European Benchmark Regulation: Steps towards
re-establishing the credibility of Benchmarks
Wednesday 9 September 2020
European Benchmark Regulation (BMR) provisions initially came into effect in January 2018 but the largest impacts to date were not felt until 1st January 2020 as the transition period for European benchmark administrators ended. From this date, any supervised entities that “use” benchmarks published by administrators located in the European Union need to ensure that those administrators are registered with the European Securities and Markets Authority (ESMA). In the near future, further provisions pertaining to benchmark compliance are still to come into force.
What is a benchmark?
Before discussing the regulation, it is important to understand what a benchmark actually is and this can be achieved by bearing in mind that it is a type of index. An index can be defined as any figure which is publicly available and that is regularly determined either through the application of a formula or calculation in order to measure the characteristics and performance of specific markets or asset classes .
The critical distinction between whether an index is a benchmark is based on how the output value of the index is used rather than the nature of the input data used to compose it. As such, an index is deemed to be a “benchmark” within the scope of the BMR when it is used for the following purposes:
to determine the amount payable under a financial instrument or financial contract, or the value of a financial instrument.
to measure the performance of an investment fund for the purpose of tracking the return; defining the asset allocation or a portfolio; or computing the performance fees .
What is the scope and purpose of BMR?
European Benchmark Regulation imposes new requirements on firms in order to regulate the (i) provision of, (ii) contribution to, and (iii) use of benchmarks. The scope of BMR is as broad as necessary to create a preventative regulatory framework and it can be applied to a range of financial, interest rate, regulated data and commodity benchmarks. Under BMR, competent authorities will have the power to impose a range of warnings, administrative sanctions, bans on holding positions, and custodial sentences for non-compliance.
BMR was introduced in order to provide a consistent approach to the regulation of financial benchmarks: it aims to increase the accuracy and soundness of benchmarks whilst also protecting them along with the markets they support from manipulation. There is an inherent conflict of interest involved whenever an index is controlled by a party who benefits from its performance: this was evidenced during the well-scrutinised LIBOR (London Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate) scandals which saw banks being issued large fines for collusion and malpractice in the setting of these rates (e.g. the £57.5m imposed by the FCA on Barclays in 2012) . In the backlash of the scandals, the market lost a lot of trust in these benchmark rates which resulted in large-scale economic impacts given
the significant notional amounts referencing them; the BMR can be seen as the European Commission’s response in combatting the surrounding issues.
Administration / Provision of Benchmarks
An administrator has control over the provision of and the arrangements for determining a benchmark: they collect and analyse the input data, and control the index methodology and publication. Under BMR, every benchmark will need to have an administrator who is regulated by a national competent authority and who appears on the ESMA register. If an administrator does not comply with the provisions of BMR, then the competent authority has the power to withdraw or suspend their authorisation .
Contribution to Benchmarks
A contributor provides input data required in the determination of the value of the benchmark and that data is deemed to be not readily available to the benchmark administrator or other persons. Under BMR, supervised contributors will be required to comply with codes of conduct and implement control frameworks.
Use of Benchmarks
Since 1st January 2020, any supervised entity that engages in activity referencing a benchmark in the EU, such as the issuance of financial instruments, needs to ensure that they only use authorised benchmarks (i.e. those issued by administrators which are captured on the European Securities and Markets Authority register). Supervised entities will be required to have rigorous controls in place to avoid the use of a non-compliant benchmark and also to ensure that they have sufficient plans in place to substitute a benchmark on existing contracts. Such contingency plans will safeguard against the potential cancellation of or material change to a benchmark, and this must be reflected in new and legacy contractual documentations with their clients.
What is next for BMR?
There are additional transitional provisions which will allow the continued use of existing benchmarks until 31st December 2021 where those benchmarks are classified as either critical benchmarks or benchmarks published by third-country administrators.
The BMR classifies benchmarks as non-significant, significant, or critical, based on their risk profile and proportionality, and this classification determines the degree to which the new provisions apply. Critical benchmarks are effectively those which would have a significant and material impact on market stability and the real economy if they ceased to be published. These critical benchmarks are subject to stricter rules including the power for the relevant competent authority to mandate contributions of input data.
Only a select few benchmarks have been classified as critical, namely: LIBOR, EURIBOR, EONIA (Euro Overnight Index Average), STIBOR (Stockholm Interbank Offered Rate) and WIBOR (Warsaw Interbank Offered Rate) . Administrators of these critical benchmarks are permitted under the BMR to continue to provide them in the EEA until 31st December 2021 – even if not yet in full compliance with the regulation – at which point they must transfer the supervision powers to ESMA.
Although European administrators had to ensure they were registered with ESMA by the turn of 2020, administrators who provide benchmarks from countries outside the European Economic Area (EEA) have been granted an extension to the deadline for ensuring their compliance.
In order to continue providing benchmarks for use in the EU after the deadline of 31st December 2021, administrators from outside the EEA (i.e. those considered to be third-country administrators) must apply to be added to the ESMA list of benchmarks in one of three ways:
Recognition – This allows a benchmark published by a third-country administrator to be used in the EU if the administrator has been ‘recognised’ by an EU National Competent Authority (e.g. BaFin in Germany).
Endorsement – A third-country administrator would need an EU entity willing to endorse their benchmarks for use in the EU and to also take responsibility for their provision.
Equivalence – A third-country administrator would need a positive equivalence decision to be made by the European Commission, which would include considerations such as whether that jurisdiction’s benchmark regime is sufficient in comparison to BMR.
Impact of Brexit
There are further considerations for benchmark administrators located in the UK following Brexit. Such UK based administrators will continue to be listed on the ESMA register and will continue to be able to provide services to EU and UK customers until the “Brexit Transition Period” ends on 31st December 2020 – at which point the UK will be deemed to be a third-country administrator – and the third-country BMR provisions will begin to apply instead. The primary problem arising in the context of Brexit is that, in the absence of registration with ESMA by one of the three means discussed above (i.e. recognition, endorsement, or equivalence), EU supervised entities will be prevented from using a UK administered benchmark after the third-country transition period ends on 31st December 2021.
The UK Financial Conduct Authority (FCA) has plans to implement its own equivalent benchmarks legislation and will set up a public register for UK and third-country benchmark administrators that want their benchmarks to be authorised for use in the UK .
The BMR provisions present additional challenges in an already burdensome year in terms of regulatory initiatives and the benefits of its implementation may take some time to be realised. However, the enhanced levels of governance and the additional supervision measures should certainly be viewed as a step in the right direction towards improving the credibility of benchmarks. The intentionally broad scope of the regulation defines obligations and conduct requirements for benchmark administrators, users, and contributors alike to promote integrity which will be key in ensuring the smooth functioning of financial markets.
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