European Benchmark Regulation - Sufficient to Prevent a LIBOR Like Crisis Repeat?
The ink has not yet dried on the drafts of European Benchmark Regulation (Regulation) and while the markets and the industry are trying to gauge the effect of this all encompassing regulation, one thing seems increasingly evident - the benchmark regulatory practices across the globe converging towards the same destination - of Restoring Investor Confidence.
However, it may be noted that the objective of restoring investor confidence is only the first step - which in turn leads to informed and transparent choices for more efficient capital allocation. This underlying thread can be seen through the four fundamental objectives envisaged by the Regulation:
Improving governance and controls over benchmark process, especially by managing conflicts of interest
Enhancing the quality of input data and administration methodology
Ensuring that adequate controls are in place for benchmark contributors (and their submissions) to avoids conflicts of interest
Protecting consumers and investors through greater transparency and adequate rights of redress
The scope of Regulation is broad and encompasses benchmarks of all sizes, asset classes and regulates all the stakeholders through the entire spectrum of production and usage. The approach taken by the regulators in this case is a clear indication of cautionary approach adopted. While there is no clear evidence that warrants tighter control across all flavours of major and minor benchmarks, it is a movement in the right direction to build a level playing field for market participants.
Principle of Proportionality
The fundamental tenet of the Regulation is based on preventive regulatory framework and that is efficiently accommodated using the principle of proportionality. Every benchmark, major or minor, internal or market-driven, though have certain common components, differ in terms of the degree of risks associated with it. The one-size-fits-all approach does not address the varied flavours of benchmarks available and thus calls for a tailored approach for each benchmark according to the risks it poses.
The Regulation makes way for this using the principle of proportionality emphasising on regulating the benchmarks in proportion to the amount of activity they witness, their individual characteristics, operating environment, global impact, substitutability, vulnerabilities and magnitude of risks.
The benchmarks and corresponding norms are therefore divided based on significance, underlying asset/sector and the source of data. Refer to Exhibit A below for key features.
The Case of Third Country Benchmarks
A key point of discussion for the regulation is with respect to the treatment of Non-EU benchmarks. While the original proposal provided only one way to treat the third country benchmarks - through Equivalence - further negotiations and iterations resulted in three forms of treatment.
Equivalence applies to all the Non-EU third country benchmarks for which relevant cooperation agreements are in place and that the Commission has fundamentally confirmed the “Equivalence” of legal framework and supervisory practice in the relevant third country. Administrators of these benchmarks which are authorised and regulated in the third country, should notify ESMA of their interest in providing the benchmark in EU for enabling the usage from thereon.
Until the EU commission adopts the equivalence decision, Recognition to a Non-EU benchmark could be provided if the concerned third country administrator is recognised by the member state of reference. For this to fructify, the administrator should demonstrate compliance of either the benchmark regulations or IOSCO principles for financial benchmarks of 2013 or the IOSCO principle of oil price reporting agencies, 2012.
Recognition to a Non-EU benchmark could be provided if a registered or authorised administrator in EU endorses the third country benchmark administrator by filling an application with competent authority. In this case of Endorsement, the endorsing EU administrator must
Ensure and demonstrate benchmark(s) endorsed fulfils the requirements as stringent as the Benchmark regulation at the least.
Demonstrate that it has necessary expertise to manage and monitor the provision activities in third country and manage associated risks
Ensure that there is objective reason to provide benchmark in third country and endorse its use in EU
The impact of regulation of this magnitude and scope will no doubt have far reaching impact on a variety of stakeholders involved in the benchmark determination, dissemination and consumption. Though, this should not deter any particular party to embrace the regulation, it is critical that it is clearly understood, in letter and spirit, and ensure that the necessary strategic and tactical changes are undertaken as necessary.
For Benchmark Administrators, there is clear upsurge of regulatory requirements and scrutiny. On the backdrop of principle of proportionality, administrators of critical benchmarks would likely witness increased requirements and thereby costs in the areas of authorisation and registration, governance, control and oversight of benchmark computation. On the flip side, the administrators of Non-Critical Benchmarks will also benefit from the lighter-touch regime which reduces the burden comparatively. Regardless of the criticality of benchmark, all the administrators would have to put in place controls for input data consumption and benchmark computation, enable procedures for reporting of infringements and handling complaints, establish revised publishing methodology, code of conduct and set up corresponding infrastructure.
Though the regulation makes a clear distinction between supervised Contributors and non-supervised contributors, the impact of the regulation will nevertheless affect both the categories relatively equitably. This is primarily because the code of conduct and the operational procedures to be followed in providing the input remains dependent on the administrator’s guidance which could be expected to be uniform. Contributors need to put in place framework “to ensure the integrity and reliability of all contributions of input data to the administrator”. This ranges from establishing procedures on submission of input data, how and who is submitting, establishing governance structures and audit control processes, devising conflict management measures and meticulous record keeping of all communications, input data, conflicts of interest, internal and external audits.
The clause of third country provisions requires adherence of a minimum of the Regulation to be adopted for usage in EU region. The usage of non-EU benchmark thus will be dependent on the adherence to a regulation of such scope and magnitude. Since, there are no regulations at the moment to match this, there could be implications for market participants and investors in terms of closing their positions based on these benchmarks or closure of products or offerings based on them. This needs to be carefully considered and an appropriate transition plan needs to be devised to avoid market disruption.
The regulatory terrain around the world is quickly adjusting. While this is a right step, It is poignant to recollect that historical evidence suggests that too much regulation isn’t beneficial for innovation in any industry and financial industry is no exception. With multiple regulatory initiatives across the globe from Americas to Pacific, It is imperative that regulators do not overburden the parties involved such as financial institutions and administrators with multiple regulations in similar areas thereby compounding the requirements and compliance costs. The regulatory frameworks should be streamlined and consolidated where possible.
The European Benchmark Regulation is a first of its kind in terms of scope, intensity and reach. It is designed for the purpose of restoring investor confidence. Whether this will suffice to prevent another LIBOR like crisis and achieve its objectives within the timeframe remains to be seen.