The integrity of a benchmark (an index that is used as a reference price) is critical to the pricing of many financial instruments and contracts. Any manipulation of a benchmark is likely to cause significant losses to owners of assets valued by reference to that benchmark. Concerns about the risk of benchmark manipulation are also likely to undermine market integrity and confidence.
These aspects were recognised by the European Commission’s recent proposal to regulate indices used as benchmarks in financial instruments and financial contracts (EC’s Proposed Regulation), announced yesterday in Brussels on 18 September 2013.1 If approved by the European Parliament, the EC’s Proposed Regulation would result in the regulation of all published benchmarks used to reference traded financial instruments, financial contracts (such as mortgages) and benchmarks that measure the performance of an investment fund. In effect, this includes indices ranging from financial benchmarks (such as LIBOR) as well as benchmarks used to set the price of physical commodities.
From a competition / antitrust perspective, a key objective of the EC’s Proposed Regulation is to limit the risk of cartel conduct. The EC’s Proposed Regulation also seeks to avoid conflicts of interest among benchmark contributors by reducing discretion and enhancing the integrity and reliability of the input data and methodology used to produce a benchmark, thereby increasing the robustness of benchmarks. Investor protection is also likely to be enhanced through the transparency protections in the EC’s Proposed Regulation.
The impact of the EC’s Proposed Regulation is unlikely to be limited to Europe, given that many regulators around the world are dealing with similar issues and looking for their own solutions to these problems. While there are as yet no plans to roll out Australian regulation, or investigate Australian benchmarks and indices, it will be interesting to watch developments in this space over the coming months.
What prompted the EC’s Proposed Regulation?
The EC’s Proposed Regulation follows the announcement of a number of investigations that are currently being conducted by regulators in relation to index-based prices setting mechanisms which, in turn, followed regulators’ investigations into the manipulation of the LIBOR. For example:
- in December 2012 Hong Kong’s central bank, the Hong Kong Monetary Authority (HKMA), began investigating UBS in relation to possible misconduct in relation to the setting of Hong Kong’s benchmark interest rates2 and in June 2013 it was reported that the HKMA had extended its investigation to other lenders, including HSBC;3
- in May 2013 the European Commission conducted dawn raids relating to allegations of anticompetitive conduct in the oil and biofuel sectors (click here to read Gilbert + Tobin's article relating to this);
- in June 2013 it was reported that that the US Federal Trade Commission (FTC) had opened a formal investigation into how prices of crude oil and petroleum-derived products are set;4 and
- also in June 2013, the Monetary Authority of Singapore (MAS) completed its year-long review of the processes involved in banks’ submissions to various Singaporean benchmarks. It undertook supervisory actions against 20 banks for deficiencies in their governance, risk management, internal controls and surveillance systems involved in benchmark submissions. The MAS also proposed a regulatory framework for financial benchmarks.5
Such investigations, coupled with the EC’s Proposed Regulation, have placed a wide range of index-based price setting mechanisms under increased regulatory scrutiny, with potential ramifications across a broad range of industries.
What does the EC’s Proposed Regulation involve?
The EC’s Proposed Regulation generally involves the following:6
- regulating administrators of benchmarks (price reporting agencies) through supervision by national competent authorities, coordinated by the European Securities and Markets Authority. For critical benchmarks, colleges of national supervisors would be formed;
- all those involved in calculating benchmarks or contributing information used in benchmark calculations would be required to tighten up their governance and scrutiny procedures, in particular to prevent conflicts of interest;
- data for the calculation of benchmarks would have to be publicly available, as well as information on what each benchmark measures and its intended purposes; and
- banks would have to assess the suitability of the benchmarks they use before entering into any financial contracts (such as a mortgages) with a customer, and would have to warn the client if the benchmark is unsuitable.
Perhaps the most significant proposal is the requirement in Article 9 of the EC’s Proposed Regulation for price reporting agencies to adopt a code of conduct for each benchmark which would be legally binding not only on the price reporting agency but also on all contributors to that benchmark.
There are concerns that this requirement might mean that companies would no longer voluntarily contribute data to price reporting agencies, with the consequence that the benchmark would not be as representative as it might otherwise have been. Potentially in response to this concern, Article 14 of the EC’s Proposed Regulation provides that certain benchmark contributors can be compulsorily required to contribute input data to critical benchmarks.
What has been the industry’s response?
While the EC’s Proposed Regulation is the most recent proposal to reform benchmarks, it is by no means the only one. In response to the LIBOR investigations, there were a number of proposals for reform, some by governmental organisations and others by industry participants in an attempt to implement industry self-regulation.
For example, the Index Industry Association (IIA) (formed by Standard & Poor’s, FTSE and MSCI) published its “Set of Best Practices indexing standards” (IAA Best Practices) on 22 July 2013.7 The IIA Best Practices are stated to apply only to activities, policies and structures of an index provider associated with the administration, maintenance and calculation activities with respect to its indices. IIA members are required to abide by the IIA Best Practices, while non-IAA members can adopt the IIA Best Practices by becoming a signatory and confirming their compliance.
Another example is the set of proposed “Principles for Financial Benchmarks” published on 17 July 2013 by the International Organization of Securities Commissions (IOSCO).8 IOSCO comprises the regulators of more than 95 percent of the world’s securities markets with its membership including more than 120 securities regulators and 80 other securities market participants (such as stock exchanges). IOSCO stated that its objective in publishing the Principles was to create an overarching framework of principles for benchmarks used in financial markets to be implemented by benchmark administrators and submitters (contributors of data to those benchmarks).
What does the future look like?
The regulation of benchmarks is in state of flux and, therefore, there are opportunities for market participants to innovate in this space. Such innovation can take the form of self-regulatory arrangements, such as those outlined above, and can also translate into the creation of entirely new benchmarks. For example, in February 2013, gas brokers ICAP Plc, Marex Spectron Group Ltd and Tullet Prebon Plc initiated a range of indexes (the Tankard European natural gas indexes) which bypass the involvement of price reporting agencies.
In any case, it is unlikely that attempts at increased regulation and scrutiny of benchmarks will go away. While the final form of any regulatory package is yet to be decided, there will continue to be debate around these issues. We will watch developments in this space with interest over the coming months.