What to Expect
The Regulation defines an index as a figure which is publically available and is regularly determined, either by applying a formula to or making an assessment of a representative set of underlying data. This captures benchmarks which are referenced in:
- financial instruments traded on trading venues;
- mortgage and consumer credit contracts, and;
- those used to measure the performance of investment funds.
It is interesting to note that this definition will not capture all benchmarks. For example, a benchmark used to support only instruments which are not traded on trading venues, would not be in scope.
Most importantly for asset managers, composite or blended benchmarks (those where benchmarks are combined together to form a new benchmark rate) will be considered ‘use’ of these benchmarks rather than ‘administration’ of a new benchmark. This means that asset managers blending two or more benchmarks together to create a composite benchmark will not become Benchmark Administrators under the Regulation for this activity.
Other exemptions include benchmarks which reference the price of a single financial instrument (such as the price of a specific share) will not be in scope, nor will benchmarks provided by Central Banks (such as the Base Rate) or other authorities for public policy purposes (including standard measures of inflation). Standard variable rates offered by credit institutions will not be considered benchmarks when used in mortgage or consumer credit contracts.
The Regulation will supersede the UK’s Financial Conduct Authorities (FCA) existing rules and affect a wider set of firms than the UK’s current rules. These can be divided into three main groups: benchmark administrators, contributors and users.
The Regulation will require the authorisation or registration of benchmark administrators, who will then be subject to supervision against the requirements in the Regulation. These requirements, like the IOSCO Principles for Financial Benchmarks, cover governance and accountability as well as the design and methodology of any benchmarks provided.
Benchmark contributors who already conduct regulated financial activities and provide data which are not readily or publicly available will need to meet additional requirements to ensure the integrity of their submissions. Their governance and systems and controls will be subject to supervision by national competent authorities.
Supervised users will need to ensure that they have in place written plans in case the benchmarks they are using cease to be produced. These plans would include designating alternative benchmarks, if and where appropriate. This issue was exposed during the Libor scandal when users and regulators realised that there was no viable alternative benchmark on standby. Additionally, some benchmarks may not prove strong enough to meet the requirements of the Regulation or be commercially viable, and therefore cease to be produced.
Recognition of non-EU benchmarks
Users who are already supervised entities including credit institutions, asset managers, UCITS funds and AIFMs, will no longer be allowed to use a benchmark unless it is provided by an authorised or registered administrator in the EU or, in the case of third countries, the third country administrator has been recognised or the benchmark has been endorsed.
The Regulation contains mechanisms for all benchmarks to be admitted for use in the EU but these do require action by their administrators to either become ‘recognised’ in the EU (by a relevant national competent authority) or to have their benchmarks ‘endorsed’ by an EU supervised entity who would then become responsible for ensuring that benchmark was provided in a manner consistent with the Regulation. It is anticipated that all the major non-EU benchmark administrators will utilise one of these routes to authorization. It is possible, however, that some benchmarks will not pass this test, in which case it will not be possible to reference these benchmarks in the EU post implementation of the Regulation.
How to Prepare
Firms must not to wait until the Level 2 regulatory process is finished before taking steps to focus on the risks the Regulation is seeking to address. Firms are also urged not to only focus on what is now set to be the scope of the Regulation; indices that are outside the perimeter of the Regulation may also present risks for which controls could be important. Whilst the regulatory approach taken by Europe may be more comprehensive and prescriptive than some other regimes, the aims and expectations are essentially those set out previously by IOSCO.
The Regulation is not only a matter for benchmark administrators, or submitters. Users will be affected too, for example, where administrators fail to become authorised or registered in the EU, their benchmarks will no longer be available for use. Users must identify and manage this risk to minimize disruption to their own business. There are two important steps involved:
- Users should make sure they are aware of which benchmarks they use, and seek assurances from the administrators of these benchmarks that they are aware of the regulation and have plans to comply with it. This is particularly important where the benchmarks are provided by smaller administrators, especially in third countries.
- In anticipation of the future requirements and for clear reasons of prudence, users should start thinking now about potential alternative benchmarks in case any benchmark they currently use becomes unavailable. Contingency plans such as robust contractual fall back clauses are necessary in case a benchmark cannot be used, or is no longer available.
Many benchmark administrators and users have already begun to raise their standards under the IOSCO Principles ahead of the EU Benchmark Regulation. Additionally, some users have already documented their benchmark activities and produced benchmark governance plans.
Blending benchmarks together into a composite benchmark will be permitted as ‘use’ of a benchmark and will not require the user to be supervised as an ‘administrator’ under the Regulation. However, it is prudent to document the process and methodology used to create such benchmarks, and preferable to have independent calculation and verification checks of the new benchmark created.
The Regulation will set minimum standards for benchmarks, make them more robust and transparent, and therefore less easily manipulated. But, benchmark users must take responsibility for ensuring the benchmarks they use are appropriate, and that they have plans in the event that a benchmark is no longer available.
In the UK, the FCA will be looking to support administrators, contributors and users of benchmarks in meeting the new standards, the FCA team will be reaching out to market participants to provide information that will help them. They have created a mailing list which we will be used to update recipients on the regulatory changes.