European Union: Setting The New Benchmark: EU Regulation On Financial Benchmarks

Last Updated: June 21 2016
Article by Peter Green and Jeremy C. Jennings-Mares

Background

The integrity of benchmarks used in financial transactions has been the subject of increasing focus from regulators since the investigations into manipulation of the setting of LIBOR, EURIBOR and other benchmarks. Action was taken in the UK following the Wheatley Review of LIBOR1 to reform the setting and usage of LIBOR, and the UK Financial Conduct Authority (FCA) has subsequently taken action to regulate additional specific financial benchmarks2.

At an international level, in July 2013, the International Organisation of Securities Commissions (IOSCO) published its Final Report on Principles for Financial Benchmarks3. Shortly thereafter, the EU Commission published a draft regulation seeking to establish a pan-European approach to the regulation of benchmark administrators, contributors and users. The subsequent legislative process has been lengthy and has involved significant amendments to the initial draft. However, on 17 May 2016, the European Council of Ministers formally adopted the final version of the Regulation on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (the "Benchmark Regulation") which had previously been adopted by the EU Parliament. It published what is expected to be the final version of the Benchmark Regulation on 10 June 2016.4 The Benchmark Regulation will come into force the day after it is published in the Official Journal of the EU. This is expected to happen in June or early July 2016. Most of its provisions will not, however, be implemented until 18 months after such date (so December 2017 or January 2018) with the exception of some provisions that will apply immediately upon it coming into force and provisions amending the Market Abuse Regulation5 (which will apply from 3 July 2016 to dovetail with the Market Abuse Regulation becoming effective).

Scope of Regulation

The Benchmark Regulation will apply to a very wide range of indices, including proprietary indices, which are used as benchmarks in financial instruments. The key definitions in this context include the following:

Benchmark: There are two elements to this definition:

  • in relation to financial instruments or financial contracts, any index by reference to which the amount payable under such instrument or contract is determined, or by which the value of a financial instrument is determined;
  • in relation to investment funds, any index that is used to measure the performance of any such fund with the purpose of tracking the return of such index or of defining the asset allocation of a relevant portfolio or in computing performance fees.

Index: This is defined as any figure that is:

  • published or made available to the public; and
  • regularly determined (i) entirely or partially by the application of a formula or any other method of calculation, or by an assessment, and (ii) on the basis of the value of one or more underlying assets or prices including estimated prices, actual or estimated interest rates, quotes and committed quotes, or other values or surveys.

In draft technical advice referred to further below, the European Securities and Markets Authority (ESMA) provides that an index should be deemed to be made available to the public if (i) it is accessible by a large or potentially indeterminate number of recipients, or (ii) it is provided or is accessible to one more supervised entities to allow use of the index in the EU.

Financial instrument: Any instrument listed in Annex I(C) to MiFID II6 that is either traded on a trading venue (as defined in MiFID II) or is the subject of a request made for admission to trading on a trading venue or via a systematic internaliser7. The instruments listed in Annex I(C) of MiFID II are very wide and include transferable securities, money-market instruments, UCITS, a very wide range of derivative transactions and financial contracts for difference.

Financial contract: Any credit agreement within the ambit of the Consumer Credit Directive8 or the Mortgage Credit Directive9 (basically EU consumer credit agreements and residential mortgages).

Investment fund: An alternative investment fund (AIF) as defined in the Alternative Investment Fund Managers Directive (AIFMD)10, or a UCITS fund as defined in the UCITS IV Directive11.

The Benchmark Regulation therefore diverges from the existing approach to regulation of benchmarks by the FCA and other regulators which have to date focused on a small number of key benchmarks that are widely used in the financial markets and which are regarded as systemically important. In contrast, the Benchmark Regulation will, subject to limited exceptions, apply to all indices used in financial securities or derivatives traded on a regulated venue in the EU or traded outside such a venue, using an investment firm designated as a systematic internaliser under MiFID II. Although the definition of "index" limits the scope of the Benchmark Regulation to indices that are published or made available to the public, this is likely to be construed widely with the draft ESMA technical standards recommending that an index should be considered as being made available to the public even if only provided to supervised entities to allow use of the index in the EU.

To ameliorate the impact of the vastly increased number of benchmarks to become subject to regulation and supervision in the EU under the Benchmark Regulation, the Regulation distinguishes between "critical", "significant" and "non-significant" benchmarks as specified further below with differing standards of regulatory requirements applying to each category.

The Benchmark Regulation will not, however, apply to the following:

  • central banks;
  • public authorities, in respect of such an authority contributing data to or having control over the provision of benchmarks for public policy purposes (e.g., indices measuring employment, economic activity or inflation);
  • central counterparties (CCPs) in their capacity of providing reference prices or settlement prices used for CCP risk-management purposes and settlement;
  • the provision of a single reference price for any financial instrument;
  • commodity benchmarks based on submissions from contributors, the majority of which are non-supervised entities, provided that the benchmark is referenced by financial instruments for which a request for admission to trading has been made on only one trading venue or which are traded on only one trading venue, and the total notional value of financial instruments referencing the benchmark does not exceed €100 million;
  • an index provider, in respect of an index provided by it where such provider is unaware and could not reasonably have been aware that the index is used as benchmark within the scope of the Benchmark Regulation.

Regulation and Supervision of Benchmark Administrators

One of the key elements of the Benchmark Regulation is a new regulatory and supervisory regime that will apply to administrators of benchmarks that fall within the scope of the Benchmark Regulation. For these purposes, an administrator is any natural or legal person that has control over the provision of a benchmark. There is no guidance as to the meaning of "control" for this purpose, but the definition is likely to be construed fairly widely so any person or entity involved in producing a financial benchmark should consider whether it comes within the scope of the Benchmark Regulation as a benchmark administrator.

Title VI of the Benchmark Regulation requires any benchmark administrator that is located in the EU to apply to its relevant competent authority for authorisation to act in such capacity if it provides or intends to provide indices for use as benchmarks within the scope of the Benchmark Regulation. There is a registration regime for entities supervised under other relevant EU regulation (including credit institutions, MiFID investment firms, insurance and reinsurance undertakings, UCITS funds and managers, AIFs regulated under the AIFMD and CCPs and trade repositories regulated under EMIR12). Benchmark administrators only need to be registered (rather than authorised) with their competent authority if they are only providing indices that are non-significant benchmarks (see further below).

There are also transitional provisions for benchmark administrators that are already providing benchmarks on the date the Benchmark Regulation comes into force. Such entities will have 42 months from such date to apply for authorisation or registration, as applicable. Until the end of that 42-month period (or, if earlier, until any application for authorisation or registration during that time is refused), such existing administrators may continue to provide such existing benchmark(s). If such administrator wants to provide a new benchmark after the Benchmark Regulation becomes effective, it will need to obtain appropriate authorisation or registration prior to doing so.

Benchmark administrators are subject to a number of requirements under the Benchmark Regulation aimed at maintaining the integrity and reliability of relevant benchmarks, including:

  • Governance and conflicts of interest: benchmark administrators are required to have in place robust governance arrangements including a clear organisational structure with well-defined transparent and consistent roles and responsibilities for all persons involved in the provision of a benchmark. Administrators will also be required to take adequate steps to identify and prevent or manage conflicts of interest and to ensure that where any judgment or discretion is required in the benchmark determination process, it is exercised independently and honestly. The provision of the benchmark must be operationally separated from any part of the administrator's business that may create an actual or potential conflict of interest.
  • Oversight function requirements: benchmark administrators will be required to establish and maintain a permanent and effective oversight function to ensure oversight of all aspects of the provision of their benchmarks. They will be required to develop and maintain robust procedures regarding their oversight function and make this available to the relevant competent authorities.
  • Control framework requirements: it will be necessary for benchmark administrators to have in place a control framework that ensures benchmarks are provided and published or made available in accordance with the Benchmark Regulation. The framework must be reviewed and updated as appropriate and made available to the relevant competent authority and, upon request, users of the benchmark.
  • Accountability framework requirements: benchmark administrators will be required to have in place an accountability framework covering record-keeping, auditing and review and a complaints process.
  • Record-keeping: record-keeping requirements provide that benchmark administrators must keep various records, including records of all data, the methodology used for the determination of a benchmark, exercises of judgment or discretion by the benchmark administrator and changes in or deviations from standard procedures and methodologies, including those made during periods of market stress or disruption. Records should be kept for a period of at least five years.
  • Outsourcing: benchmark administrators must not outsource functions in the provision of a benchmark in such a way as to impair materially the administrator's control over the provision of the benchmark or the ability of the relevant competent authority to supervise the benchmark. The administrator must comply with certain specified conditions when outsourcing any functions, including ensuring that the service provider has the ability, capacity and any applicable authorisations to perform the outsourced functions, services or activities reliably and professionally.
  • Input Data: various requirements apply to input data, including that it should be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure. The input data must be transaction data if available and appropriate. If transaction data is not sufficient or is not appropriate to represent accurately and reliably the market or economic reality that the benchmark is intended to measure, input data which is not transaction data may be used, including estimated prices, quotes and committed quotes or other values. ESMA is required to develop draft regulatory technical standards to specify further how to ensure that input data is appropriate and verifiable.
  • Methodology: benchmark administrators are required to use a methodology for determining a benchmark that is robust and reliable, has clear rules identifying how and when discretion may be exercised in the determination of that benchmark and is rigorous, continuous and capable of validation including, where appropriate, back-testing against available transaction data. The methodology must also be resilient in a wide set of possible circumstances and be traceable and verifiable. The benchmark administrator must also develop, operate and administer the benchmark and methodology transparently.
  • Reporting of infringements: benchmark administrators will be required to report to the relevant competent authority any conduct that may involve manipulation or attempted manipulation of a benchmark under the Market Abuse Regulation and in this regard must monitor input data and contributors in order to be able to make any such notifications.
  • Code of conduct for contributors: where a benchmark is based on input data from contributors, the benchmark administrator must develop a code of conduct for each benchmark clearly specifying contributors' responsibilities with respect to the contribution of input data. This code of conduct shall contain the elements specified in the Benchmark Regulation. ESMA is required to develop draft regulatory technical standards to specify further the elements of the code of conduct.

Requirements for Specific Types of Benchmark

Commodity benchmarks: administrators of commodity benchmarks will be subject to additional requirements set out in Annex II of the Benchmark Regulation. These require the benchmark administrator to formalise, document and make public any methodology that the administrator uses for the benchmark calculation. It must also specify the criteria that define the physical commodity that is the subject of a particular methodology and give priority to concluded and reported transactions in respect of its input data. A commodity benchmark also cannot benefit from any of the exclusions relating to significant or non-significant benchmarks specified below. However, if a commodity benchmark which has gold, silver or platinum as the underlying asset is a critical benchmark, it will be able to comply with the rules generally relevant to financial benchmarks rather than the specific commodity rules.

Interest rate benchmarks: specific requirements set out in Annex I of the Benchmark Regulation will apply to interest rate benchmarks. These provide that the general priority of use of input data for such benchmarks will be:

  • a contributor's transactions in the underlying market that the benchmark is intended to measure or, if not sufficient, in related markets;
  • a contributor's observations of third-party transactions in such markets;
  • committed quotes;
  • indicative quotes or expert judgments.

The administrator of an interest rate benchmark must also have in place an independent oversight committee and ensure that a contributor's systems and controls include specific matters set out in Annex I. Additional record keeping requirements also apply, including in relation to input data and names and responsibilities of submitters (defined as a natural person employed by a contributor for the purpose of contributing input data).

Regulated data benchmarks: a regulated data benchmark is one that is determined by the application of a formula from input data contributed entirely and directly from certain regulated venues as specified in the Benchmark Regulation. Such benchmarks will be exempt from certain of the governance and control requirements that would otherwise apply under the Benchmark Regulation, including in relation to input data and the need to develop a code of conduct for contributors. Regulated data benchmarks may benefit from the provisions relating to significant and non-significant benchmarks if used as a reference for financial instruments or financial contracts or for measuring the performance of investment funds, having a total value of up to €500 billion on the basis of all the range of maturities or tenors of the benchmark, where applicable.

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Footnotes

1 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/191762/wheatley_review_libor_ finalreport_280912.pdf.

2 SONIA (Sterling Overnight Index Average), RONIA (Repurchase Overnight Index Average), WM/Reuters London 4pm Closing Spot Rate, ISDAFIX, London Gold Fixing, the LMBA Silver Price and the ICE Brent Index.

3 https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf.

4 http://data.consilium.europa.eu/doc/document/PE-72-2015-REV-1/en/pdf.

5 Regulation 596/2014, 65 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0596&from=EN.

6 The recast Markets in Financial Instruments Directive, Directive 2014/65/EU, http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014L0065&from=EN.

7 investment firms which, on an organised, frequent, systematic and substantial basis, deal on own account by executing client orders outside a regulated market, MTF or organised trading facility as defined in MiFID II.

8 Directive 2008/48/EC, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2008:133:0066:0092:EN:PDF.

9 Directive 2014/17/EC, http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014L0017&from=EN.

10 Directive 2011/61/EC, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:174:0001:0073:EN:PDF.

11 Directive 2009/65/EC, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:en:PDF.

12 European Market Infrastructure Regulation ("EMIR"), Regulation 648/2012, http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0648&from=EN.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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