The manipulation of Libor and Euribor, and investigations and enforcement action by regulators into these and other benchmarks, have raised significant concerns about the integrity of benchmarks. Benchmarks are vital to the pricing of many financial instruments and commercial and non-commercial contracts. It is in this context that on 18 September 2013 the European Commission published its proposal for a Regulation on indices used as benchmarks in financial instruments and financial contracts.
Hedge fund businesses and underlying investors need benchmarks to be accurate and not subject to manipulation and, as such, should generally welcome regulation of benchmarks. However, some aspects may be negative. This piece outlines the current proposals for the Regulation and its likelyimpact on key stakeholders, including hedge fund businesses.
Current status and timing
On 28 October 2014 the Commission published the latest compromise proposal on the Regulation. Agreement is expected to be reached on it in 2015, following which it will be adopted and published in the Official Journal. It will come into force on the following day, and apply 12 months from then.
Scope of the Regulation
The scope of the Regulation is very wide. A benchmark is defined in the Regulation as any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument, is determined. An index that is used to measure the performance of an investment fund (meaning an AIF or a UCITS) is also a benchmark. Accordingly, it is not the nature of the input data which determines whether a benchmark is within scope of the Regulation. An index is both “published or made available to the public” and regularly determined, entirely or partially, by the application of a formula, other method of calculation, or assessment, where this determination is made on the basis of the value of one or more underlying assets, or prices, including estimated prices, or other values. The extent to which indices are regulated will depend on whether they are “published or made available to the public”. This could lead to privately constructed indices being subject to regulation.
In defining benchmarks broadly, the Regulation does not sufficiently distinguish between rate benchmarks such as Euribor and Libor and market indices that value the return on a basket of securities. The risk of manipulation is clearly significantly greater where the benchmark is based on submitted rates rather than transaction data. Additional requirements for certain benchmarks are addressed by the Commission with annexes to the Regulation in relation to inter-bank interest rate benchmarks (that is, benchmarks referenced in relation to the rate at which banks may lend to, or borrow from, other banks, such as Libor and Euribor) and commodity benchmarks.
“Critical benchmarks” mean those where the majority of the contributors are “supervised entities” (namely credit institutions, investment firms, insurers or reinsurers, UCITS, AIFMs, CCPs, trade repositories or administrators) and the benchmark is referenced by financial instruments worth at least €500 billion. The Commission is required to draw up a list of “critical benchmarks”. “Critical benchmarks” are subject to additional requirements. The Regulation will affect three main categories of stakeholder: namely benchmark administrators, contributors and users.
Administrators
An “administrator” is defined as the person that has control over the provision of a benchmark. The activity of “provision of a benchmark” is comprised of administering the arrangements for determining a benchmark; collecting, analysing or processing input data for the purpose of determining a benchmark; and determining a benchmark through the application of a formula or other method of calculation, or by an assessment of input data provided for that purpose. There will be extra burdens on an administrator. Administrators will need to apply for authorization by the competent authority in the member state and to comply with the conditions for authorization.
The Regulation contains a number of provisions governing the input data of a benchmark and the methodology used by an administrator to determine a benchmark. Input data must be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure. It should be transaction data, unless it is necessary to use alternative, non-transaction data, in which case that data must be verifiable. Transaction data is defined as “observable prices, rates, indices or values representing transactions between unaffiliated counterparties in an active market subject to competitive supply and demand forces”. The administrator must put in place adequate systems and controls to ensure the integrity of the input data. A reliable and representative panel or sample of contributors must be used by the administrator to obtain the input data. The administrator must use a robust and reliable methodology to determine a benchmark, with clear rules identifying how and when discretion may be exercised in the determination of that benchmark. The administrator must develop, operate and administer the benchmark data and methodology transparently.
Administrators must publish the input data used to determine a benchmark immediately after publication of the benchmark, except where this would have serious adverse consequences for the contributors or adversely affect the reliability or integrity of the benchmark (in which case, publication may be delayed to minimize the impact). An administrator must also publish a procedure concerning the actions it will take in the event of changes to, or the cessation of, a benchmark.
Administrators are also required to publish a benchmark statement for each benchmark provided. This must unambiguously define the market or economic position measured by the benchmark and the circumstances in which measurement may become unreliable. It must describe the purposes for which it is appropriate to use the benchmark and the circumstances in which it may cease to be fit for these purposes. The statement must set out technical specifications on the elements of the calculation where discretion may be exercised, the criteria applicable to the exercise of this discretion and the persons by whom discretion is exercised. Notice must be given of the factors (including external factors beyond the control of the administrator) which may necessitate changes to, or the cessation of, the benchmark, and the administrator must advise that any financial contracts or other financial instruments that reference the benchmark should be able to withstand, or otherwise address the possibility of, changes to or cessation of the benchmark.
Administrators must monitor the input data and contributors to identify and notify the relevant competent authority of any suspicions of a material breach of MAR and conduct that may involve manipulation or attempted manipulation of a benchmark. The administrator must operate procedures for its staff and other relevant persons to report internally any breaches of the Regulation.
The administrator must establish and maintain robust governance arrangements, including a clear organizational structure with well-defined, transparent and consistent roles and responsibilities for all persons involved in benchmark provision. The administrator must have an accountability framework covering record keeping, auditing and review, and a complaints process that provide evidence of compliance with the requirements of the Regulation. The administrator must ensure that actual or potential conflicts of interest do not affect the provision of a benchmark and that the exercise of any required discretion or judgement in the benchmark process is independently and honestly exercised. The administrator must establish an oversight function to provide oversight of all aspects of the provision of its benchmarks. The administrator must have a control framework that ensures benchmarks are provided and published or made available in accordance with the requirements of the Regulation.
Administrators must adopt a legally binding code of conduct for each benchmark, clearly specifying the administrator’s and contributors’ responsibilities and obligations, including a clear description of the input data to be provided and specified matters relating to the systems and controls a contributor is required to establish. Administrators mustnot outsource functions relating to benchmark provision if it would materially impair the administrator’s control over the provision of the benchmark or the ability of the relevant competent authority to supervise the benchmark. If an outsourcing arrangement is to be entered into, the relevant administrator must ensure the requirements of the Regulation are satisfied. Notwithstanding any such arrangement, the administrator remains fully responsible for discharging its obligations.
Exclusion from scope of Regulation
Where an administrator produces an index that it is unaware (and could not reasonably have been aware) constitutes a benchmark that is used as a reference to a financial instrument or a financial contract without their knowledge, the Regulation will not apply to that administrator. In addition, where ESMA notifies an administrator that their index has or may become a benchmark, the administrator need not consent, in which case the index may not be used as a benchmark and the requirements of the Regulation will not apply.
Contributors
A “contributor” is defined as a person contributing the input data used by the administrator to calculate the benchmark. The Regulation requires all contributors to sign up to, and comply with, the legally binding code of conduct that has been adopted by the benchmark administrator in relation to each benchmark to which they provide input data. Where, in any year, at least 20% of the contributors to a “critical benchmark” have ceased contributing, or there are indications this is likely, the competent authority of the administrator of the critical benchmark will have the power to require selected supervised entities to contribute input data to the administrator.
Additional requirements apply to “supervised contributors”, defined as a supervised entity that contributes input data to an administrator located in the EU. “Supervised contributors” must ensure their provision of input data is unaffected by any existing or potential conflict of interest, and must exercise any discretion honestly and independently, based on relevant information and in accordance with the code of conduct. They must also operate a control framework that ensures the integrity, accuracy and reliability of the input data, and that this data is provided in accordance with the provisions of the Regulation and the code of conduct. “Supervised contributors” must also comply with the additional systems and controls requirements specified in the Regulation. Among other things, these include training submitters on the Regulation and MAR and conflict management measures, including physical separation of employees, consideration of how to remove incentives to manipulate any benchmark that are created by remuneration policies, and the retention for an appropriate time period of records of communications concerning input data provision. ESMA will develop draft regulatory technical standards to further specify the internal oversight and verification procedures of a contributor that the administrator shall use seek to ensure the integrity and accuracy of input data.
Users
Only benchmark users that are “supervised entities” will be subject to the Regulation. If the supervised entity is a party to financial contracts, or issues or owns financial instruments that reference a benchmark, it becomes subject to a requirement to produce and, on request, submit to the competent authority “robust written plans” setting out what it would do if the benchmark were to materially change or cease to be produced.
Before entering into a financial contract with a consumer, a “supervised entity” must conduct a suitability assessment to determine whether referencing the contract to a benchmark is suitable for the consumer, by obtaining information about the consumer’s knowledge and experience of the benchmark and financial situation and objectives concerning the financial contract. It must also obtain the benchmark statement that the administrator is required to publish. If the “supervised entity” considers that the benchmark is not suitable, it must warn the consumer in writing. Crucially, a “supervised entity” may only use a benchmark in the EU as a reference in a financial instrument or financial contract, or to measure the performance of an investment fund, if it is provided by either an authorized administrator or a non-EU administrator located in a third country that has satisfied the equivalence requirements of the Regulation.
Third country framework
Concern has been expressed about the requirement for non-EU administrators located in a third country to have satisfied the equivalence requirements of the Regulation, including compliance with requirements which are as stringent as those in the Regulation, that the administrator is registered by ESMA and that prescribed co-operation arrangements are in place. Situations may arise where a benchmark administrator is based in a jurisdiction whose rules are not perceived as equivalent. The least favourable scenario would be if the equivalence framework meant that some benchmarks could no longer be used in the EU, thereby constraining investors’ exposure to non-EU markets and preventing existing agreed investment strategies from being followed. In an effort to avoid this outcome, some administrators may choose to establish EU subsidiaries to be able to seek EU authorization. This approach may, however, expose users and, in turn, end investors to higher costs.
Is the scope of the Regulation too wide?
Manipulation of Euribor and Libor was possible due to compilation based on submitted rates, and allowing an element of discretion or subjectivity. For many benchmarks, particularly market benchmarks, the process of calculating the benchmark rate relies entirely on public data. Arguably, the focus of regulatory measures should be on addressing the issues that emerged in respect of benchmarks based on submitted rates, where there is a clear need for regulation of the administrator and the submitters. Market indices such as the FTSE 100 and the S&P 500 are privately owned by the relevant provider, who makes them available for a licencing fee. The Regulation may constrain the ability of fund managers to use market indices at the level of individual securities and to create index-tracking funds. Such constraints would detrimentally narrow end investors’ choice of strategies.
A fund may gain exposure to assets by constructing a bespoke private index that delivers a particular strategy, then entering into swaps transactions with dealers to gain exposure to the assets that comprise the index. This is desirable where a fund is unable or unwilling to pursue a strategy through direct holding of assets – for example, if the assets are traded on venues to which the fund does not have access, or where it would be excessively costly to execute trades in all the assets necessary to deliver the strategy. The application of the Regulation depends on the meaning of an index being “published or made available to the public”. If “public” is construed to mean investors in a fund, then the impact of the proposals could be to cast many fund managers as benchmark administrators even in relation to private indices. Similarly, the marketing of a fund could suggest that the index is “made available to the public”. The final Regulation needs to be clear that it is not intended to apply to private indices or benchmarks provided only to a specific set of fund investors.
Conclusion
The Regulation constitutes an effort to address the benchmark manipulation scandals by instituting strict controls and requirements for all of those involved in the benchmarking process – namely administrators, contributors and users. However, it creates issues around the third country equivalence provisions and the impact on market indices and private indices; it is hoped that these will be resolved favourably in the final Regulation. Firms will need to review their procedures and be ready for the cost and compliance implications associated with regulatory reforms.