BENCHMARK REGULATION: are EU markets ready?
Volatility has foiled financial markets since the subprime crisis exposed a variety of shortcomings, prompting regulators to intervene with more stringent requirements. The crisis revealed a significant issue when major banks in the United Kingdom were accused of manipulating the London Interbank Offered Rate (Libor), a key benchmark for financial deals worth $300 trillion.1 Following the Libor scandal, regulators have voiced their concern about the potential manipulation of Euro Interbank Offered Rate (Euribor), Hong Kong Interbank Offered Rate (Hibor) and other key interest rate benchmarks. The European Securities and Markets Authority (ESMA) has responded with a new Benchmark Regulation (BMR) to maintain benchmark integrity within the European Union (EU).
In this paper, Ashutosh Agrawal and Rishabh Pandey break down the challenges market participants may encounter when the regulation takes effect. They also provide recommendations to ensure the regulation strikes an appropriate balance between benchmark integrity and business activity, and outline next steps for participants to align themselves with BMRís requirements.
The Key Players and Concepts under BMR
Broadly covering multiple indices, BMR proposes to overhaul the existing system to eliminate possible conflicts of interest. It mandates that an oversight committee be established for each benchmark and assigns well-defined responsibilities for contributors, administrators, product issuers and the assigned oversight committee.
BMR contributors—the entities that submit the input data to the index administratorsóhave the additional responsibility to ensure the accuracy of the benchmark index value. Contributors are required to submit supplementary information to the administrators on a weekly basis, which will assist the administrators in verifying the suitability of the input data. This information mainly seeks to address the justification behind the submitted inputs, especially in cases where the submitted data relies on an expertís judgment rather than on transaction numbers.
The administrators, who design the index value based on the data submitted by the contributors, will be responsible for verifying the accuracy of the data in the index and maintaining a record of the information for five years.
Last, product issuers, those issuing financial products that reference indices as a benchmark, will be restricted from using any non-authorized benchmark under the new regulation.
BMR segregates benchmarks into three classes: “critical,” “significant” and “non-significant,” which are based on the Euro value of the associated business (see Figure 2). Critical benchmarks, when compared to significant or non-significant benchmarks, have the most stringent obligations. These include mandatory contribution and notification requirements that apply when a contributor to a critical benchmark intends to cease providing input data.
Challenges for Market Participants
BMR introduces new changes related to how the benchmark industry functions and is regulated in order to achieve its objective of efficiently safeguarding and governing the benchmarks. Many of the proposed changes add a significant regulatory burden on market participants, forcing them to rethink their business strategies. Apart from the visible direct effects, market participants will also face significant indirect impacts that will lead to a number of new challenges.
Non-authorization of third-country benchmarks
BMR only allows market participants to use non-EU (or third-country) benchmarks with benchmark administrators that have been endorsed and registered with the EU until the third country provides an equivalent regime. The process for third-country administrators requires them to either be registered in their country where they are compliant with BMR equivalent binding requirements or be endorsed by EU administrators. From a third-country benchmark perspective, if obtaining authorization with the EU incurs significant cost, then such benchmark administrators may want to avoid the EU depending on their cost-benefit analysis. Taking on significant costs could potentially hurt their business’ ability to compete in both local and global markets.
Protection against third-country benchmarks
Some market participants using third-country benchmarks have concerns regarding ESMA’s potential misuse of the regulation for third-country benchmark authorization. The regulation empowers ESMA to determine the suitability of a third-country benchmark within the EU. ESMA could potentially prohibit the use of a third-country benchmark (e.g., due to political pressure), given its directive to determine the conditions whether there is an “objective reason” for the provision of a benchmark for its use in the EU. Currently, the regulation does not have a defined criterion to determine such an objective reason.
Reduction in financial products
Given the restrictions around non-authorized third-country benchmarks, those that are currently available within the EU could be restricted under BMR. Financial products referencing these benchmarks would be removed, posing serious business concerns within the EU and abroad. For example, if the administrator of the S&P 500, a widely used third-country benchmark within the EU, is not granted registration, then any financial trades using the S&P 500 (e.g., buying and selling options on S&P 500) would be prohibited within EU territory. This scenario could unfold if a third-country benchmark administrator chooses not to comply with BMR, which they may choose to do depending on their cost-benefit analysis.
Voluntary cessation of data contribution
The input transaction data and non-transaction data that contributors are required to submit to administrators may consist of certain information that a contributor might not be comfortable sharing, such as public disclosure of conflicts of interest, bids and offers, quotes (comprising of executed quotes, indicative quotes or estimates), surveys, auction price systems, market reports and judgments. This overly prescriptive and onerous requirement placed on contributors could discourage them from participating in the index, and as a result, cease contributing data to the administrator. In such an event, the benchmark would consist of input data that would not be wholly appropriate for the measurement of the target market that a benchmark is designed to capture, making it unreliable.
Greater cost burden
The weighty recordkeeping, oversight and administrative requirements imposed on benchmark administrators are bound to result in higher costs. In this scenario, the administrator would most likely try to offset the extra cost by passing it on to the product issuers who subscribe to their indices. The added cost would then be reflected in the decreased yields of the products offered by issuers, leading to lower investment returns for end users and potentially client attrition.
The purpose of BMR is to ensure the accuracy, robustness and integrity of benchmarks within the EU. In this sense, limiting access to a third-country benchmark on any grounds other than concerns regarding the oversight, appropriate administration and contribution to particular benchmarks is inconsistent with the purpose of this regulation. ESMA could solve this problem by permitting the use of third-country benchmarks that adhere to the practices established under the International Organization of Securities Commissions (IOSCO) framework and strive to seek a long-term solution by engaging National Competent Authorities from all countries to unify the minimum required benchmark standards. Meanwhile, ESMA could also conduct an independent audit of those third-country benchmarks where it feels neglect of proper rules has exposed that benchmark to manipulation.
The regulation must strive to seek a balance between having a proper system in place that limits any inappropriate activity and ensures the integrity of the benchmark without impeding businesses. This balance would help restore significant confidence among market participants and encourage enhanced participation.
Next Steps for Market Participants
With BMR expected to come into force in January 2018, it is essential that market players begin planning their responses to the regulation well in advance. Gradually adapting to the regulation would ensure a smoother transition and minimize any obstacles likely to surface.
EU-based benchmark administrators should assess their system capabilities to ensure they comply with the recordkeeping requirements under BMR. They also need to analyze and modify their internal processes and procedures to comply with the added regulatory requirements of oversight and governance.
Third-country benchmark administrators should also consider performing a cost-benefit analysis to assess if they would be willing to comply with the requirements under BMR. Ultimately, the availability of their benchmarks in the EU region would help ensure synchronization at a global level.
Further, EU-based entities should assess if they currently provide input data to EU benchmarks and if they are likely to qualify as contributors under the regulation. They need to analyze the enhancements to ensure they are aligned with the administrator’s code of conduct and provision of transaction and non-transaction data requirements. This may require a significant overhaul to their current systems to meet the added reporting requirements.
For non-significant contributors, the regulation should motivate them to continue to provide data to the administrators without allowing the comprehensive requirements to impose potential setbacks.
Other market participants should assess whether their products are linked to any type of benchmarks to determine how these will be affected by BMR. They may need to identify which benchmarks have a higher probability of being discontinued in the EU, and analyze the impact on their business line. Whatís more, they will need to take steps to mitigate the risk of such an event and should begin using products based on registered benchmarks since they are less prone to manipulation.
- The Wheatley Review, “The Wheatley Review of Libor: initial discussion paper,” August 2012 www.gov.uk/government/uploads/system/uploads/attachment_data/file/191763/condoc_wheatley_review.pdf
- European Commission, “Regulation of the European Parliament and of the Council on indices used as benchmarks in financial instruments and financial contracts,” September 2013 http://ec.europa.eu/internal_market/securities/docs/benchmarks/130918_proposal_en.pdf
- European Securities and Markets Authority, “Discussion Paper Benchmark Regulation,” February 2016 www.esma.europa.eu/sites/default/files/library/2016-288_discussion_paper_benchmarks_regulation.pdf
Ashutosh Agrawal is a Senior Associate of Business Consulting at Sapient Global Markets. He has worked on the implementation of various regulations within Sapient’s Compliance Management and Reporting System (CMRS) and has nine years of experience working with large financial institutions on over-the-counter (OTC) derivatives regulatory reporting and settlement systems.
Rishabh Pandey is an Associate at Sapient Global Markets currently pursuing his MBA (Finance) from IIM Shillong. He holds an electrical engineering degree from IIT-BHU and has three years of work experience in Coal India Limited.