The RIMES Boston Forum, held in October 2013, continued the series of presentations and discussions RIMES has hosted throughout the world this year. A more intimate, round-table event, Boston focused on the immediate challenges faced by the industry from global regulators as well as the potential impact on indices and benchmarks. Politically and media-driven reaction to high-profile scandals and market failures has hugely escalated the penalties incurred by banks; but there is concern that there has been insufficient understanding of benchmarks, whether their volume or complexity, and too little time given by politicians to debating appropriate responses to perceived inadequacies.
Recent European legislation is not only committed to imposing much tighter restrictions on corporate activity; it threatens to break up banks where there are perceived conflicts of interest. Penalties are bound to increase and personal liability will dramatically impact managed risk. However, it is reputational risk that exercises the corporate mindset most directly.
If regulators are seen as precipitate in some of their proposals, there needs to be a coordinated response from the industry in order to improve more draconian measures. The increase in the number of custom benchmarks is unlikely to encourage regulators to concentrate their focus on standard ones; all benchmarks are a target, simply because regulators cannot be seen to discriminate or fall short. Firms will be required to hold and disclose vastly more information in order to demonstrate compliance and to embed effective controls and governance as a result. And their methodologies will come under severe scrutiny, both the calculations and the underlying rationale. Appropriateness and transparency will become the endemic watchwords at a time of great uncertainty and threat.
LIBOR has been a catalyst for some of the most stringent proposals for the regulation of benchmarks across the world. There is a belief among regulatory authorities and politicians that there has been widespread manipulation of data critical to the pricing of financial instruments and to risk management. However, it is evident that these authorities have not appreciated either the quantity or the complexity of benchmarks, most of which are reliable, verifiable, transparent and open to external validation. Those suppliers, therefore, who both create benchmarks and act as pricing agent, and are perceived to have a conflict of interest in their management and use, may be forced to divest this activity. Yet the proportion of benchmarks found to have been manipulated is extremely small compared to the number of benchmarks that are in daily use. RIMES holds approximately 750 thousand benchmarks, posting some 2.3 million daily, whereas in early drafts, there has been an assumption by regulators that there are only about 50 key benchmarks.
There are no universal criteria for the choice of benchmarks; it comes down to user preference based, most often, on individual benchmark and licensing agreements. There are, however, clear trends across the industry. Not only is the use of benchmarks increasing, the use of customized and blended benchmarks is growing; in turn, investment strategies, portfolio analysis and index calculation methodologies are becoming more complex. Complexity is a product of market demand and evolution; and regulation places its own complex demands on processing and governance. LIBOR has commanded the attention of regulators simply because of its impact on so many instruments and the realization that those setting rates can profit off the back of them. Not only is this encouraging a regulatory backlash, it opens a door on multiple lawsuits where firms can demonstrate economic losses from this manipulation.
While LIBOR was originally uncovered in 2008 in an article in the Wall Street Journal, and later alluded to by the head of the Bank of England, it was not until the US Department of Justice began criminal investigations that benchmarks truly came under the spotlight. The European Market Abuse Directive widened its regulatory scope, applying legal sanctions that now target bank turnover and individuals, significantly increasing fines where misconduct is uncovered. Fines have increased exponentially and, significantly, now go directly into the Treasury in the UK, where the Wheatley review anticipated a regulatory regime that came into force this April. In July, The International Organization of Securities Commissions (IOSCO) released their Principles for Financial Benchmarks, a report commissioned by the G20; and the EU Benchmark Regulations, recently tabled in draft form, are likely to be rushed through before the European elections in 2014 without change and after little scrutiny.
IOSCO has set global standards for the securities sector since 1983. It works closely with the G20 and Financial Stability Board and, together, they anticipate the evolution of a global regulator. Firms, therefore, are unlikely to escape regulation simply by re-locating operations or ‘off-shoring’. IOSCO does, however, provide a locus, globally and locally, to which firms can respond and challenge those regulations that impact them specifically. National idiosyncrasies are unlikely to disappear altogether; particular jurisdictions will want to protect their national interests. In Europe, the European Securities and Markets Authority will both interpret EU law and supervise the securities markets, themselves regulated locally through a variety of national agencies.
A steering group under the auspices of the Financial Stability Board will focus primarily on interest rate benchmarks and has been tasked with finding alternatives. The IOSCO, in its final report, focused on benchmark administrators, who will be required to comply with prescribed principals and to demonstrate compliance:
“for a benchmark to be robust and credible it should be based on actual data collected from diverse sources based on transactions, executed in a well regulated and transparent market and should be supported by appropriate governance, compliance and monitoring. ” [IOSCO]
The emphasis on good governance and benchmark quality reflects the regulators’ concerns that benchmarks are, and are seen to be, credible and transparent. The integrity of a benchmark relies upon the accuracy of the data used in its construction and the rationale underpinning the methodology. Methodologies, it is anticipated, will be published and the administrators held accountable. An enormous burden of paperwork will be placed on administrators and the increase in the number of custom benchmarks will only serve to sharpen the regulatory focus.
In the United States, the CFTC is the authority focusing particularly on benchmarks. Dodd-Frank, still only 40 per cent complete, will apply an Average Daily Trading Volume and Public Information Availability test according to the issue type and, depending whether a security index is narrow or broad-based, the swap will be regulated by the SCC or CFTC. However, if an index changes from narrow to broad-based in the lifetime of the swap, the other regulator has to be notified within 24 hours. RIMES has created this as a data field to enable such changes to be flagged to avoid the need for an individual to monitor swaps continually.
The European regulator has been equally assiduous, acting in haste to strengthen its grip on markets and, as elsewhere, targeting benchmarks. A UCITS fund will no longer be able to invest in a financial index if rebalancing prevents investors replicating the index, if the calculation methodology is not disclosed and if weights and constituents are not published online. This in itself is costly and has delayed the launch of funds in the UK. However, index providers have acted responsibly, opening up constituents when requested by an ETF or a fund to minimize the regulatory threat. The threat to custom benchmarks is more unsettling because these are, by definition, created or calculated at the request of a limited number of market participants and will no longer be regarded as adequate. This law is retroactive and will create enormous problems for asset managers. The regulators acted on the basis that there was no transparency and investors were unable to determine their exposures. Fund managers have, as a consequence, either had to delay fund launches and risk losing seed capital or simply closed funds down rather than put their constituents and, therefore, their investment methodologies online.
The requirement that the UCITS ensures that a financial index is subject to independent valuation appeared to present an opportunity. The valuation can either be done by an entity independent of the index provider or by a functionally independent internal unit, the UCITS undertaking due diligence. The problem lies in the fact that there is considerable ignorance as to the implication of these measures, even among lawyers, and while RIMES has advised that identifiers, under licensing restrictions, need not be displayed beyond the security name and closing weight, most firms have chosen to display what is expensive and very detailed information. The industry has argued that this is transparency for transparency’s sake, and commentators note that it is, ultimately the investor who will pay and the regulator has failed to consider this fact and that the rules are disproportionate to the problem.
Under the auspices of ESMA, it is proposed that a College of Supervisors will oversee critical benchmarks above 500 billion while the European Commission will have powers to force anybody subject to EU regulations to contribute to benchmarks if necessary to keep them representative of the markets. They budget that oversight will be undertaken by just one full-time employee at the European Commission and two temporary staff at ESMA using a spreadsheet recording every benchmark referenced in a financial instrument.
‘The biggest impact for asset managers is that if you blend a benchmark for one of your funds, under the proposal, you are now deemed to be a benchmark administrator. ’
It may be that benchmarks calculated outside the EU on any EU fund, if it is not regulated by an equivalent regime will not be admissible. However, this and the interpretation as to who actually is or becomes an administrator will need to go back to the European Parliament for clarification and voting.
The bigger asset managers and their lawyers are now actively looking at these proposals in the hope that they can challenge them, and the industry is beginning to consolidate in order to have a coherent voice. Positively, regulators are now communicating with each other across borders and their objectives, to ensure the integrity of benchmarks and to eradicate conflicts of interest, are shared by the industry itself. However, the focus on benchmarks post-LIBOR has been in large part precipitate and driven by public perception and political opportunism and discomfort. It is a time of considerable uncertainty, creating enormous financial and administrative pressure that will undoubtedly challenge the industry for some time to come.