In July 2012, the Chancellor of the Exchequer announced that a review into the setting of LIBOR would be conducted by Martin Wheatley. The Wheatley Review will look to the framework for future rate-setting, and it is intended that any necessary statutory amendments could be incorporated into the Financial Services Bill which is currently before Parliament. For further information on LIBOR and the potential impact of the Wheatley Review, please refer to our previous advisory, "LIBOR – The Wheatley Review".
In a more recent development, the European Commission has circulated a consultation document requesting comment from stakeholders on EU-wide regulation of financial indices, which would include LIBOR, EURIBOR and other market benchmarks (European Commission, "Consultation Document on the Regulation of Indices", 5 September 2012).
This alert will briefly summarise the perceived problems with indices and will examine the key questions which are being put to consultation by the Commission.
The Commission has rightly observed that (i) the integrity of indices and benchmarks is crucial in pricing interest rate swaps and many other financial instruments and (ii) that alleged manipulation can undermine market confidence. Sanctions – including criminal penalties-- for the manipulation of benchmarks have already been put forward by the Commission bay way of revisions to the Market Abuse Directive.
In contrast, the new consultation assesses how the production and governance of benchmarks can be improved. The Commission has identified five core areas of concern on which it has asked for comment.
- Indices and benchmarks: What they are, who produces them and for which purposes
In an effort to better gauge the nature of existing indices and benchmarks, the Commission has requested that interested parties provide information on benchmarks which are currently available.
Questions put by the Commission include:
- Which benchmarks do you produce or contribute data to?
- Which benchmarks do you use? What do you use each of these benchmarks for?
- How many contracts are referenced to benchmarks in your sector?
- To what extent are these benchmarks used to price financial instruments?
- Governance and transparency in the calculation of benchmarks
As the Commission in keen to stress, the preparation of indices and benchmarks is not a mechanical exercise and can require a degree of discretion and subjectivity from both contributors and calculators. The Commission notes that the integrity of a given index will be impacted when that discretion is not exercised appropriately.
The Commission suggests that benchmarks could be altered to maximise the availability of concrete data, thereby reducing the reliance on estimates and discretion. For example, an index could be produced less frequently, with a more broadly defined scope. Accepting that in some markets the availability of hard data is not a realistic option, the Commission suggests that a 'hybrid' system could be employed as an alternative, with estimates only to be considered when no firm transaction data is available. Finally, the Commission suggests that, where insufficient clear information is available, the benchmark should not be produced for a given period.
The Commission cites conflicts of interests as a major threat to the integrity of benchmarks, and suggests that a framework of measures should be considered to address concerns. This framework would include adequate management systems, controls to prevent improper influence or communications, the auditing of the contributing process and public reporting of the methods used by a given benchmark. Where panels contribute data to the formation of an index, the Commission suggest that such panels should be representative and of a sufficient size that no individual member is able to influence the index. The Commission also suggests that the activity of contributing to a benchmark could be regulated. As noted in our previous advisory, the contribution of data for the calculation of LIBOR is not currently subject to regulatory supervision in the United Kingdom.
At times the calculator of the index may be best placed to review the data which has been submitted. The Commission suggests that such calculators could be charged with auditing the accuracy of the data received and establishing a code of conduct, underpinned by "appropriate disciplinary procedures". As with those that contribute to indices, the Commission suggests that calculating indices could be subject to national regulation.
Specific questions put by the Commission include:
- What do you consider are the advantages and disadvantages of using a mixture of actual transaction data and other data in a tiered approach?
- What specific transparency and governance arrangements are necessary to ensure the integrity of benchmarks?
- What do you consider to be the advantages and disadvantages of mandatory reporting of data?
- Who should have the responsibility for auditing contributed data, e.g., the index provider or an independent auditor or supervisor?
- What are the advantages and disadvantages of making benchmarking a regulated activity?
- The purpose and use of benchmarks
The underlying rationale for the use of benchmarks is that they should closely, or perfectly, align with the reality faced by its users. Notwithstanding this, the Commission accepts that it is unlikely that a benchmark will be perfectly aligned and instead focuses on improving an inherently imperfect mechanism. The Commission suggests, therefore, that the use of benchmarks could be controlled and limited only to those instances in which their use is suitable.
Questions raised by the Commission include:
- Is it possible and desirable to restrict the use of benchmarks?
- Should specific benchmarks be used for particular activities?
- Who should have the responsibility for ensuring that indices used as benchmarks are fit for purpose, the provider, the user, the trading venues or the regulators?
- Benchmarks provided by private or public bodies
In light of the recent alleged manipulation, the Commission has opened discussion as to the proper bodies to calculate indices, whether public or private. The Commission directly suggests that private bodies may be less inclined to ensure integrity where commercial interests and conflicts of interest are present. The Commission suggests, therefore, that the role of public bodies in the preparation of benchmarks should be considered.
Specific questions raised by the Commission include:
- What role do you think public institutions should play in governance and provision of benchmarks?
- Which indices, if any, would be best provided by public bodies?
- The impact of potential regulatory change
Aware that large-scale change to international indices and benchmarks would have widespread impacts on contracting parties and the economy at large, the Commission has consulted on the perceived impact of regulatory change.
The Commission has included the following questions on this issue:
- What are the likely transition challenges for relevant benchmarks?
- How can reforms of the regulation of benchmarks be most easily implemented?
- In which countries are benchmarks used in your sector produced?
- Are there international benchmarks which could serve as substitutes for national benchmarks?
As noted in our previous advisory, there would be significant difficulty in dealing with the very large number of contracts that would straddle any substitution of indices. For that reason, it seems likely that the present titles and manner of calculation of LIBOR and other benchmarks will be retained, but that the mode of calculation and governance arrangements will be significantly revised.
As frequently happens in this type of situation, there are parallel and competing consultations on essentially the same subject matter. This is perhaps inevitable but also unfortunate, especially where differing conclusions and recommendations are made. In the present instance, however, both the Wheatley Review and the Commission Consultation appear to be proceeding along the same lines, with an apparent recognition of the need to maintain the current benchmarks on pragmatic grounds but to undertake structural and governance reforms to restore market and public confidence.
We will publish further advisories on this subject as occasion demands.