‘Not even Mother Teresa wouldn’t manipulate Libor if she was setting it and trading it’ – Tom Hayes
The EU Benchmarks Regulation (BMR) is the first of its kind in the world – and it’s causing a lot of confusion.
The London Inter-bank Offered Rate (Libor)-rigging scandal, which saw traders collude over a number of years to manipulate financial benchmarks in their favour, severely damaged public perceptions of the financial industry.
The scandal is a strange one in that there were – as those implicated argue – no clearly identifiable victims. The mortgage payments of buy-to-let investors, private bank clients and subprime borrowers may have been adversely affected, but conversely others will have benefited.
Regulators feel very strongly that this argument misses the point, and that without standards, processes and procedures governing benchmarks, such misconduct will continue to fester. Enter the BMR.
How did it come about?
Markets have everyone’s favourite Financial Conduct Authority (FCA) chief executive to thank for the BMR: Martin Wheatley.
The infamous/famous Wheatley Review of 2012 recommended that Libor be reformed, and that regulators introduce criminal sanctions for benchmark manipulation.
That proposed reform suggested shifting administration of the rate from the now-defunct British Bankers’ Association to a new unknown administrator, improvements to the calculation methodology, and enshrining administration and submissions in the Financial Services and Markets Act 2000 as regulated activities.
While agreeing to rig a rate in exchange for a curry is clearly a governance issue, regulators felt that there were systems and control issues too. Benchmarks themselves – Libor in particular – needed reforming just as much as the people in charge of them.
The feeling is that the Senior Managers & Certification Regime, which aims to improve culture in financial services – a notoriously difficult thing to regulate, did not go far enough when it comes to benchmarks.
How does it work?
Technically, the BMR places the burden of compliance on the users of benchmarks rather than their providers. Once it’s fully implemented, EU-based benchmark providers will only be able to use financial benchmarks that have received prior authorisation from the European Securities and Markets Authority (Esma). If they can’t find the provider on the approved register, they can’t use the rate.
But ‘technically’ is the operative word there. Most financial benchmark providers make money out of others (mostly asset managers) using their benchmarks – so the burden is, arguably, still on the provider.
As for what’s actually required, sources say it’s not too rigorous: internal oversight, controls and accountability frameworks and the regulation of methodologies and input data.
“The BMR makes it formal, but it’s all about a standard of care which is very reasonable,” says Adam Schneider, partner at Oliver Wyman. “If benchmark administrators are operating in EU markets it’s very much in their interest to get authorised – and I hope those working in indexes understand that.”
The initial scoping exercise was significant, too: firms at the larger end of the scale can have 500 or more prop indices in operation. And because it’s such a complex area, the number of people in that organisation who fully understand the index is likely to be limited, potentially even to just the desk that operates it.
Next up was establishing exactly who was using the indices, where they were, and what they used it for. According to sources, many fell at the first hurdle.
Late last year consultants were still receiving questions on how to establish benchmark users.
What about non-EU benchmark providers?
While most major providers see benchmarks as a core tenet of their business – or a revenue-generating element, at least – some do not.
“There’s an enormous number of people who haven’t realised they’re administrators yet, particularly on the buyside,” a market participant close to the Libor reform process told IFLR’s sister publication Practice Insight late last year. “The moment you customise someone else’s indices, you are an administrator…there’s an awful lot of people on the buyside who don’t seem to understand this.”
The BMR outlines three potential routes for third country providers: endorsement, recognition, and equivalence.
First, equivalence, which is a relatively well-understood regulatory concept, and is being pursued by lawmakers in Australia and Singapore.
Both remaining routes require a significant level of expertise and experience – and risk appetite. While recognition is considered a stepping stone to equivalence, endorsement is more far-reaching and significantly riskier for the endorser.
Given that indices on the whole is a relatively new industry, it’s not clear how many people even exist in the EU with that level of understanding.
“As an endorser you take on the entirety of the legal risk for that benchmark, and I’m not sure there’s many willing to do that,” says a director at a firm considering providing these services.
And it can be significant risk. Another source at a large benchmark administrator said that understanding of what constitutes indices manipulation is still severely lacking at certain operators. “We found once we started offering these services that traders would ask us all the time to fiddle the index because they don’t like the way it’s going,” he says. “These desks are under extreme pressure to enhance performance – and this is widespread.”
So far there are just over 66,000 third-country benchmarks to have received authorisation; the vast majority of which are in the US.
What benchmarks will be regulated?
The main principle of the BMR’s scope is the end purpose of the benchmark. For an index to be considered a benchmark, it needs to be referenced by either a financial instrument which is traded on a trading venue (a Mifid annex is cited here) or via a systematic internaliser, a financial contract, or an investment fund.
The figure also has to be published or made available to the public, which the regulator considers an “indeterminate number of persons”. That’s obviously vague – some believe this was deliberate – and can be interpreted in a whole range of ways.
When will it be implemented?
As with many EU regulations, there have been various phases to the BMR. Some were effective from January 1 2018; the whole hog was initially intended for January 1 2020. But in a slightly embarrassing concession from EU lawmakers, that date was pushed back to 2022 for critical and third-country indices.
“I think some of the regulators themselves also acknowledged that they couldn’t meet the deadline either,” says Rick Redding, chief executive of the Index Industry Association. “Some providers were actually a little upset about the delay as they’d spent so much time and money getting ready, but I think it was the right move.”
At that point not a single Asian benchmark provider had signed on.
What about Brexit?
The eternal question.
Of the 36 EU-based benchmark administrators on the Esma register so far, exactly half are in the UK – so Brexit is incredibly pertinent.
The FCA has created its own UK Benchmarks Regulation and launched its own benchmarks register to replace the Esma database in the event of a no-deal Brexit.
Are there opportunities?
As with any key piece of regulation, there are winners and losers. Potential losers include third-country benchmarks who lack the time, resource or backing from management to seek Esma authorisation.
There are plenty looking to maximise the opportunities, too, by offering third country benchmark administrators a route in to the EU via either recognition or endorsement.
It’s a risky business though. Endorsers take on the entirety of the legal risk for that benchmark – which many are not too keen on.
“We’re talking to some people about it, but carefully weighing the level of exposure against the provider’s willingness to give us full governance access,” one such firm told Practice Insight last year.