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EU Benchmark Regulation – RIMES Update

After almost 4 years of legislative work, the EU legislators are now ready to adopt this Benchmark Regulation into law in the 28-country Union. The Commission has released a tentative timetable and the law is expected to enter into force in May or June 2016 and be fully applied by the end of 2017.

To quote Jonathan Hill, EU Commissioner responsible for Financial Stability, Financial Services and Capital Markets in the Union: “Benchmarks are critical for the functioning of our financial markets. Manipulating benchmarks amounts to stealing from investors and consumers and undermines confidence in markets“.

Investment Management Companies will be directly affected by this regulation, as the regulation official title makes very clear:

REGULATION (EU) …./…. 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 (p3)

The text of the law also makes clear that the legislator wants the scope to be very broad:

“The scope of this Regulation should be as broad as necessary to create a preventive regulatory framework. The production of benchmarks involves discretion in their determination and is inherently subject to certain types of conflicts of interest, which implies the existence of opportunities and incentives to manipulate those benchmarks. These risk factors are common to all benchmarks, and all of them should be made subject to adequate governance and control requirements. … In particular, benchmarks that are currently not widely used may be so used in the future, so that, in their regard, even a minor manipulation may have significant impact” (p10)

As a result of this fast-approaching regulation, we are encouraging our clients to perform a full audit of the way they use Benchmarks and the way Benchmarks are provided in their organizations. To comply with the law, Investment Management companies will have to make sure that the Benchmarks that they use are authorized in the EU. To be authorized Benchmarks will have to follow a strictly regulated process. Benchmarks will only be authorized for use in the EU if they are provisioned by a registered or authorized Benchmark Administrator. Benchmark Administrators will be regulated and have to follow very specific rules to be registered as BM Administrators. ESMA (European Securities and Markets Authority) is currently refining the rules that Administrators will have to follow. A number of rule chapters have been presented by ESMA: governance and conflict of interest (Article 5), oversight function (Article 5a), control framework (Article 5b), accountability framework (Article 5c), input data (Article 7), transparency of methodology (Article 7b), reporting of infringement (Article 8), code of conduct (Article 9) … We understand that Administrators will have first to put in place an Oversight function dedicated to their Benchmark activities. Some of the obligations falling on Benchmark Administrators are clear: Administrators will have to be able to reconstruct all Benchmark values and keep all necessary records for a period of 5 years (Auditability, Traceability). Methodologies will have to be transparent and all changes to methodologies will have to be recorded, justified and communicated to stakeholders (Transparency). Input data will have to be evaluated, validated and verified, a conflict of interest policy will have to be publicly available and monitored. Prior to the start of provisioning a benchmark, a Benchmark Administrator will have to submit a Benchmark statement to the regulator. All Benchmarks currently in use in the EU will have to be registered. ESMA is currently developing the Benchmark statement template.

Some of the index calculations activities routinely performed internally by Investment Management Companies for their client reports (e.g: calculating a hedged index and using the calculated index in client reporting for performance or risk, calculating a blend of indexes and using the resulting index in performance, risk or asset-allocation reporting…) are almost certain to be categorized as “Provision of Benchmarks” under the law. These newly regulated activities will impose the full requirements (strict governance framework, sanctions for non-compliance etc…) associated with benchmark Administrators onto the institutions that provision these benchmarks.

We are therefore encouraging our clients to pay particular attention to the potential costs, complexities, regulatory risks (fines, interdictions…) associated with the function of Benchmark Administrator under the EU Benchmark Regulation (BMR). As a start, all Investment Managers will want to have a complete and accurate catalog of the benchmarks that they use (externally and internally provisioned) as soon as the law enters into force. A complete Benchmark Inventory will allow Investment companies to assess the efforts required to be in compliance with the law and determine the true costs and risks associated with non-compliance. Provisioning Benchmarks internally, using non-authorized benchmarks will have different but very significant regulatory risks and costs implications associated with them.

As intended by the legislators, the new EU Benchmark regulation is going to have a great impact on the entire financial industry (Banks, Insurance, Investment management,…) : “EU regulation is necessary to improve the functioning and governance of benchmarks and to ensure that benchmarks produced and used in the EU are robust, reliable, representative and fit for purpose and that they are not subject to manipulation”.

All Investment Management Companies will want to understand the implications of the new law for their own infrastructure. Different paths to full compliance will be possible with very different risks, costs and strategic implication. The tight implementation deadline will also need to be considered.

For further information, please contact us.

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