Libor, Euribor, Tibor, Noribor… Fines of $1.5 billion, £390 million and more expected across the globe …Fallout from benchmark manipulation is not new news, but the way in which we are driving towards new benchmarking regimes is. Why?
Benchmarks are at the very core of the financial markets and even slight regulatory variances can result in big swings in the cost to implement them and the resulting risk levels in the system. Consequently, local tax codes, accounting practices, language and market norms will make it difficult to come up with a consistent, detailed set of standards for ‘good benchmarking.’
This means that the current approach – that aligns regulators in a loose federation – is likely to be challenged as we attempt to solve this problem quickly in different ways, at variable speeds.
As noted by the incoming Governor of the Bank of England and FSB chair, Mark Carney the question is really about how changing the way benchmarks restores trust in the markets. So what makes them so hard to fix?
Let’s examine some of the major near-term issues at hand in this process:
- Politically charged. Benchmarks are a contentious area of regulation due to recent abuse, meaning that regulators are unlikely to allow the industry to self-regulate
- Not standalone. Benchmarks and indices are woven into the financial markets at all levels – changes to benchmarks will affect a global technology and data web – decades in the making
- Many flavours. There are many different types of benchmark and indices: some are set subjectively (e.g., LIBOR), others are set automatically (e.g., FTSE 100), many of them are relied upon by the real economy and end consumers
- Potentially risky and expensive. Cost is a big unknown in these proceedings due to a number of variables relating to the scope, contracts and overlapping/conflicting sets of rules
- Policy uncertainty. Some jurisdictions could use benchmarks as a way to create advantage for their markets’ ways of operating – new trade barriers in effect.
Politicians are keen, not only to be seen as aggressively defending the consumer and making their jurisdiction safe, but also – at long last – holding the bankers accountable for an action that contributed to the financial crisis. Putting evidence of poor behaviour in the public domain and levying large fines may well be a path towards a more trustworthy system but it has led to a rushed and splintered rulemaking process.
The approach to regulating benchmarks is both confusing for firms and risky for their infrastructure, which will be challenged to put in place a system that meets conflicting aims. The problems will be created by different perspectives on their scope, political will, the role certain benchmarks play in the economy and the rush to implementation.
Today, EU regulators are leading the race to implement benchmark reforms via market abuse regulation and through a recent joint ESMA/EBA consultation. Globally, IOSCO is still behind, forming a task force and releasing its high-level consultation report on financial benchmarks. The US still has yet to make a move, though the CFTC Chairman Gensler has said “it’s time for a new or revised benchmark…to restore the confidence of people around the globe”, in addition to holding an upcoming meeting with IOSCO regarding this. Clearly, without major players such as the US and EU on the same page, benchmark regulation may remain more a fiction than a reality.
Is it possible to untangle the benchmark web?
There are many flavours of benchmark that are used for a variety of purposes. As US CFTC Commissioner Bart Chilton said recently, benchmarks impact “virtually anything consumers purchase on credit from a car to a home mortgage to a student loan.” However, ESMA’s cursory analysis of the fundamental role that benchmarks play fails to distinguish between the ways they are set, who is contributing, how the calculations are done or what the use of the benchmark is. It does, however, note that the challenge is far from regional in that the underlying data for an EU benchmark may be obtained or calculated outside the EU but used widely within the EU.
It is clear from recent CP responses, and the differences introduced by IOSCO, that the EU started with an incomplete understanding of the complexity of how benchmarks are both constructed and used. This means that we will have unintended severe consequences from the EU’s approach that will be exacerbated by regulatory divergences in other jurisdictions.
How many flavours of benchmark would you like?
In summary, assumptions about what needs to be considered within the scope of the ‘benchmark problem’ differ. It would appear that Europe is of the view (in ESMA’s 2012 consultation) that any index or published figure ought to be policed.
This means that the global definition of a benchmark would include only the rates used to determine interest payments, contracts or prices, whereas the EU definition would also include all other rates, such as market indices that might not be captured by the IOSCO definition (all depending on how they are calculated/used).
|Benchmark: The benchmarks in scope of this report are prices, rates, indices or figures that are:a) Made available to users, whether free of charge or on payment;b) Calculated periodically, entirely or partially by the application of a formula or another method of calculation to, or an assessment of the value of, one or more underlying assets, prices or certain other data, including estimated prices, rates or other values, or surveys;ANDc) Used for reference for purposes that include one or more of the following: determining the interest payable, or other sums due, under loan agreements or under other financial contracts or instruments; determining the price at which a financial instrument may be bought or sold or traded or redeemed, or the value of a financial instrument; and/or measuring the performance of a financial instrument.||Benchmark: Any commercial index or published figure, including those accessible on the internet whether free of charge or not,a) Calculated entirely or partially by the application of a formula to or an assessment of the value of one or more underlying assets, prices or certain other data, including estimated prices, interest rates or other values, or surveys;b) By reference to which the amount payable under a financial instrument or the value of the financial instrument is determined.|
There are ways to differentiate between indices – for example, the delineation between benchmarks set subjectively (and, therefore, open to manipulation) and market indices set automatically (therefore, harder to manipulate). As ever, there will be many ways to classify and ‘carve out’ various types of market activity and we have only just begun to see a discussion of what this will look like.
How much risk are we willing to bear, and at what cost?
Fundamental to the benchmark discussion is the ‘emperor’s new clothes’ problem: indices are only valid if people believe in them.
If the calculation behind a benchmark, or the underlying mechanism, changes, then confidence will not automatically be transferred to the new or refined indicator. This creates a risk that someone may decide that the benchmark does not reflect the realities of the market. In this case, we have introduced risk into the system and potentially destabilised it.
The place where the costs are most likely to be felt by end investors is where loan agreements and their like, which were pinned to certain benchmarks (e.g., LIBOR, EURIBOR, etc.), are forced to change. This would involve re-evaluating existing contracts, possibly followed by redrafting and termination, in order to rebase the contract on a new benchmark.
For instance, most pension funds in the UK use interest rate swaps with long term maturity (up to 50 years). If the benchmark changes, this will lead to a fundamental shift in the value of swaps and may significantly affect a pension fund’s ability to pay its members.
The banks and their suppliers will feel the pinch as they need to change massive systems portfolios and data feeds. Thousands of applications, spreadsheets, databases and online web portals would need to be modified. A Y2K-like programme could well be required to remediate legacy systems to meet the new specifications introduced by these reforms. Perhaps, not least, vendor contracts would need to be re-evaluated to see if they comply with both the spirit of the new regulations and whatever new standards are agreed.
All this means that the costs of this regulation may get passed onto consumers.
How certain are we that a global policy will emerge?
It’s clear that a ‘one size fits all’ approach to benchmark regulation is inappropriate and that, in fact, all benchmarks are not created equal. Some clearly give rise to greater risk than others.
The fundamental question, therefore, is ‘what does good benchmark regulation look like?’ The answer will, in large part, depend on how prescriptive a given jurisdiction is, not only in their approach, but in the one deployed globally.
A major challenge will be the incentives for secondary financial centres to stray from the herd. A jurisdiction might find it attractive to allow benchmark practices that are more favourable to its local market conditions, tax law, etc. Of course, if their rules are more attractive to the market and the result is more tax revenue, all the better.
Firms would like some to take a proportionate, or ‘risk-based’, approach. Proportionality would allow firms and market participants to exercise their own judgment when subscribing to benchmarks. The exercise of this judgment could then be supervised by a regulator.
However, not all jurisdictions buy the idea of proportionality. Many are more likely, given the industry’s record of bad practice in the benchmarking arena, to introduce prescriptive rules that remove any room for firms to exercise judgement.
Europe‘s inclusion of benchmarks in market abuse regulation means that they have a head start. However, without the rest of the pack, we are bound to see similar, but different, standards that result in higher costs and potentially increased risk.
Experience with global initiatives, like Recovery and Resolution Plans, OTC trade repositories and the Legal Entity Identifier, have shown that it is nearly impossible to introduce technically compatible market data regulation with even subtly different political objectives and timelines. For instance, the scramble in Europe to classify non-financial counterparties by 15 March under EMIR in a way not foreseen by the Dodd Frank Act shows that even small deltas in approach can have big consequences.
Where are we headed next?
With Brussels just announcing that banking cartels can be fined up to 10% for each of their transgressions – potentially putting 30%+ of a bank’s global turnover at risk – things are due to move quickly in this space.
The European Parliament is scheduled to debate benchmarks in three months. CFTC and IOSCO have held a roundtable at the end of February that should help give clarity on what regulation is coming. In Asia, Hong Kong, South Korea and Singapore have announced that they have efforts underway.
As David Wright, Director General of IOSCO, has suggested previously, we lack a regulator who will oversee a global rulebook and be empowered to take enforcement action.
Ultimately, however, without binding consequences and a coordinated approach, regulators cannot create a truly global agenda. We remain hopeful that these reforms will create global standards which lead to a safer, fairer financial system that restores global trust.
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