European Commission to Regulate Benchmarks: LIBOR, Commodities Face Additional Rules
Last week, the European Commission published its much-anticipated draft regulation on benchmarks. The legislative proposal sets out broad measures to improve the governance, transparency, and supervision of benchmarks and specifies more detailed provisions for interest rate benchmarks and commodity benchmarks — a recognition of the damage to market integrity from the LIBOR and Euribor scandals and investigations into commodity price manipulation. A timely reminder of the importance of this regulatory initiative (as if we needed it) came this week with news of ICAP’s pending settlement with the U.K. and U.S. authorities over the interdealer broker’s involvement in the LIBOR affair.
The draft regulation is broad in scope, capturing all indices used as a benchmark (i.e., a reference price) in financial instruments and contracts, as well as indices used to measure the performance of investment funds.
Under the proposal, benchmark administrators are required to be authorised and supervised by the local regulatory authority (more on supervision later). Administrators must also ensure adequate governance and oversight arrangements, manage conflicts of interest, establish a control framework, and ensure accountability through recordkeeping and audit requirements. Additionally, administrators must draw up a code of conduct for contributors of benchmark input data, and these contributors must also employ adequate controls and manage conflicts of interest.
The draft regulation also contains provisions on input data and benchmark methodology, specifying that input data shall be transaction data. If transaction data is not available, other types of input data may be used provided that such data is verifiable. One of the main lessons from the LIBOR scandal was that the discretion afforded to contributors to submit estimated rates that were not required to be verified increased the benchmark’s susceptibility to manipulation. By firmly emphasizing the prominence of observable transaction data in the construction of benchmarks, and by requiring corroboration of other inputs, the draft regulation should improve the transparency, robustness, and credibility of benchmarks.
There has been much debate in policy forums over the extent to which benchmark providers should disclose details of their index methodology. Some index providers have expressed concern that full disclosure of their methodology would infringe intellectual property rights. The European Commission’s regulation would not seem to settle those concerns; it calls for providers to publish a “benchmark statement” that, among other things, specifies the criteria and procedures used to determine the benchmark, including a description of the input data, the priority given to different types of input data, the use of any models or methods of extrapolation and any procedure for rebalancing the constituents. The benchmark statement must also outline the controls and rules that govern any exercise of discretion or judgment by the administrator.
With regard to supervision of benchmark administrators, there was initially some contention around the allocation of supervisory responsibility between national regulators and the European Securities and Markets Authority (ESMA), with early drafts of the regulatory proposal calling for ESMA to supervise “critical” benchmarks such as LIBOR. The final proposal keeps supervision in national hands but requires colleges of supervisors — comprising the local regulator of the administrator and contributors, and ESMA — for critical benchmarks, with powers of binding mediation given to ESMA. Regulators may also compel submissions to a benchmark under certain circumstances.
Additional Measures for Interest Rate Benchmarks, Commodity Benchmarks, “Critical” Benchmarks
Although broad in scope, the draft regulation follows a two-tiered approach with general requirements for all benchmarks and specific requirements for interbank interest rate benchmarks, commodity benchmarks, and critical benchmarks, which are defined as referencing financial instruments with a notional value of at least €500 billion (which would include LIBOR). There are also exemptions from certain provisions for benchmarks based on exchange data from regulated markets. Consequently, the regulation seems sensibly calibrated and avoids imposing LIBOR-type requirements across the board.
Regarding interbank interest rate benchmarks, the draft regulation contains detailed provisions on the types of acceptable input data, including the specific types of transactions and non-transactions data. There are also specific provisions on administrator governance, external audits, contributor systems and controls, and key elements of the code of conduct that administrators must establish for contributors. Similarly, for commodity benchmarks, the draft regulation sets out detailed provisions regarding methodology and input data, benchmark calculations, reporting, and controls.
For the most part, the provisions for interest rate benchmarks are broadly consistent with the recommendations of the U.K.’s Wheatley Review of LIBOR, published last year. The two-tiered approach to the draft regulation is also consistent with the IOSCO principles for financial benchmarks, published in July, which similarly espouses general principles for all benchmarks and additional measures for submissions-based benchmarks such as LIBOR. Indeed, the EU proposal gives added weight to the IOSCO principles. If an index provider wants to operate in the EU, the European Commission will make a third country equivalence assessment of the rules in the provider’s home jurisdiction; the main criteria for assessing equivalence will be compliance with the IOSCO principles.
Overall, the EU’s regulatory proposal should help to underscore benchmark integrity and provide greater confidence to investors and other users that benchmark information is robust and reliable. As we’ve noted in previous posts, these regulatory measures are an important step towards restoring financial market integrity; on first evidence, it seems like the European Commission has taken a sensible path.
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