The Practical Consequences of Benchmark

Transcription

1 1 rimes WHITE PAPER The Practical Consequences of Benchmark Regulation We expect all firms to identify, manage and control the risks arising from their benchmark activities, put in place appropriate oversight and controls, and instil a culture in which market integrity and consumers interests are at the heart of how they run their businesses FCA Financial Benchmarks: Thematic review of oversight and controls July 2015 Executive Summary There has been widely publicized misconduct by some financial firms and their employees in the management of financial benchmark activities. Global regulators have taken enforcement actions against numerous firms including unprecedented financial sanctions and the imprisonment of several individuals. Given the extensive use of benchmarks in the economy, it is essential that they are accurate and credible for markets to operate efficiently. As well as directly supervising some benchmark activities, regulators have imposed and proposed more fundamental intervention in the form of legislative changes. The UK s Financial Conduct Authority (FCA) has recently conducted a thematic review of oversights and controls for financial benchmarks (the Review). This paper draws on the conclusions from the Review and evaluates the impact of the significant reforms both completed and under proposal. It also makes recommendations for industry best practice for benchmark activities. Benchmark activities are complex and expensive to manage. As firms face spiralling benchmark costs they must find new operating approaches. Now is the time to examine processes and procedures surrounding the management of benchmark activities to increase benchmark transparency and comply with new legislation. Critically, firms must obtain a holistic view of their benchmark activities, to understand who is accessing or submitting what data, where, why and how. Introduction It should come as no surprise that global regulators are producing multiple regulations pertaining to financial benchmark data. On the contrary, we should be wondering why such a keystone of the financial services industry has gone largely unsupervised 1 for so many years. Against the backdrop of widespread corporate fines and individual criminal prosecutions, arguments against the direct regulation of the benchmark industry or proportionality of legislation to the problem are subdued. Benchmarks help to reduce information asymmetries and price-search costs for a wide range of users, and any doubts about their honesty and accuracy can clearly undermine market confidence, distort the economy and result in real losses for investors. Firms have behaved unacceptably, and changes both need to be made, and from the politicians perspective need to be seen to be made. Some firms lacked an understanding of the wider importance of benchmarks to the economy and the potential for damage to market integrity. As a result they failed to identify and develop controls to manage conflicts of interest that arose in relation to benchmark activities, with some conflicts being intrinsic to their business models. Several traders made internal requests to their benchmark submitters for submissions to be changed to benefit their trading positions. They also colluded with traders at other firms and at contributing banks and acted in concert with brokers on particular days on which the traders positions stood to benefit. The ultimate aim of these requests

2 The global drive to 1regulate benchmarks was to influence benchmark rates in a way that could potentially disadvantage their clients and the market. With millions 2 of indices and benchmarks in circulation they are certainly not a homogenous product, yet they do all share similar vulnerabilities to manipulation. Consequently, any regulatory proposals must ensure a proportional approach by calibrating their requirements to the risks and specificities of the different types of benchmarks. In general, there is a trend to move from submissions-based benchmarks to other forms of price formation and to support any expert judgement using as much transactional data as possible. Transparency is now a key feature, with expert judgement becoming a less frequent feature of benchmarks. In precious metals, for example, the LBMA Gold Price fix has moved from a conference call to a public electronic auction 3. This paper will look briefly at the key regulations impacting benchmarks before focusing in detail on a recent thematic review of firms oversight and controls in relation to financial benchmarks. From this analysis we will identify and make recommendations of best practice for benchmark activities. 1 With the exception of the UCITS Product Directive (2001/108/EC) which detailed authorized replication of indices recognized by the competent authorities as being sufficiently diversified; representing adequate benchmarks for the market to which they refer; and being published in an appropriate manner. There has been little regulation of Indices and benchmarks globally prior to IOSCO, European Commission and ESMA/EBA Consultations. LexUriServ/LexUriServ.do?uri=OJ:L:2002:041:0035:0042:EN:PDF 2 Collectively, the members of the Index Industry Association (which include MSCI, FTSE, S&P, Russell, Markit and Nasdaq) calculate over one million indices. That is only some of the index providers calculating equity and fixed income Indices and does not include other asset classes such as commodities and real estate. benchmarks/index_en.htm 3 See: /data-management/gold-benchmark-moves-ice-benchmarkadministration-march The international nature of business makes legislating the financial services industry complex and fragmented. There is no authoritative global regulator, only government cooperation, securities commissions and national supervisors. Post the LIBOR and FX scandals national authorities have been keen to act swiftly to cure their own local benchmark deficiencies, this has led to a number of temporary and some permanent rules and principles being put in place, the most important of which are outlined below. At the international level In July 2013, the International Organization of Securities Commissions (IOSCO) issued a report with the objective of creating an overarching framework of Principles for Financial Benchmarks (Principles). The Principles, which cover governance, quality of benchmarks, quality of methodology and accountability, offer a global standard of good market practice and benchmark administrators are encouraged to adopt them. IOSCO stated that the Principles are not intended to be one size fits all and that administrators may apply them proportionately. Administrators are expected to describe their level of implementation of the Principles in public statements of compliance annually. The Principles were endorsed by the G20 leaders in September Earlier this year, IOSCO conducted a review of the implementation of the Principles across a sample of administrators from a variety of jurisdictions and asset classes and the findings were published in February The Financial Stability Board (FSB) endorsed the IOSCO Principles for Financial Benchmarks and commissioned IOSCO to conduct a review of the implementation of its Principles. IOSCO published its review into the administrators of EURIBOR, LIBOR and TIBOR in July The FSB also published a report in September 2014, their Final Report on Foreign Exchange Benchmarks, which focused on a number of benchmarks IOSCO stated that Principles for Financial Benchmarks are not intended to be one size fits all and that administrators may apply them proportionately. 2

3 in particular the WM/Reuters London 4pm Closing Spot Rate. The report made a series of recommendations regarding the methodology for these benchmarks, their use within the industry, and management of conflicts of interest. Previous to their report on FX benchmarks the Official Sector Steering Group (OSSG) of the FSB had focused its efforts on the interest rate benchmarks. Their report: Major Interest Rate Benchmarks, contained two main recommendations to be applied to major existing interest rate benchmarks, with particular emphasis on EURIBOR (Euro Interbank Offered Rate), LIBOR and TIBOR (Tokyo Interbank Offered Rate). The first recommendation was to strengthen these benchmarks by looking to underpin them to the greatest extent possible with transaction data. The second, was to encourage the development of alternative, nearly risk-free, reference rates in order to foster market choice around interest rate benchmark selections. The OSSG is to publish a final report in July 2016, covering the implementation of its recommendations. At the European level The European Securities and Markets Authority (ESMA) consolidated guidelines on ETFs and other UCITS (ESMA 2012/832) became effective in February The Guidelines have a major impact on managers of UCITS, ETFs and particularly index tracking UCITS. The prospectus of index tracking UCITS must now clearly describe the indices, including information on their underlying components. It should direct investors to an appropriate source such as a website where exact components and security weights are published - to enable investors to replicate the financial index. This must include detailed information on index constituents, index calculation, rebalancing methodologies, index changes and relevant information on any operational difficulties in providing timely and accurate information. The regulation of financial benchmarks proposal is currently under negotiation by the European Parliament, the Council and the Commission. The new rules are expected to be published shortly. 4 IOSCO Principles for Financial Benchmarks pdf/ioscopd415.pdf 5 Review of the Implementation of IOSCO s Principles for Financial Benchmarks pdf/ioscopd474.pdf 6 Review of the Implementation of IOSCO s Principles by Financial Benchmarks by Administrators of LIBOR, EURIBOR and TIBOR pdf/ioscopd444.pdf 7 Final Report on Foreign Exchange Benchmarks org/2014/09/r_140930/ 8 Reforming Major Interest Rate Benchmarks org/2014/07/r_140722/ 9 Guidelines-ETFs-and-other- UCITS-issues 10 ESMA-EBA Principles for Benchmark - Setting Processes in the EU. Final Report system/files/ _ esmaeba_principles_for_benchmarksetting_processes_in_the_eu_-_ final_report.pdf 11 market/securities/benchmarks/ index_en.htm#maincontentsec eu/sides/getdoc.do?pubref=- //EP//NONSGML+REPORT+A DOC+WORD +V0//EN In June 2013, the ESMA and the European Banking Authority (EBA) published the ESMA-EBA Principles for Benchmark - Setting Processes in the EU. The aim was to address the widespread problems associated with benchmarks that came to light from previous misconduct in relation to LIBOR, until a formalized regulatory and supervisory framework is created in Europe. The report lists a series of principles for benchmark submitters, calculation agents, publishers and users. It also included principles for the continuity of benchmarks suggesting that all those participating in the benchmark setting process should have in place credible contingency provisions to ensure key benchmarks remain available to the market. In September 2013, the European Commission published a legislative draft proposal for the regulation of financial benchmarks 11. The proposed regulation addresses concerns about the integrity and accuracy of benchmarks by regulating administrators, contributors and users of benchmarks. The regulation is extensive in scope, and the new rules will lead to the transformation and even the extinction of some benchmarks. The proposal is currently under negotiation by the European Parliament, the Council and the Commission. Although not yet finalized, the new rules are expected to be published at the end of this year and apply in The regulation presents a significant implementation challenge and compliance burden for firms that administer, use or contribute to financial benchmarks. The rules also pose specific challenges for EU market participants that utilize non-eu benchmarks. Compliance with the new rules will be onerous and resource intensive as firms develop frameworks and processes for the first time. The legislation will impact most financial services firms as the latest draft 12 throws a wide net over all benchmark activities with broad definitions for benchmarks and their use. 3

4 KEY DEFINITIONS Benchmark Index Provision of a benchmark Use of a benchmark Any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument is determined. Any figure: That is published or made available to the public That is regularly determined, entirely or partially, by the application of a formula or any other method of calculation, or by an assessment Where this determination is made on the basis of the value of one or more underlying assets, or prices, including estimated prices, actual or estimated interest rates, or other values or surveys Administering the arrangements for determining a benchmark Collecting, analyzing or processing input data for the purpose of determining a benchmark Determining a benchmark through the application of a formula or other method of calculation or by an assessment of input data provided for that purpose Issuance of a financial instrument which references an index or a combination of indices Determination of the amount payable under a financial instrument or a financial contract by referencing an index or a combination of indices Being party to a financial contract which references an index or a combination of indices Determination of the performance of an investment fund through an index or a combination of indices for the purpose of tracking the return of such index or combination of indices, of defining the asset allocation of a portfolio or of computing the performance fees At the national level - background to UK benchmark regulation The UK Chancellor of the Exchequer commissioned the FCA s Martin Wheatley to undertake a review of the framework for the setting of LIBOR 13. Following Wheatley s report, legislation was introduced to make LIBOR the first regulated benchmark. A series of recommendations were implemented including the creation of a new chapter in the FCA Handbook Market Conduct Sourcebook - MAR 8, and the creation of two new Controlled Functions - CF40 and CF50. Subsequent to the introduction of MAR 8, there are now a number of specific requirements for both the administrator and the submitters of specified benchmarks. For example, administrators are required to appoint a benchmark administrator manager (CF50), carry out monitoring and surveillance of benchmark submissions (if submissions are made), set up an oversight function, notify the FCA of any misconduct or attempt of manipulation, produce periodic statistics and have adequate financial resources. Concurrently, regulated submitters of benchmarks must establish appropriate oversight of the submission process by senior personnel and compliance, appoint a benchmark manager (CF40), ensure they have an effective methodology for submitting the benchmark which has to be reviewed at least quarterly, establish a conflicts of interest policy and effective controls around them, notify suspicious transactions and have a periodic external audit. Other initiatives in the UK have included The Fair and Effective Markets Review (FEMR) 14 commissioned to reinforce confidence in the wholesale fixed income, currency and commodities markets in the wake of serious misconduct. One of the first FEMR recommendations was that a further seven benchmarks to LIBOR be brought into the scope of UK regulation: SONIA, RONIA, ICE Swap Rate, LBMA Gold Price, LBMA Silver Price, WM/ Reuters London 4pm Closing Spot Rate and ICE Brent Index. This took effect from 1 April In addition, following the recent FX benchmark scandals, the FCA have also implemented an industrywide supervisory program relating to FX remediation to ensure that firms learn the lessons from past failures. They have additionally asked senior management at the firms in question to attest that they have appropriate controls in place. 4

5 2The Practical Consequences of Benchmark Regulation Financial Benchmarks: Thematic review of oversight and controls What the FCA did The FCA has presented the findings from its thematic review of firms oversight and controls in relation to financial benchmarks in publication TR15/ The Review was carried out between August 2014 and June 2015 to provide an early assessment of the extent to which firms had learnt the lessons from previous failures around benchmark activities and taken appropriate action in response. It highlights the regulators key messages to the industry and provides examples of good and poor practice that they found at the firms they assessed. They warn that firms should ensure they learn the lessons from previous enforcement cases on other firms and apply them to the wider scope of their own benchmark activities, and that: It is essential that firms senior management pay heed to the findings and messages outlined here, and take the steps necessary to identify and resolve any outstanding issues. 17 The regulator conducted onsite visits to a sample of twelve banks and broking firms. This involved engaging in direct dialogue with senior management, compliance, desk heads and traders/brokers. Their inspection covered firms systems and controls arrangements around benchmark activities including: (i) governance, accountability, oversight and control; (ii) monitoring and surveillance arrangements; and (iii) identification and management of the potential conflicts of interest arising in day-to-day activities, as well as the design and management of benchmarks. Furthermore, the FCA also discussed the firms understanding and implementation of the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks. All benchmarks were in scope of the Review with the exception of LIBOR and the WM/Reuters London 4pm Closing FX Spot Rate. The FCA makes clear that the findings in the Review apply to the wider UK financial It is essential that firms senior management pay heed to the findings and messages outlined here, and take the steps necessary to identify and resolve any outstanding issues. 13 Wheatley Review of LIBOR, Final Report wheatley_review_libor_ finalreport 14 Fair and Effective Markets Review, Final Report markets/documents/ femrjun15.pdf 15 See: com/news/financial-datatrends/data-management/ fca-regulates-additionalbenchmarks-1st-april 16 FCA Financial Benchmarks: Thematic review of oversight and controls July documents/thematic-reviews/ tr15-11.pdf 17 ibid p See Benchmark in Annex A, page 35 for IOSCO definition pdf/ioscopd415.pdf services industry, not just to those banks and brokers that participated in the Review. In particular, firms are urged to take note of the outcomes (fines) of recent enforcement cases relating to benchmarks such as LIBOR, FX and Gold, and apply the lessons learnt more widely across any business lines engaged in benchmark activities. What the FCA found All firms still have work to do The FCA found that progress to improve oversight and controls around benchmark activities across most firms appeared slow. They note that the lack of urgency is disappointing given the importance of benchmarks to the economy, the similarity and severity of a number of previous benchmark failures, the high level of public concern as a result of the misconduct made public, and the scale of enforcement fines levied on firms. It is their conclusion that all firms still have work to do. In particular, they found that firms were failing to identify a wide enough scope of benchmark activities by interpreting the IOSCO definition 18 too narrowly. In addition, some firms had not made sufficient effort to properly identify the conflicts of interest that could arise from their businesses and benchmark activities. For example, the FCA says that some firms were unaware that the definition also captured activities such as in-house benchmarks and data regularly sent out by the firm that could be used for purposes such as the execution, termination and valuation of contracts. As a consequence, firms did not give sufficient consideration to establishing a relevant governance framework around their in-house benchmark business. However, most firms had developed a formal benchmark strategy in an attempt to ensure that they had adequate oversight and controls around benchmark activities. 5

6 The Review found that: All firms had made changes to their approach to benchmark activities, however there were a number of areas where firms needed to take further action in order to manage the risks of their benchmark activities appropriately No firm had fully implemented changes across all benchmark activities Progress has been uneven. The progress firms had made in improving their oversight and controls for contributing data, designing, managing, administering or trading around benchmarks varied. While some had made significant changes to their approach, others were still at an early stage in the process There was evidence to suggest that previous enforcement fines levied by the FCA and other authorities had been effective in instigating change at some firms. Senior management had taken steps to focus on conduct issues and undertake reviews to identify and develop controls to manage conflicts of interest that arise in relation to benchmark activities Change had lacked urgency. Overall, the progress to improve oversight and controls around benchmark activities across most firms and within individual firms appeared slow. The speed and extensiveness of the improvements varied across firms with completion timescales ranging from several months to three years. We would encourage firms to set more ambitious deadlines and complete projects more rapidly 19 Inconsistent benchmark identification and follow-up. There was inconsistency in how firms determined the range of benchmark activities within the firm Identifying and managing conflicts of interest. Narrow interpretations of the IOSCO definition of benchmarks as well as stand-alone structures led to firms not applying the lessons learnt from one benchmark to another. What is a benchmark activity? The Review observed a lack of understanding by some firms of what constitutes benchmark activity, or an inability to recognize that benchmarks were deeply rooted in their business models. Different business lines at one firm reviewed had an inconsistent understanding of and approach to what constituted benchmark activity, evidencing a lack of clarity within the firm. Examples of benchmark activities include: Administering benchmarks whether by designing, calculating or publishing them Submitting quotes or transactional data inputs to a benchmark Communicating indicative prices to clients that are used by them for the purposes of executing, terminating or valuing third party contracts Trading (or avoiding to trade) at or close to benchmark windows where transactional data may be used to determine a benchmark Trading or sending of trade data out of the firm (e.g. for valuation purposes) Publishing pages that could be used as a reference point in financial contracts. To help ensure that all potential benchmarkrelated activities were captured by their improvement plan, three firms reviewed had given adequate consideration to what activity should be considered as contributing to or constitute administration of a benchmark. This included a wide application of the IOSCO definition of benchmarks and controls around trading activity in the underlying securities to which the benchmark refers. A few firms adopted an approach that included proactive engagement by senior management on conduct risks, relevant training in relation to benchmarks, and appropriate management information (MI). This approach delivers a more comprehensive and impactful message across the firm around benchmark activities. It is crucial that firms appreciate that the production of in-house benchmarks could fall under the scope of benchmark administration. 19 FCA Financial Benchmarks: Thematic review of oversight and controls July 2015 P documents/thematic-reviews/ tr15-11.pdf 6

7 Learn more at Conversely, several firms were unable to show evidence of awareness of all the activities that they undertook that were caught under the IOSCO definition of benchmarks. For example, 50% of firms did not realize that prices calculated and published by the firm (that could be used for valuation purposes) could be a benchmark, thereby making the firm a potential benchmark administrator or a data provider. In addition, a number of firms had not considered the impact of their trading/broking activity on benchmarks where they were not a direct submitter but their transactional data may have had an influence on the benchmark. Lack of consistency in the industry The Review highlighted inconsistency in how firms determined their range of benchmark activities within the firm and how change programs and lessons learnt from previous benchmark failures were applied across business areas. A small number of firms sought to broadly interpret the IOSCO definition of benchmarks, including activities such as the calculation and publication of a rate or price, which could be widely used for trading and valuation purposes. However, most firms adopted a narrow definition of benchmarks which leads to a less rigorous approach to the governance and controls that ought to apply around benchmark activities. Missing the point Narrow interpretations of the IOSCO definition of benchmarks as well as standalone structures led to firms not applying the lessons learnt from one benchmark to another. Improvements in identification, monitoring and management of conflicts of interest were not transmitted to other teams undertaking similar benchmark activities within the same firm. Only one firm could demonstrate that it had an awareness of the IOSCO recommendations for their in-house benchmark administration activity and had published a comprehensive IOSCO Compliance Statement. For the other firms, there was a risk identified that lack of appropriate ownership and formal oversight could provide opportunities for the front office to influence the construction, design, and inputs to an index or prices for their own self-interest. The Review identified that where firms used internally generated inputs to calculate their in-house benchmarks, only some had put processes in place to manage the potential risks associated with this. On the positive side, firms generally shared their in-house benchmark methodologies with investors with some also publishing these on their external websites to ensure transparency. Some firms even conducted back-testing and independent price verification where possible, to ensure compliance with the in-house benchmark calculation methodology. The FCA highlighted that firms need to assess and consider the conflicts of interest arising in their day-to-day benchmark activities. Such conflicts can arise via: benchmark submissions, administration or publication. Poor awareness and understanding of conflicts of interest across the firm could result in traders/brokers being unable to identify risky situations resulting in the unintentional engagement in inappropriate behaviour, which could compromise the integrity of a benchmark. It was noted that some firms also did not have a conflicts of interest log or register that incorporated benchmark activities. Overall, it was clear that firms were not thinking broadly enough about the conflicts of interest that encompassed their benchmark activities. It is crucial that firms appreciate that the production of in-house benchmarks could fall under the scope of benchmark administration Ibid P

8 We observed that only a few firms had fully implemented an adequate governance framework. Benchmark data governance The Review found that only some firms had established a governance framework with appropriate oversight functions to manage their benchmark activities. To enable formal oversight of their activities, some firms had established an overarching governance committee structure. These firms aimed to monitor the risks posed by their benchmark activities and applied sufficient scrutiny as well as determine an appropriate escalation path should issues arise. Another firm had created a benchmark repository, with periodic attestations by global business heads to confirm that information contained in the repository was accurate; it also identified the benchmark submitters at desk level. To ensure risks were addressed strategically based on urgency and proportionality, some firms had adopted a risk-based approach to their remedial work, tackling the areas perceived to be of highest risk first. With regards to submitting data to benchmarks, only one firm scrutinized in the Review had a code of conduct in place for the submissions process. Driven by a desire to improve benchmark controls in a timely manner, a small number of firms had undertaken a comprehensive survey of all their benchmark submission activities. These firms then assessed the relative importance of each activity to their business model and created a formalized, forward-looking improvement plan detailing their approach to the review and improvement of controls around those benchmarks they wanted to continue to make submissions. An example included a firm formally reviewing (on an annual basis) the decision to submit to a specific benchmark. This formal review assisted the firm to give due consideration to market integrity, consistency and continuity of support for benchmarks. Overall, senior management appeared to be initiating a change in culture (and conduct), but it was not evident that the messages had yet been embedded at desk level. Firms had generally committed further resource to surveillance and monitoring and while improvement was evident it remained inadequate. Conflict of interest Potential conflicts of interest can arise for in-house benchmark administration when the trading desk designs and manages a benchmark that is referenced to a structured product it has issued. Conflicts may also arise, where the firm exercises discretion and is able to change the components of an in-house benchmark, or if there is an incentive for a trader to design this in a way that economically benefits the firm. This is an area of significant concern for the regulator, especially as they found in the Review that awareness and understanding of conflicts varied between firms and also within firms between desks, as well as between desk heads and traders/brokers on the same desk. Most firms had attempted to mitigate conflicts of interest by automating the submissions process wherever possible, creating separate reporting lines and ensuring the physical separation of desks. Other did not have adequately documented policies and procedures for their benchmark submissions which were found to be manual, infrequent and inconsistent. One firm sent non-validated data to clients, which could give rise to a potential conflict of interest if not independently verified. 21 The Review noted that in some cases a separate department such as IT or back office/operations took a snapshot of the required data and delivered it to the benchmark administrator. While this reflected segregation of responsibility there was little evidence of data integrity checks, either through an IT system or by the first or second lines of defence. 22 Not all firms had given due consideration to market integrity, and the impact on clients and the wider market when deciding to exit a benchmark Ibid P The first line of defence refers to the risk mitigation and control exercised by front-line staff. Firms need to ensure that the front line is aware of the standards they are expected to adhere to. The second line of defence refers to the activity of control functions such as Compliance, Legal and Risk as well as other independent control functions such as Financial Control. 23 Ibid P

9 What firms 3must do Please exit in an orderly manner Regarding the withdrawal from benchmark activities, the Review highlighted that firms need to engage constructively with other stakeholders such as the administrators and submitters of those benchmarks and the firm s clients, to ensure exits are undertaken in an orderly manner. Firms should take into account any legal, operational and financial risks (amongst others) that could arise as a result of not exiting from a benchmark in an orderly manner. The Review noted that the decision by two firms to exit a benchmark was not accompanied by a full consideration of the impact on other stakeholders and, ultimately, on market integrity. Lack of consideration of these factors may result in a disorderly exit, this could also cause a disorderly failure of the benchmark. Such actions could lead to client detriment and affect the reliability and/or credibility of the benchmark as well as negatively affect confidence in the overall market. Some firms reviewed had assessed their participation in in-house benchmarks with some considering withdrawal from this activity altogether. The FCA recognize that, in line with normal market dynamics, benchmarks should be allowed to evolve or cease in an orderly way. They acknowledged that some firms they had assessed had ceased to administer or submit to certain benchmarks, yet whilst they understood that firms would make commercial decisions to withdraw from certain benchmarks, they were concerned that in some cases firms did not pay sufficient consideration to the potential consequences of their actions. The Review recommends that careful attention should be given to establishing an appropriate governance framework around the decision to enter or exit a benchmark as consideration needs to be paid to the potential impact on clients and the integrity of the market when making such decisions. Firms need to strengthen their governance and oversight of benchmark activities. In particular, firms need to ensure they have relevant oversight functions providing effective challenge and formal sign-off around decisions relating to benchmarks. Firms also need to ensure that there is an integrated approach to adequate management information, monitoring and surveillance with clearly defined roles and responsibilities for the first, second and third lines of defence. Firms need to ensure that they identify all of the activities that constitute a benchmark activity or that could affect a benchmark. Firms should adopt the broad IOSCO definition of benchmarks and then consider their business activity, business practices and controls. Where firms interpret the broad IOSCO definition of benchmarks too narrowly, there is risk that their benchmark strategy, governance arrangements, oversight, controls and risk management processes will not be applied to all benchmark activities. Firms senior management need to act quickly to improve any outstanding gaps in their approaches to benchmark activities. Firms need to ensure that the lessons learnt from previous benchmark failures are applied in a consistent way across all business lines engaged in benchmark activities. There should be comprehensive improvement plans in place with clear senior management focus and accountability for delivering this work in a timely manner. 9

10 Firms need to continue to identify, raise awareness of and manage conflicts of interest in relation to benchmark activities. Firms should regularly review all of the processes linked to benchmark activities to identify whether and how conflicts might manifest themselves. Where they are identified, firms should ensure they take adequate steps to manage them. Firms should ensure they establish robust controls and oversight for any in-house benchmarks being used. Even where benchmark methodologies are in-house, firms still need to ensure that the methodologies are robust and adhered to, and that potential conflicts of interest are identified and managed. For example, staff that input to the design and production of a particular in-house benchmark, but who also have other economic incentives linked to its composition and/or performance, may be conflicted. When exiting benchmark activities, it is essential that firms give due consideration to the wider impact of their actions. Firms need to engage constructively with other stakeholders such as the administrators and submitters of those benchmarks and the firm s clients, to ensure exits are undertaken in an orderly manner. Firms should take into account any legal, operational and financial risks (amongst others) that could arise as a result of not exiting from a benchmark in an orderly manner. Following the Review by the FCA all firms must: Establish appropriate arrangements to identify and mitigate risks occurring in their benchmark activities Identify the conflicts of interest between sales and trading activities and benchmark administration or design and record these within their compliance conflicts of interest log Detect potential manipulation attempts as a result of a lack of appropriate oversight or monitoring Recognize that individual desks including sales staff or traders/brokers might have incentives that differ from those of the firm as a whole Implement effective training programs that enhance and improve long-term adherence to conduct standards. In Europe, it is essential that firms consider the existing legislative provisions relevant to benchmark activities. Firms senior management should satisfy themselves that their current approaches are coordinated across their businesses, in line with regulatory requirements where applicable and take into account industry best practices described by the IOSCO principles. The application of these principles should be proportionate to the size and risks posed by each benchmark. Benchmark administrators should publicly disclose the extent of their compliance with the Principles annually. These approaches should be robust enough to manage the inherent risks associated with benchmarks (including operational, legal and reputational risks) in a wide range of asset classes, and should ensure delivery of fair outcomes to consumers and maintain market integrity. Specific UK FCA rules on market conduct, as set out in MAR 8 24, apply to benchmark administrators and submitters, where the benchmark is specified in UK legislation. MAR 8 also sets out the requirements applying 10

11 4CONCLUSION to firms that are benchmark submitters or administrators when carrying out the activities of providing information in relation to a specified benchmark (MAR 8.2) or administering a specified benchmark (MAR 8.3). In addition, all regulated firms involved in benchmark activities should carefully consider the Review. Finally, employee training was highlighted in the FEMR Final Report as an area that would help raise standards of professionalism 25. Educating front office and relevant employees through effective and comprehensive training helps to ensure that they understand what constitutes acceptable conduct and helps them to make appropriate judgments in their day-to-day roles. Structured frameworks and data governance will be crucial for firms to succeed; all firms still have work to do. 24 MAR See section Documents/femrjun15.pdf Learn more at The FCA has used a number of supervisory tools to drive an improvement in standards for benchmark activities. These include regulatory fines, requiring individual firms to conduct remediation exercises, and their ongoing supervisory work with firms. The FCA have also been active in promoting international dialogue in relation to benchmarks with the Financial Stability Board, IOSCO and others. Where the regulator has identified shortcomings from their Review, they expect improvements to be made. For the twelve firms scrutinized, each has be given individual feedback, but for all firms, the FCA will follow up on this work as part of its supervision of benchmark activities. There is evidence to suggest that previous enforcement fines levied by the FCA and other authorities have been effective in instigating benchmark activity change at many firms. Senior management appear to have taken steps to focus on conduct issues and undertake assessments to identify and develop controls to manage conflicts of interest that arise in relation to benchmark activities at their firms. There is additionally evidence of a change in culture in most firms with this change more pronounced around those business areas where previous failings had been widely publicized. However, the regulator was clearly disappointed that most firms had not yet taken all appropriate steps to identify and then manage fairly and effectively relevant conflicts of interest regarding benchmark activities. Indeed, some firms were still not able to identify all the benchmarks they administered, submitted data to or published. Some firms still had manual submissions processes and inadequate surveillance in place. Progress in tackling deficiencies also lacked urgency given the proliferation of the issues: We would encourage firms to set more ambitious deadlines and complete projects more rapidly the FCA commented in the Review. Benchmark activities are numerous and disparate, and these characteristics create ongoing challenges for firms who must manage an increasing volume of data that is often lacking in consistency. The implementation of the proposed European Regulation will be resource intensive for many firms. Structured frameworks and data governance will be crucial for firms to succeed; all firms still have work to do. 11

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