Benchmark manipulation and fallout from it is not new news, but the global drive to regulate benchmarks is. The political sensitivity surrounding regulation in this space means that national regulators are racing at different speeds and approaches to implement reforms to ensure benchmarks are transparently regulated and set.
The connection of benchmarks to multiple levels and products in the financial markets mean that even slightly divergent regulation can result in increased cost for firms and risks to the system. As this race continues, global regulators such as IOSCO, will be challenged to coordinate local regulators in a concrete benchmark regulation framework.
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.
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.
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. This means that we may have unintended severe consequences from the EU’s approach that will be exacerbated by regulatory divergences in other jurisdictions.
At present, there is no concrete definition of a benchmark, so ESMA and the EBA are attempting to create their own. 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.
IOSCO has taken a more practical approach, in its 2013 consultation, by including a ‘use test’ that limits the scope of what can be considered to be a benchmark to the purpose of its intended use. This means that the global, IOSCO, definition of a benchmark would come closer to the conventional usage of the word ‘benchmark’, whereas the EU definition would include other rates, such as market indices that might not be captured by the IOSCO definition (depending on how they are calculated/used).
Ultimately, there are clear ways to differentiate between indices – for example, the delineation between benchmarks set subjectively (i.e. those open to manipulation) and market indices set automatically (i.e. those 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.
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 changes, confidence may not automatically transfer to the new 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 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 to bring legacy systems up to date. On the other hand, 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/termination, in order to rebase the contract on a new benchmark.
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 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.
Based on responses to ESMA’s consultation, many firms would like the freedom 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.
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 announced a roundtable at the end of February that should help give clarity on what regulation is coming. And in Asia, Hong Kong, South Korea and Singapore have announced that they have efforts underway. Ultimately, however, without binding consequences, regulators will fall short of creating the global agenda necessary to rule out a repeat of LIBOR.