Discussion On Post Due Tomorrow

Earlier this year, while announcing the European Commission’s draft legislation relating to the integrity of financial benchmarks, the Internal Market Commissioner Michel Barnier said: Benchmarks are at the heart of the financial system: they are critical for our markets – yet until now they have been largely unregulated and unsupervised. This cannot go on: we must rebuild trust. Similar regulatory reviews and proposals to reform the benchmarking process are continuing around the world’s financial markets, including in the UK, India, Australia, Singapore and the US. So what is the future of financial benchmarking?

How incoming regimes and changing market practices will ensure that financial benchmarks don’t risk losing their relevance

Earlier this year, while announcing the European Commission’s draft legislation relating to the integrity of financial benchmarks, the Internal Market Commissioner Michel Barnier said:

“Benchmarks are at the heart of the financial system: they are critical for our markets…yet until now they have been largely unregulated and unsupervised. Market confidence has been undermined by scandals and allegations of benchmark manipulation. This cannot go on: we must rebuild trust.”

Similar regulatory reviews and proposals to reform the benchmarking process are continuing around the world’s financial markets, including in the UK, India, Australia, Singapore and the US.

At the same time, the increasing focus on moving the trading of financial instruments onto exchanges or into central clearing as a means of reducing systemic risk, suggests that traditional means of establishing financial benchmarks are becoming less relevant to the daily operation of the markets they are supposed to represent. This has led to comments that historic benchmarks will become obsolete, as measures and rates are inexorably linked to real transaction data.

So what is the future of financial benchmarking? It is not straightforward to reconcile the two positions set out above. However, we find much to suggest that financial benchmarks will remain entirely relevant – indeed may become more prevalent and diversified – under the new proposed regulatory regimes.

The history of benchmarking

The challenges of doing business based on opaque standards are nothing new. One of the earliest benchmarks used in England, the yard, was supposedly derived from the length of Henry I’s arm or, more generally, the measure of a man’s arm from the tip of his nose to his thumb. There are historical reports of merchants using people with short arms to measure out cloth, thus short-changing customers. Indeed, the explosion of English town and city trade in the late 15th and 16th centuries led to so many issues that Henry VII ordered bronze rods placed on the sides of 43 town Exchequers, so that merchants and customers would have a common benchmark for the yard against which to measure their transactions.

“The traditional means of establishing financial benchmarks are becoming less relevant to the markets they are supposed to represent”The parallels with the development and use of financial benchmarks over the last 10 years are striking. Banks in London have been lending to one another for centuries, whereas Libor [London Interbank Offered Rate] is a comparatively new concept. What drove the British Bankers Association to launch Libor in 1986 was not interbank lending, but the dramatic increase in use of futures contracts to hedge against interest rate risk and the need for a standard interest rate to settle those contracts.

A similar pattern can be seen in the commodities markets. Historically these have been specialist markets comprising very few participants for the most bespoke and illiquid commodities contracts. The traditional commodities market benchmarks have also been in place for tens, if not hundreds, of years (such as the LBMA [London Bullion Market] Gold Fixing price which was first implemented in 1919). In contrast, today’s market is much more diverse, with far more participants using commodities reference pricing for a range of other financial instruments.

In the same way as 15th century cloth trading, it is the increasing and varied use of a particular benchmark which raises systemic issues about method and accuracy of calculation. Indeed, it is not too much of a leap to say that many of the risks associated with using financial benchmarks are a reflection of their overall success in driving financial innovation.

Review framework

Against that background, the various regulatory reviews in this area have a number of common themes, not least the complexity and hierarchy of the review process. In February 2013, the G20 countries called for more progress on:’measures to improve the oversight and governance frameworks for financial benchmarks…including the promotion of widespread adoption of principles and good practices’. The Financial Stability Board (FSB) was in turn mandated by the G20 to promote the’dissemination and adoption of principles and good practices’ regarding benchmark setting processes and to ensure that national/regional authorities adopt a coordinated approach. The FSB set up the Official Sector Steering Group (OSSG) of regulators and central banks responsible for coordinating and maintaining the consistency of reviews of existing interest rate benchmarks and for guiding the work of a Market Participants Group responsible for examining the feasibility and viability of adopting additional reference rates and transition issues.

Following the recommendation of the OSSG, the FSB has also endorsed the International Organization of Securities Commissions (Iosco) Principles for Financial Benchmarks published in July 2013. These cover key issues of benchmark governance, integrity, methodology, quality and accountability. Iosco intends to review the extent to which the Principles have been adopted within an 18-month period (ie by December 2014) by obtaining inputs from stakeholders, regulatory authorities and actual benchmark administrators.

So what does the future of financial benchmarking look like through this complex and layered regulatory prism?

The Iosco Principles

The Iosco Principles focus on protecting the integrity of any benchmark determination process, addressing conflicts of interest as well as oversight and accountability procedures. In particular, they envisage single point accountability for the overall reliability of any one particular benchmark process. Interestingly, the final form of the Principles places responsibility for accountability on benchmark administrators, rather than jointly between administrators and contributors. Many respondents to the early draft Principles commented that a presumption of direct liability for contributions would substantially reduce the number of overall participants for key benchmarks.

Transparency of relevant information is another core thread of the Principles, including disclosure of conflicts of interest, a published control framework, and transparency as to any third parties who participate in the benchmark determination process. In the consultation phase, Iosco envisaged that this transparency would involve the ability to actually replicate a published benchmark level, giving rise to widespread index industry concern around disclosure of proprietary information. However, the final Principles make clear that an adequate level of transparency does not automatically equate to full disclosure of methodology or historical data.

“We are likely to see a lot more regulatory innovation and arbitrage before the dust truly settles”The other significant issue addressed by the Principles is the extent to which benchmarks should be based on actual transactions. Some national regulators, notably the Commodities Futures Trading Commission, had made clear their preference for benchmarks (specifically interest rate benchmarks) to reflect actual price discovery, based entirely on observable transactions. The Principles take the somewhat less strict view that a benchmark should be’anchored’ by observable transactions entered into at arm’s length between buyers and sellers in such an active market. The Principles also reflect the idea that in an active market conditions on any given day might require different forms of observable market data to supplement actual transaction results. Indeed the Iosco final report indicates this could’result in an individual benchmark determination based predominantly, or exclusively, on bids and offers or extrapolations from prior transactions’ providing, of course, that the methodology is suitably transparent, as set out above.

So the Iosco Principles, on their face, give a level of flexibility to benchmark administrators, while ensuring a more transparent and open process. But in return they demand accountability and traceability for the benefit of regulators and market participants. Early signs are that national regulators are also minded to adopt this approach in principle, with the EU’s recently published draft Benchmark Regulation being held out as fully consistent with the Principles. Key benchmark administrators are also starting to set out their response to the changing regulatory environment, with Platts (one of the largest energy, petrochemical and metals information administrators) recently confirming the results of its independent assurance review and stating it complies with Iosco’s specialist benchmark Principles for Oil Price Reporting Agencies.

The EU Benchmark Regulation

In other areas, the impact of national regulation on benchmarks could be much more significant. In particular, a core requirement of the EU Benchmark Regulation is that EU-supervised entities (including credit institutions, investment firms, insurers, central counterparties, repositories and administrators) will only be able to use benchmarks provided by authorised EU administrators (or non-EU administrators registered with the European Securities and Markets Authority). While the EU proposal does allow for third-country benchmarks to be used in some circumstances, this is only where the European Commission has formally recognised that the benchmark provider is located in a jurisdiction with an appropriate legal framework, taking into account whether the third country’s supervisory practice is compliant with the Iosco Principles. It is unclear exactly what process the European Commission will go through before issuing this equivalency-type decision, and how long it will take for third-country benchmarks to be approved for use in this way. And while the Commission ultimately decided against including a proposed liability provision requiring benchmark contributors to meet losses from any breach of a benchmarking process, there is a contractual requirement in the draft to comply with administrators’ codes of conduct as well as a proposed obligation on administrators to identify anomalous or suspicious benchmarking data. These requirements, if implemented, will go further than envisaged by the Iosco Principles and, so far, are potentially stricter than reforms announced elsewhere in the world.

On current understanding, the EU Benchmark Regulation is unlikely to come into force until 2015 at the earliest, and there are transitional provisions proposed to permit the continued use of a benchmark which does not meet the requirements of the Regulation in some circumstances (force majeure, frustration or breach of the underlying contract which references the benchmark). However, financial organisations are unlikely to want to rely on this provision for any significant period of time – given the inherent uncertainty about what may constitute a breach or force majeure event under contracts which are likely be governed by a different national laws, or which can be enforced under different country legal regimes

Future developments

If other regulators take a similar view to the EU, we may well see the development of new and diverse benchmarks that are relevant to particular geographical areas: the US, Europe and Asia Pacific, alongside a number of globally used benchmarks that exist today. We may also see far more obsolescence of benchmarks as markets develop and particular benchmark processes start to fall outside the increasingly strict regulatory environment. Regulators may also have a preference for their supervised firms to use benchmarks which are directly under that regulator’s control (recognising that where two international firms do business this is unlikely to work in practice).

Given all this focus, the lasting impression which comes out from the various reviews and consultations is the complexity of the issues faced by not only the benchmarking industry and its regulators, but also by the end-users. Benchmarks are as varied as the market participants that use them, and there is now a tacit acknowledgement that a one-size-fits-all approach to regulation is unlikely to achieve the high aims set out by the G20.

At the same time, market participants will need to become more sophisticated about how they use benchmark rates in agreements, particularly contemplating contractual provisions for replacement of obsolete benchmarks, or those which become unregulated in future. The largest market participants may even want to transition their existing contracts to a consistent set of benchmarks (via a consensual counterparty process), given the potential governance and control issues around the new regulatory regimes which are coming into force.

The high-level regulatory response gives comfort that benchmarks will not only continue but potentially can thrive in a more transparent and accountable, but ultimately balanced process. The unknown quantity is how those high-level principles will be implemented in practice, in different industries and across different jurisdictions. This remains a developing area where we are likely to see a lot more regulatory innovation and arbitrage before the dust truly settles.

By Jones Day partners Harriet Territt and John Ahern in London