On 15 February, ESMA released a discussion paper with the purpose of consulting stakeholder opinions on the technical implementation of the incoming Benchmarks Regulation. This regulatory process was initiated on 18 September 2013 at an EU level when the Commission published a legislative proposal for a new regulation on benchmarks, which falls in line with recommendations from International Organisation of Securities Commissions (IOSCO) and, most recently, on 9 December 2015, an agreement was reached on the final text of the proposed regulation, with the European Council issuing approval. The text is currently awaiting a final vote from the EU Parliament before it is set in stone and sent to the Official Journal to be published.
Under the text of the new regulation, the current definition of ‘benchmark’ is “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 or an index that is used to measure the performance of an investment fund with the purposes to track the return of such index or to define the asset allocation of a portfolio or to compute the performance fees”. Benchmarks are the cornerstone of the financial system as they are critical for the functioning of the markets, as well as being central to the mortgages and savings of millions of people, yet their unregulated status to date has proven to be problematic with widespread cases of manipulation and abuse.
Now, with the current tally of fines stretching to over $9 billion in regulatory settlements and over 30 individuals being charged for their actions in the scandals of LIBOR and EURIBOR, it has become clear that benchmark rigging is a pressing issue that is damaging the financial services industry. Therefore, regulatory measures to prevent their manipulation have become necessary and the response has been uncompromising. In the UK, the publication of the Wheatley Review of LIBOR in September 2012 set up a framework for benchmark reform which led to the FCA taking regulatory responsibility of LIBOR on 1 April 2013 and a further seven UK benchmarks in April 2015. This pace of change towards formal and stringent supervisory measures is only set to intensify when the EU’s Benchmark Regulation comes into force and the implementing measures are released.
Why are regulatory measures necessary?
The current idea for a regulation has stemmed from principles that were agreed at an international level by IOSCO. Published in July 2013, the report set out 19 different principles providing an overarching framework for the operation of benchmarks in financial markets in four different areas: governance, benchmark quality, quality of the methodology and accountability mechanisms. These principles and their implementation have most recently been reviewed for the second time on 26 February 2016, making reference to progress so far, and to issues yet to be resolved, however, the new EU regulation is mentioned as progress for the regulation of EURIBOR.
Along with this, both the Market Abuse Regulation (MAR) and Criminal Sanctions for Market Abuse Directive (CSMAD) have incorporated amendments which stipulate that any manipulation of benchmarks is illegal and subject to administrative or criminal sanctions.
The Benchmarks Regulation goes one step further, and sets out to completely restructure the governance process of benchmarks and ensuring implementation of a common framework. Benchmarks, in particular LIBOR and EURIBOR, have been stigmatised by recent scandals, and these measures are the regulators’ attempt to regain control and ensure integrity and accuracy.
What does the regulation set out to achieve?
The general objectives of regulating benchmarks at an EU level include the need to mitigate issues surrounding their manipulation which have arisen due to inadequate supervision, problems surrounding conflicts of interest and the lack of a formal governance framework. This will hopefully be achieved by improving the governance and control systems of the benchmark process, and by ensuring that data management is monitored correctly. There will also be an emphasis on improving the quality of input data that is used by benchmark administrators. Finally, the protection of consumers and investors will be achieved through increased transparency requirements on how a benchmark is produced and the incorporation of adequate rights of redress for breaches.
The application of the regulation will involve the categorisation of benchmarks using three separate criteria.
The first depends on the nature of the underlying assets, specifically whether it is an interbank interest rate or a commodity as these are subject to an independent set of rules under Annex II and Annex III respectively in the text of the regulation.
The second step in the classification process concerns the significance of the benchmark – either critical, significant or non-significant. The test for critical benchmarks is set out in Article 13 of the regulation and, if satisfied, these critical benchmarks will be subject to mandatory contribution requirements and certain notification requirements. Significant benchmarks are defined in article 14b, while non-significant benchmarks are defined in article 14d. Both are subject to less-stringent requirements and administrators of these benchmarks are also exempted from certain requirements.
The third classification criteria centres around the data source, i.e., if this is regulated data then exemptions apply.
Wide powers of supervision and investigation are also given to national regulatory authorities, in addition to allowing the creation of sanctions for breach.
What is the current status of the regulatory measures?
With the final text of the regulation being confirmed on 9 December 2015, ESMA’s discussion paper has been drafted and disseminated with the goal of capturing stakeholder opinions based on 113 questions regarding the technical implementation of the Benchmarks Regulation. This discussion paper seeks to clarify, in extensive detail, certain points that will have an impact on the implementation process for those that will fall under the scope of the new regulation.
In general, the paper covers six broad areas, namely definition of benchmarks, requirements for the benchmark oversight function, requirements for the benchmark input of data, governance and control requirements for supervised benchmark contributors, authorisation and registration of an administrator and transparency requirements regarding the benchmark methodology. An open hearing was held to discuss the paper on 29 February, while the deadline for responses involves a relatively quick turnaround by 29 March 2016. ESMA is aiming to publish the responses in the third quarter of this year.
The final text of the regulation is still awaiting formal adoption by the European Parliament, followed by publication in the Official Journal of the EU. It will then enter into force the following day and will apply 18 months after this, thereby creating a concrete implementation deadline.