We have previously reported on the consultation on financial benchmarks by the International Organization of Securities Commissions ("IOSCO")5, and its follow-up consultation report (the "Consultation Report")6 setting out draft principles (the "Principles") regarding inter alia benchmark calculation, determination, related governance issues and transparency processes. IOSCO has now released its final report (the "Final Report") on the Principles on 17 July 2013.7
The Final Report makes certain amendments and clarifications to the draft Principles and the scope of their application, in response to consultation feedback. The Final Report states that in general, there was a good level of support for the Principles, with the majority of comments on the technical detail rather than the substantive approach. The key amendments are analysed below.
In relation to submission-based benchmarks, where information is provided by third party submitters to the administrator (the entity which calculates, determines and disseminates the benchmark) to determine the benchmark, the definition of "Submission(s)" now explicitly excludes data sourced from regulated markets or exchanges with mandatory post-trade transparency requirements. This amendment was made in response to concerns that certain Principles were less relevant for benchmarks based on prices that are made public. Further, the Final Report amends Principle 14(g)(xi) to clarify that submissions from front office staff are allowed (under the draft Principles they were prohibited) but only if there are adequate internal oversight and verification procedures, including to address potential conflicts of interest. The potential for conflicts of interest and manipulation is considered to be increased when front office staff are involved with benchmark determination, but this amendment reflects the fact that smaller organisations may not be able to segregate staff accordingly and thus valuable market information may be lost by applying such an outright prohibition.
Principles 4 (Control Framework for Administrators), 5 (Internal Oversight) and 12 (Changes to the Methodology) now allow for summary information and key features to be disclosed to stakeholders (those who use or rely on benchmark determination services), rather than full disclosure being required. This amendment was made in response to a concern from benchmark providers that certain transparency practices should not apply to them as they have a strong incentive to disclose to stakeholders, with IOSCO’s response being that a proportional application of such transparency Principles would be appropriate.
Principles 2 (Oversight of Third Parties) and 18 (Audit Trail) also relax certain requirements relating to benchmarks based on transactions in securities on regulated markets and exchanges in line with IOSCO’s desire for a proportional application of the Principles. IOSCO reiterates in the Final Report that these Principles have been designed as a set of recommended practices and it does not expect a "one-size-fits-all" method of implementation. IOSCO highlights that there is an overarching theme of proportional application of the Principles depending on the size and risk posed by each benchmark and/or administrator and the benchmark-setting process.
The Final Report also excludes central counterparty risk management and settlement prices from the application of the Principles, since such central counterparties that are regulated already have to comply with stringent risk management and governance requirements.
Use of Transaction Data
IOSCO highlights that a benchmark should be underpinned by an observable market consisting of bona fide, arms-length transactions, but introduces a clarification in the Final Report that a benchmark does not need to be constructed solely of transaction data, nor does transaction data carry more significance in the determination of a benchmark than non-transaction data. The Final Report recognises that in certain circumstances, such as in a low liquidity market, confirmed bids or offers may carry more meaning than an outlier transaction. Further, the Final Report states that non-transactional data can be used to determine benchmarks in relation to certain indices which are not designed to represent transactions, as long as data is derived from, and thus "anchored" in, a transparent, active market.
Transparency of Benchmark Determination and Expert Judgment
The final Principles include a new Principle 9 (Transparency of Benchmark Determinations) which recommends that benchmark administrators should provide a concise explanation of how a benchmark has been determined, including certain minimum information such as the size and liquidity of the market being assessed, the pricing methodology and the extent to which any "expert judgment" (discretion in data selection and modification) was used.
Annex C of the Final Report provides further guidance on Principle 9, stating that its focus is to provide stakeholders with sufficient information to understand how a benchmark is determined. The guidance highlights that benchmarks that regularly publish their methodologies would comply with this Principle when they are derived from data sourced from regulated markets or exchanges with mandatory post-trade transparency requirements. Further, a benchmark that is based exclusively on executable quotes would not need to explain in each determination why it has not used transaction data, provided that it includes the requisite disclosure in its published rules and procedures.
IOSCO has called on benchmark administrators to publicly disclose their compliance with the Principles within 12 months, and stated that it intends to review the extent to which the principles have been implemented within 18 months. IOSCO will also consider the need in due course for any modification of the Principles for Oil Price Reporting Agencies8, which it adopted in October 20129 and took into consideration when developing the Principles.