When the LIBOR scandal first came to light, governments and regulators quickly took the view that "something had to be done" about pricing indices (Benchmarks). Since that moment, the FX scandal and further investigations into commodity pricing mechanisms have served only to enhance that perception. Everything has become subject to review, with new sectors coming under the spotlight in turn. Only this month, for example, the European Commission launched another dawn raid, this time on various companies in the ethanol market.
The response from governments and regulators has manifested itself (broadly) in the following ways:
- increased use of existing investigatory and enforcement powers (and increased reliance on information-sharing arrangements between regulators); and
- by making new rules:
- on market conduct (specifically, addressing conduct around benchmarks); and
- on the administration of benchmarks themselves.
This is all happening, more or less simultaneously, and without much in the way of coordination, at national, EU and global levels, giving rise to a series of potentially confused and overlapping regulatory proposals.
On the market conduct side, though, the message is relatively clear. The question of whether or not market abuse legislation already covers benchmarks is to be put beyond doubt by the inclusion of express prohibitions on the manipulation of benchmarks in new and proposed laws. We see this, for example, in the EU Market Abuse Regulation (MAR), which introduces a category of market manipulation comprising transmitting false or misleading information or inputs to a benchmark where a person knew or ought to have known that it was false or misleading, or engaging in any other behaviour which manipulates the calculation of a benchmark.
We also see it in the creation of a specific new criminal offence of benchmark manipulation in the UK under the Financial Services Act 2012. In the EU gas and power market, new market abuse rules under the Regulation for Market Integrity and Transparency (REMIT) do not expressly refer to benchmarks, but the intention is nonetheless crystal clear. With regard to REMIT, the UK has signalled its intention to go further than what the EU legislation requires. The Department of Energy and Climate Change (DECC) recently consulted on the UK's REMIT proposals, which suggest that criminal sanctions may be imposed on those in breach of REMIT and make specific reference to benchmark manipulation in that context.
However, when it comes to deciding how benchmarks should be administered, there are real disparities between the approaches being framed globally (at IOSCO level) and within the EU. The relatively proportionate approach taken by IOSCO contrasts with the uncompromising stance being formulated in Europe. The UK's unilateral steps in this area further complicate the picture.
What Should I Do About All This?
- Decide whether or not to engage with regulators and lawmakers to influence the debate.
- Decide whether to do so individually, or through trade associations.
- Consider what (if any) role your business should have in the benchmark setting process, whether as contributor, administrator or otherwise.
- Identify benchmarks used in your business – whether under derivatives or commercial contracts.
- Identify if any of these benchmarks are at risk. Will they cease to be published in the future? Will they be replaced or heavily modified? Will they be subject to a prohibition, if they are provided by non-EU administrators? Or will their reliability be adversely affected through reduced data?
- Review your existing contracts. Market disruption provisions will need to be reconsidered in the light of these risks. Many long-term physical commodity contracts, for example, may require reconsideration, to legislate for fallbacks and termination against this new landscape.
- Review your standard forms, and approach to market disruption, in all new contracts.
This Client Alert focuses primarily on these initiatives around regulating the administration of benchmarks (the Benchmark Reviews). To help take stock of this fluid and evolving landscape, we have taken a snapshot of the various Benchmark Reviews, and set them out in a summary matrix. Much of this relates to proposed laws still under consideration – particularly at an EU level - and participants need to monitor developments on them carefully, as highly contentious issues are in play, and the debate to date has been politicised.
Regulatory policy makers treat "integrity" and "transparency" as twin cornerstones of markets policy. Benchmarks which provide transparency in markets (by definition) are now perceived to lack integrity; some may do, but all of them now are under review. The challenge for the various Benchmark Reviews is to provide adequate regulation to dispel that perception, without running the risk of regulating too many benchmarks out of existence altogether. By striving too hard for integrity, regulators threaten transparency.
Firms face an unattractive prospect if they wish to participate in price-setting mechanisms under some of the current proposals. Under the EU Benchmark Regulation, for example, these could include: the requirement to impose structural segregation between their "submission" and trading functions; being bound to a "legally binding" code of conduct (the liability position on which is unclear), and being subject to a monitoring and reporting regime policed by benchmark providers.
This all means two things: increased costs and liabilities. It has been widely remarked that firms may simply cease to participate. Against that possibility, the EU may raise the prospect of compulsory participation (for certain benchmarks) and an effective ban on the use of benchmarks provided by non-EU entities.
For the administrators of benchmarks, there is the prospect of having to establish the various added layers of governance, oversight and other arrangements required to ensure their benchmarks are robust. Not such a simple task, particularly in less liquid markets.
So for market participants and for administrators alike, there is a risk/benefit (and indeed a cost/benefit) calculation in deciding the level of their commitment to less liquid benchmarks in the future.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.