Benchmarks Regulation: has it flown under your radar?

This year the buy-side regulatory headlines have been dominated by the EU’s Markets in Financial Instruments Directive II (MiFID II), Brexit and the Financial Conduct Authority’s (FCA) asset management market study. As 2018 approaches, there is another significant regulatory development on the horizon that asset managers would be ill advised to ignore. This is the EU Benchmarks Regulation.

In 2012, as a result of scandals, the then CEO of the FCA, Martin Wheatley, was asked to conduct a review into the London Interbank Offered Rate (Libor). The resulting report, the ‘Wheatley Review’, recommended criminal sanctions for benchmark manipulation, and a program of reform, rather than replacement, for Libor (including its transfer to a new administrator, improvements in the methodology for calculating the benchmark, and that administration of and submission to Libor be made regulated activities under the Financial Services and Markets Act 2000).

Libor’s administrator and its 20 panel banks became regulated for benchmark activities on 1 April 2013. In April 2015 the list of regulated benchmarks in the UK was enlarged to include seven other major benchmarks – LBMA Gold Price, and LBMA Silver Price, the ICE Swap Rate, SONIA, RONIA, the WM/Reuters London 4pm Closing Spot Rate and the ICE Brent Index.

The administrators of these benchmarks are subject to FCA rules that require them to put in place appropriate governance arrangements (including the formation of an oversight committee) to have effective controls to ensure the integrity of input data and to keep adequate records. Benchmark submitters are subject to similar requirements to ensure that they manage any conflicts of interest and are subject to an annual audit. Both administrators and submitters need to have a named individual responsible for compliance with these rules.

While work was being undertaken in the UK, the International Organisation of Securities Commissions (IOSCO) developed global Principles for Financial Benchmarks, published in July 2013. These principles created a common cross-jurisdictional framework for good market practice and have been widely adopted as industry standards. They impress upon administrators the need for strong governance, robust benchmark design, transparent methodologies and clear accountability.

On 29 June 2016, Regulation (EU) 2016/1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (the Benchmarks Regulation) was published in the Official Journal of the EU. It entered into force on 30 June 2016. The Benchmarks Regulation generally applies from 1 January 2018 subject to certain transitional provisions (see below). The Benchmarks Regulation, being directly applicable in Member States, will supersede the UK’s existing requirements.

Article 3(3) of the Benchmarks Regulation sets out the definition of “benchmark”. The definition does not hinge on what the benchmark references, but how it is used:

“’benchmark’ means any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument, is determined, or an index that is used to measure the performance of an investment fund with the purpose of tracking the return of such index or of defining the asset allocation of a portfolio or of computing the performance fees.”

Article 3(1) of the Benchmarks Regulation defines an “index” as meaning any figure

• that is published or made available to the public; and
• that is 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.

A Commission Delegated Regulation sets out further guidance as to the meaning of “published or made available to the public” (Commission Delegated Regulation of 29 September 2017 supplementing Regulation (EU) 2016/1011 of the European Parliament and of the Council specifying technical elements of the definitions laid down in paragraph 1 of Article 3 of the Regulation).

Article 2 of the Benchmarks Regulation sets out certain exemptions to the definition of benchmark. Benchmarks provided by central banks or other authorities for public policy purposes are excluded. Also, benchmarks that reference a price of a single financial instrument (such as the price of a specific share) are not in scope¹. Standard variable rates offered by credit institutions will not be considered benchmarks when used in mortgage or consumer credit contracts.

Applying the principle of proportionality, the Benchmarks Regulation classifies benchmarks as ‘critical’, ‘significant’ and ‘non-significant’, and the nature and degree of the requirements under it will be determined by these classifications. A benchmark is deemed to be either ‘critical’ or ‘significant’ where it satisfies the conditions set out in Articles 20(1) or 24(1) of the Benchmarks Regulation². A ‘non-significant’ benchmark is one that meets the definition of ‘benchmark’ but does not satisfy the conditions to be either a critical or significant benchmark (Article 3(27) of the Benchmarks Regulation)³. The Benchmarks Regulation also contains requirements for different types of benchmark: regulated-data benchmarks (Article 17), interest rate benchmarks (Article 18) and commodity benchmarks (Article 19).

The primary impact of the Benchmarks Regulation will be on benchmark administrators, as it introduces a requirement for their prior-authorisation/registration (Article 34) and ongoing supervision (Articles 4 to 14 and 27 to 28). Where an administrator has been authorised its details shall be placed on a public register maintained by the European Securities and Markets Authority (ESMA) (Article 36 of the Benchmarks Regulation). ESMA will start publishing this register as from 1 January 2018. The ongoing requirements, like the IOSCO Principles, cover governance and accountability as well as the design and methodology of any benchmarks provided.

The Benchmarks Regulation also introduces a code of conduct for contributors of input data requiring the use of robust methodologies and sufficient and reliable data (Article 15 of the Benchmarks Regulation). It also sets out governance and control requirements for contributors (Article 16 of the Benchmarks Regulation).

The Benchmark Regulation also impacts users of benchmarks who are already 'supervised entities' (defined in Article 3(17) of the Benchmarks Regulation). This includes alternative investment fund managers (AIFMs), undertakings for collective investment in transferable securities (UCITS) management companies (and self-managed UCITS), MiFID II investment firms and credit institutions as defined by the Capital Requirements Regulation.

Supervised entities will need to consider carefully whether they ‘use’ a benchmark. Article 3(7) of the Benchmarks Regulation defines ‘use of a benchmark’ as:

• issuance of a financial instrument which references an index or a combination of indices;
• determination of the amount payable under a financial instrument or a financial contract by referencing an index or a combination of indices;
• being a party to a financial contract which references an index or a combination of indices;
• providing a borrowing rate as defined in point (j) of Article 3 of Directive 2008/48/EC calculated as a spread or mark-up over an index or a combination of indices and that is solely used as a reference in a financial contract to which the creditor is a party; and
• measuring the performance of an investment fund through an index or a combination of indices for the purpose of tracking the return of such index or combination of indices, of defining the asset allocation of a portfolio, or of computing the performance fees.

Asset managers represent an important group of benchmark users, either in the case of passive managed funds and exchanged traded funds – where benchmarks are used as a target for index linked funds – or in the case of the evaluation of an active manager’s performance – where the fund performance is measured against a selected index or a set of indices. Asset managers as benchmark users are generally not involved in the production, calculation and contribution to data on which benchmarks are based⁴.

Where a fund uses a benchmark to measure its performance for the purpose of either tracking the return of the benchmark or defining the asset allocation of the portfolio or computing performance fees payable by it, such use will fall within the scope of the Benchmarks Regulation (Article 3(7)(e) of the Benchmarks Regulation)⁵.

Also, a fund will be considered to use a benchmark where it enters into a derivative contract (the underlying of which is a benchmark) which is traded on a trading venue unless the terms of that contract are set by:

• the trading venue on which the derivative is being traded.
• the counterparty where that counterparty is an investment firm acting as a systematic internaliser.
• the central counterparty clearing the relevant trade⁶.

The Benchmarks Regulation provides that:

• supervised entities may only use benchmarks that are provided by an EU authorised benchmark administrator, or a non-EU benchmark administrator where a positive equivalence or recognition determination has been made (see below);
• where the prospectus of a UCITS fund references a benchmark, the prospectus must include information on whether the index provider complies with the Benchmarks Regulation. This disclosure must be included in the prospectus of all new UCITS authorised on or after 1 January 2018 (Article 29(2) of the Benchmarks Regulation). Existing UCITS must incorporate such disclosure the next time they are updating their prospectuses after that date or at the latest within 12 months after that date (Article 52 of the Benchmarks Regulation). No equivalent disclosure requirements are imposed on alternative investment funds;
• supervised entities must have in place certain written contingency plans setting out the steps which will be taken in the event that the benchmark ceases to exist or materially changes. Where possible and appropriate, these arrangements should identify a replacement benchmark and explain why such replacement benchmarks are deemed suitable. The Benchmarks Regulation requires that these contingency arrangements should be reflected in contracts with clients. The plans and any updates to them are deliverable to the relevant Member State competent authority upon request (Article 28(2) of the Benchmarks Regulation); and
• any breaches in respect of the use of a benchmark within the scope of the Benchmarks Regulation are subject to a number of administrative sanctions including fines, which may be levied on both a firm and an individual (Article 42 of the Benchmarks Regulation);

The Benchmarks Regulation provides for the following mechanisms under which third country benchmarks may be used by supervised entities in the EU

• equivalence (Article 30 of the Benchmarks Regulation): the European Commission (Commission) makes a positive decision on the equivalence of a third country’s regime for benchmark administrators or a positive equivalence decision is made as regards specific administrators, benchmarks or families of benchmarks in a third country. In either case ESMA is to establish cooperation arrangements with the relevant third country competent authority.
• recognition (Article 32 of the Benchmarks Regulation): recognition is a temporary measure until the Commission can adopt a positive equivalence decision. A benchmark provided by an administrator located in a third country may be used by EU supervised entities provided the administrator acquires prior recognition by the Member State competent authority of reference. Prior recognition is based on the third country administrator’s compliance with the IOSCO Principles. A third country administrator must also have a legal representative in the EU.
• endorsement (Article 33 of the Benchmarks Regulation): administrators or supervised entities located in the EU can apply to their Member State competent authority to endorse third country benchmarks.

In each of the above cases, the details of the third country administrators shall be placed on the public register maintained by ESMA.

Article 51 of the Benchmarks Regulation provides for certain transitional periods

• an index provider which was already providing a benchmark on 30 June 2016 benefits from a transitional period until 1 January 2020 to apply for authorisation or registration as an administrator.
• a non-authorised or non-registered index provider may continue to provide an existing benchmark until 1 January 2020.

Article 52 of the Benchmarks Regulation provides that for UCITS prospectuses approved prior to 1 January 2018, the underlying documents shall be updated on the first occasion or at the latest within 12 months after that date.

For some firms the introduction of the Benchmarks Regulation will not come as a huge shock where they have already been raising their standards under the IOSCO Principles. However, for other firms meeting the new requirements will be a challenging exercise.

Any supervised entity, including AIFMs and UCITS managers, should carefully consider their risk exposure to the Benchmarks Regulation. They should create an inventory of the benchmarks that they use, and seek assurances from the administrators of those benchmarks that they are aware of the Benchmarks Regulation and have plans in place to comply with it from 1 January 2018. This is particularly important where the benchmarks are provided by smaller administrators, particularly in third countries. Supervised entities should also be thinking about potential alternative benchmarks in case any benchmark they currently use becomes unavailable, and the creation of written contingency plans mentioned above. For UCITS funds, new prospectuses will need wording regarding compliance with the Benchmarks Regulation as will existing prospectuses that are updated.