The need for a new EU Regulation
1.1 There has been increased pressure on the EU to restore confidence in the integrity and accuracy of benchmarks following the LIBOR and EURIBOR market-rigging scandals. Multi-million Euro fines have already been levied against several European banks and further investigations into manipulations of interest rate, energy and foreign exchange benchmarks are still on going.
1.2 Benchmarks are often used as a reference price for other financial instruments and contracts such as mortgages, and so any manipulation of benchmarks has the potential to negatively impact upon a broad range of investors and consumers. Hence, the need for more stringent regulation to ensure benchmarks are reliable and free from conflicts of interest and manipulation.
1.3 There was also a perceived need for regulation at the EU level as (even small) divergences in the approach taken by national regulators "could lead to significant impediments in the cross border provision of benchmarks". An EU approach also reduces the scope for regulatory arbitrage.
The Benchmark Regulation
2.1 On 18 September 2013, the EU Commission published legislative proposal for a new regulation on benchmarks ("Benchmark Regulation"). This follows IOSCO's July 2013 Final Report on 'Principles for Financial Market Benchmarks' (the "IOSCO principles") which set out recommended practices for benchmark administrators and submitters.
2.2 On 19 May 2015, the EU Parliament agreed a negotiating mandate on the Benchmark Regulation. Trialogue discussions began in June 2015 with the intention to agree a final version of the Regulation by the end of 2015. Once adopted, it will apply 12 months from publication in the Official Journal, e.g. likely to be 2016 or early 2017.
2.3 The Benchmark Regulation is designed to improve the governance and controls over the benchmark process, improve the quality of input data and methodologies used by administrators and ensure proper management of conflicts. To ensure compliance, the Regulation gives national regulatory authorities wide powers of supervision and investigation and creates sanctions for breach. The maximum fine that can be imposed is: (i) at least three times the amount of the profits gained or losses avoided; or (ii) EUR 500,000 on an individual and EUR 1 million or 10% of total annual turnover on a firm.
2.4 This note looks at the scope of the latest version of the Benchmark Regulation ("texts adopted" document, pages 19 to 110) and practical implications for administrators and submitters.
What is a benchmark?
3.1 The Benchmark Regulation applies to "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"
3.2 An "Index" is any figure that is both: (a) published or made publicly available; and (b) regularly determined (entirely or partially) by the application of a formula, other method of calculation, or an assessment. That determination needs to be made based on the value of one or more underlying assets, or prices, including estimated prices, actual or estimated interest rates, or other values or surveys.
3.3 The concept of "financial instrument" has been borrowed from the MiFID. However, only financial instruments which are admitted to trading (or for which a request for admission to trading has been made) are included for the purposes of the Regulation. "Financial contract" is either a consumer credit agreement or a residential mortgage.
3.4 Benchmarks provided by central banks, public authorities, central counterparties, the press and credit unions, and priced/value reference priced benchmarks are exempt. In addition, only certain provisions of the Regulation apply to commodity benchmarks.
What is a critical benchmark?
4.1 The Benchmark Regulation distinguishes between critical and non-critical benchmarks and fewer requirements apply in relation to a non-critical benchmark.
4.2 A "critical benchmark" is: (i) a benchmark which is not based on regulated data (e.g. data from trading venues) with reference value of more than EUR 500 billon; or (ii) a benchmark, which, if ceased, would have a significant adverse impact on financial stability, the orderly functioning of a market, or the real economy of a Member State.
4.3 ESMA is tasked with developing RTS to specify how values of benchmarks falling within (i) are calculated. It is also envisaged that the EUR 500 billon threshold will be reviewed every three years. The Regulation sets out a procedure for the recognition by the national regulatory authority of a benchmark which falls within 4.2(ii) above.
Who needs to comply with the Benchmark Regulation?
5.1 The Benchmark Regulation applies to benchmark administrators, contributors (including submitters) and users. However, index providers (persons who control the provision of an index) who are not aware that benchmarks provided them are used fall outside the scope of the Regulation.
5.2 Administrators and contributors of non-critical benchmarks, and non-supervised contributors are subject to a lighter-touch regime under the Regulation. Further detail is set out below.
Practical issues for administrators and contributors (submitters)
6.1.1 The Benchmark Regulation overhauls and substantially increases administrators' regulatory burden by requiring strict control standards and oversight requirements on benchmark computation.
6.1.2 Administrators of critical benchmarks are required to be authorised, but administrators of non-critical benchmarks are only subject to a registration requirement. Obtaining authorisation is likely to involve significant costs.
6.1.3 Administrators of non-critical benchmarks are subject to a lighter-touch regime. For instance, certain governance requirements (including the control framework requirements, oversight function, record keeping, other than records of input data) and certain requirements relating to input data, use of methodology and reporting do not apply to administrators of non-critical benchmarks. The Code of Conduct requirements (see below) also do not apply.
6.1.4 However, all administrators will need to:
(a) put in place controls (if not already in place) in respect of input data;
6.1.5 Certain matters (e.g. governance) are still to be determined by secondary legislation and therefore administrators should keep up to date with developments. The impact on the systems and controls they put in place to comply with the Regulation would also need to be considered.
(b) put in place procedures for reporting of infringements;
(c) conduct their work in a transparent manner, including publishing the methodology used for each benchmark it administers. As administrators are also required to put in place a complaint handling framework, such transparency may prove to be detrimental in any subsequent complaints; and
(d) ensure any outsourcing of its functions comply with outsourcing rules (e.g. controls over the service provider and inability to outsource its regulatory responsibility). Any outsourcing agreements will need to be reviewed for compliance and may need to be re-papered.
6.2 Code of Conduct
6.2.1 Administrators of critical benchmarks are required to draw up a code of conduct for each of their benchmarks (or family of benchmarks). The Code needs to set out the respective responsibilities and obligations of the administrator and contributor. In particular, the Code needs to cover certain prescribed elements relating to description of the input data, policies to ensure contributors provide all relevant input data, systems and controls that contributors are required to establish (including record-keeping, reporting of suspicious input data reporting and conflict management). ESMA is required to develop RTSs (taking into account the principle of proportionality) which will specify further elements to be included.
6.2.2 A Code of Conduct for a critical benchmark must be submitted to the relevant national regulatory authority for verification that it complies with the Benchmark Regulation.
6.2.3 Contributors are required to confirm their compliance with the Code and reconfirm compliance when changes are made to the Code.
6.3 Contributors and submitters
6.3.1 The Benchmark Regulation draws a distinction between supervised contributors and non-supervised contributors, recognising the fact that contributing to a benchmark is a voluntary activity and should not be discouraged.
6.3.2 This means that contributors who are already subject to regulation and supervision are within scope of the Regulation and need to comply with requirements relating to governance and control "to ensure the integrity and reliability of all contributions of input data to the administrator" which includes: (i) controls regarding who may submit input data to an administrator; (ii) training for submitters; (iii) conflict management; and (iv) record keeping.
6.3.3 However, this distinction may not be important because non-supervised contributors have to comply with the administrator's code of conduct (see above) and be subject to monitoring by the administrator. In addition, although the latest draft of the Regulation does not specifically required the Code to be legally binding on the administrator and contributor, a non-supervised contributor to a crucial benchmark will be subject to increase scrutiny in relation to compliance to the Code of Conduct by the administrator (who are required to take effective measures in respect of breaches of the Code).