A guide to EU Benchmark Regulation

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Clarence Gallagher
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1 A guide to EU Benchmark Regulation How to address conflicts of interest Regulatory backdrop The European Benchmark Regulation ( BMR ) was created to combat the risk that benchmarks were susceptible to manipulation, as evidenced by the LIBOR and EURIBOR scandals. BMR builds upon the global standards set out in the IOSCO Principles for Financial Benchmarks, which were published in July 2013, and applies to any benchmark used within the EU. On 30 June 2016 BMR came into force with a number of provisions relating to critical benchmarks coming into effect immediately, and the majority of the provisions coming into effect on 1 January 2018, subject to transitional measures. BMR has significant implications for those who provide, use and contribute to those indices caught by the BMR definition of benchmark, which was made deliberately broad to capture a wide range of financial products and use cases. The far-reaching consequences of BMR have already resulted in reduced contribution to benchmarks and increased compliance costs and regulatory burdens presenting a real threat to the viability of many benchmarks and investment strategies which rely on them.

2 CONFLICTS OF INTEREST The key theme and spirit of BMR is the need to address conflicts of interest. The LIBOR scandals taught us that there is an inherent conflict involved whenever an index is controlled by a party who benefits, directly or indirectly, from the performance of a benchmark. Even the perception of a conflict of interest can damage confidence in a particular index or investments reliant on it. In the case of structured products or a passive investment strategy, appointing an internal compliance function to provide oversight is likely to be ineffective for mitigating conflicts because some degree of control remains with the trading desk. Compliance, and any other oversight function, will typically not have the expertise to sufficiently assume control of the index methodology or possibly even understand what they are overseeing. Regulators have expressed this concern and warned the markets about this in vague terms which obfuscate and in some cases, overstate the risks. ESMA believes that the potential risk of collaborative manipulation by different functions within an administrator is particularly high and, hence, that the requirement for operational separation of the benchmark administration from the remaining business should generally be applied unless the administrator can demonstrate that there is no potential for a conflict of interest, particularly that the administrator does not have a financial interest in any instruments or contracts referencing the administrator s benchmark. ESMA discussion paper, 15 February 2016 The risk of collaborative manipulation implies deliberate intent when, in reality, the likelihood is an unintentional act slipping through the cracks of weak governance. Even the most innocuous issues are likely to be scrutinised and suspected as some form of manipulation until proven innocent, exacerbating operational risk. This is likely to get

3 worse before it gets better - BMR requires benchmark administrators to disclose all existing or potential conflicts of interest. In the course of finalising BMR, the focus for regulators has seen a subtle shift. The initial focus on managing conflicts of interest has evolved to one where the absence of conflicts of interest is now the expectation. This is consistent with the approach in other areas of regulation MiFID II, for example, enhances requirements for avoiding conflicts of interest whenever possible and, where avoidance is not possible, the last resort is disclosure of the conflict. It did not take long for the implications of BMR to be understood by the many firms it touches. There is no clearer illustration than recent transactions such as Barclays sale of their index franchise to business to Bloomberg; Citi s sale of Yieldbook to LSE; BAML s sale of its fixed income indices to ICE; and of course HSBC s sale of its Asian US dollar and local fixed income indices to IHS Markit. These transactions have had varying degrees of impact on the sellers and stakeholders of the indices. These are complex transactions and success is determined by how the parties handle the inherent nuances and complexities, including the non-trivial matter of the ownership of the data underpinning these indices. Whilst the option to terminate a benchmark may not be ideal, the viability of the benchmark must be assessed and consideration given to any required changes to the construct of the benchmark. Of course, the cost of compliance must also be rationalised, as mentioned previously. Consequently, the global population of benchmarks is dwindling as termination becomes a favourable option for many. There is real irony that a regulation aiming to improve the integrity and reliability of benchmarks could chill the market and reduce the quality of benchmarks if it isn t proportionately implemented. Investors in products linked to indices are of paramount importance and in circumstances where a benchmark is terminated, product issuers will need to consider a viable substitution for the terminated benchmark in order to ensure continuity of financial instruments linked to it.

4 ADMINISTRATOR RESPONSIBILITIES Under BMR every benchmark will need an administrator, and that administrator will need to be regulated. The administrator is defined as the party having control over the provision of the benchmark, and typically this is the party that has control of the index methodology. If a benchmark owner is also a self-administrator (i.e. where the administrator responsibilities are managed within the group or one of its affiliates) conflicts of interest need to be avoided. This poses a significant challenge for most selfadministrators as they must ensure that the oversight functions are not conflicted but also have sufficient expertise to understand what they are overseeing and to ensure compliance, all whilst maintaining control of the benchmark process. Self-administrators oversight functions should not be overly reliant on expertise from conflicted functions (such as a trading desk) to carry out their obligations. This may require hiring new employees with sufficient experience, or training existing employees to the required standards as well as implementing sufficient internal processes and controls to ensure effective operation of a standalone oversight function. To achieve true avoidance of conflicts, a self-administrator should ensure its oversight function does not share in revenues related to the performance or provision of the benchmarks. Therefore, the manner in which the persons performing the regulated benchmark administration functions are remunerated must also be taken into account to ensure that conflicts are mitigated as far as possible.

5 OUTSOURCING BMR imposes obligations on administrators utilising outsourcing arrangements, similar to those within MiFID (and under SYSC 8 of the FCA Handbook). Outsourcing benchmark activities, such as calculation to third-party calculation agents, must not result in arrangements that impair materially the administrator's control over the provision of the benchmark or the ability of the relevant competent authority to supervise the benchmark. For example, in the scenario where a benchmark owner engages a third party calculation agent, the benchmark owner retains all administrator responsibilities, including for the calculation agent s performance and the regulatory risk therein. Outsourcing calculation (or appointing a secondary calculation agent for verification or engaging a publication agent) does not mitigate regulatory risk nor avoid conflicts of interest. Calculation agents do not accept control of the benchmark; therefore, the outsourcing firm remains the administrator and must be authorised by a national competent authority. Further to the above, the administrator must: Ensure that the service provider has the ability, capacity and any authorisation required by law to perform the outsourced functions, services or activities reliably and professionally; Take appropriate action if it appears that the service provider may not be carrying out the outsourced functions effectively and in compliance with applicable law and regulatory requirements; Retain the necessary expertise to supervise the outsourced functions effectively and to manage the risks associated with the outsourcing; Take reasonable steps, including having contingency plans, to avoid undue operational risk related to the participation of the service provider in the benchmark determination process; and Be able to terminate the outsourcing arrangements where necessary. Service providers, such as calculation agents, must:

6 Disclose to the benchmark administrator any development that may have a material impact on its ability to carry out the outsourced functions effectively and in compliance with applicable law and regulatory requirements; and Cooperate with the administrator and the national competent authority regarding the outsourced functions including access to data related to the outsourced activities and access to the business premises of the service provider.

7 PRACTICAL SOLUTION - INDEPENDENT ADMINISTRATION A benchmark owner may appoint an independent third party administrator, which would not constitute outsourcing. Under this arrangement, control of the benchmark is transferred to the independent administrator and, with it, the regulatory responsibility for any failures of the benchmark. In addition, under an independent administration model, the benchmark owner can retain the commercial benefits of IP ownership (see below). This model is particularly attractive for benchmark owners who are primarily interested in maintaining benchmarks in order to issue financial instruments in support of a primary business such as a structured product desk or quantitative investment group within a bank or asset manager. The relationship and appointment of an independent must be clearly documented through a contract which ensures that the responsibilities of the administrator are carried out and control is completely transferred in order for the benchmark owner to cease being considered the administrator. Where a benchmark is administered by an independent third party, the benchmark owner can choose whether to retain brand ownership (licensing the benchmark to users in its own name) or can choose to transfer the brand but maintain ownership of the underlying intellectual property. The latter route is designed to mitigate reputational risk associated with remaining the branded owner of the benchmark in the event there is an issue (e.g. where the independent administrator fails to comply with BMR or where a user suffers a loss due to a failure of the third party in administering the index).

8 Obviously, as the agreement for use of the benchmark (e.g. in the structured product determined by the benchmark) will be between the benchmark owner and user, the benchmark owner does retain some legal risk. This legal risk can be mitigated by building a mechanic into the user agreement that the benchmark owner will only be liable in relation to failings of the benchmark administrator where it has been negligent in the selection of that administrator. The benchmark owner must manage this risk by undertaking thorough due diligence on the independent administrator and its governance framework. It should also consider implementing an administrator oversight framework which embeds the receipt of periodic reports on ongoing compliance and KPIs. The underlying data inputs use in calculation of the benchmark will also require consideration and, importantly, whether or not the independent administrator has appropriate rights to access the necessary data points. Conventionally, calculation agents are considered to be service facilitators under most licensing agreement but certain providers will impose fees ranging from zero cost to amounts greater than the cost of original licensing agreement. These data licensing practices will likely come under scrutiny by regulators in the not too distant future however, for now, this issue is one of the most important for all parties to consider. Ultimately, independent administration is likely to become conventional just as the outsourcing of index calculation has become for self- indexing firms. Generally, having a single or primary administrator makes sense which requires that the administrator is capable of supporting the breadth and depth of expertise required to support global firms at scale. Successful avoidance of conflicts of interest and compliance best practices will yield competitive advantage for those who embrace it fundamentally. At maturity, most firms find their total cost of ownership reduced while their capacity to develop new products is significantly enhanced.

With over $100B in assets under management and 25,000+ daily index calculations, IHS Markit is a global

9 IHS MARKIT INDICES IHS Markit is a global index powerhouse and provides a comprehensive suite of indices and related services across all asset classes and geographical regions. With over $100B in assets under management and 25,000+ daily index calculations, IHS Markit is a global leader and the leading provider of equity, fixed income and credit indices, as well as, custom indices, index calculations and independent administration.

10 Company overview IHS Markit harnesses deep sources of information, analytics and expertise to forge solutions for the industries and markets that drive global economies. Our company partners with clients in business, finance and government to provide the unrivalled insights and perspectives that lead to well-informed, confident decisions. We call this The New Intelligence. IHS Markit serves more than 50,000 key customers in more than 140 countries, including 80 percent of the Fortune Global 500. We help decision makers apply higher-level thinking to daily tasks and strategic issues across a host of industries and disciplines including energy, finance, automotive, engineering, technology, maritime and trade, aerospace and defense, chemical, and economics and country risk. Headquartered in London, IHS Markit (Nasdaq: INFO) is committed to sustainable, profitable growth. Contact us sales@markit.com Europe Americas Asia Pacific

Index Administration Services (IAS) FX BENCHMARK STATEMENT

Index Administration Services (IAS) FX BENCHMARK STATEMENT 1. General Disclosures Benchmark family name IAS FX Date of initial publication of this document 9 July 2018 Date of last update to this document