The battle for benchmarks: divisions in the ranks?

With lots of different regulatory benchmark efforts now under way, the industry could be forgiven for not taking a common stance. With IOSCO  issuing final principles, ESMA and the EBA are simultaneously consulting on a European set of principles. Meanwhile the UK is moving ahead with its own reforms.

JWG has previously outlined three central issues that have emerged from the draft principles: the scope of the regulation and the benchmarks included, the continuity of the contracts tied to those benchmarks, and the cost of the new rules to the industry have all emerged as key areas of controversy. As attention begins to shift from setting broad principles to defining detailed rules, firmer indication of how these issues will play out is now being provided.

The most concrete recent developments are the FSB’s announcement of an Official Sector Steering Group, chaired by Martin Wheatley, with the aim of reviewing and aligning national reforms, and an EU proposal for a regulation on benchmarks.

Firms will be relieved by certain elements of the European Regulation as it is currently taking shape. As mentioned, a major industry concern so far has been the scope of the rules, with fears that a broadly-defined, one-size-fits-all approach will be adopted, which may be unworkable for some types of indices.

However, the EU regulation is expected to be limited to benchmarks referenced in financial contracts or instruments, meaning minor indices are likely to fall outside its scope. Additionally, separate standards for different types of benchmark through secondary legislation are envisaged, and caveats will be added – not all benchmarks will be expected to be based on transaction data where this is inappropriate.

The regulation should put to rest fears of having to rebase existing contracts. Transitional provisions are likely to be put in place meaning that benchmarks do not have to conform to the new requirements if doing so would breach the terms of the contracts that use them as a reference, until their value becomes ‘insignificant’.

However, this is also one example of where the regulation could introduce uncertainty: Firstly, it would lead to a potentially long transition time between the two regimes, as contracts using old non-compliant benchmarks will gradually expire and newly compliant benchmarks are established. It also raises the question of how ‘insignificant’ the value of contracts based on these old benchmarks will have to become before they are forced to adapt to the new standards.

Of course, there are also several new demands being placed on benchmark administrators. Most notably, monitoring, oversight and controls are expected to be significantly upgraded, leading to new record keeping and reporting requirements.

Administrators will be expected to set up an independent board to monitor input data before and after publication, consult on and give advance notice of any changes to methodology, and detect and report to authorities any input data deemed to be anomalous. It is also likely they will be required to keep records of all input data used to calculate benchmarks for 5 years, and store recordings of any phone conversations and electronic communication between employees of the administrator and submitters for three years. These requirements may put significant operational demands on administrators and entail a high cost in terms of staff and additional data storage.

There also seems to be a fundamental tension developing between the aim of monitoring submissions – by placing organisational and reporting requirements on firms – and encouraging more institutions to submit to benchmarks in order to dilute the impact of any one firm’s submissions.

The way the EU regulation is expected to get round this is through mandatory contributions for ‘critical’ benchmarks, and a requirement that no contributor provides more than 25% of the volume or values used in input data. This in turn would make the distinction between critical and non-critical benchmarks vital and it remains unclear which benchmarks will fall under this definition.

The fines being envisaged under the new regulation are severe, and apply to individuals as well as firms. These could be as high as €500,000 for individuals, and €10 million or 20% of turnover for firms. Full implementation is expected within a year of adoption.

Ultimately the future of benchmarks is in a state of flux.  Divisions in global and regional views over policy are defining the target operating model.  Now is the time for firms to weigh in and shape a future benchmark landscape that makes commercial sense.