Sunday, April 6, 2014

Regulating LIBOR, EURIBOR, and the like – Help restoring confidence in benchmarks’ integrity?

The story has been told many times in the financial press: Bank employee A communicates data to a financial index provider. The data then flows into the index. Bank employee B trades on the same index. As both employees know each-other, data communication and index fixing “somehow influence each-other”. Because this is illegal, we had first the LIBOR / EURIBOR scandal and, currently, the FOREX scandal.

On September 18, 2013, the European Commission has published a proposal to tackle the problem. Keeping in mind that the FOREX scandal is just about to unfold, this is certainly not the final draft. Nevertheless, the main principles should remain relevant in any case:

When does the regulation apply?

The EU proposal covers three types of activities – contributing data to a benchmark, publishing a benchmark, and using a benchmark. But what is a benchmark? A benchmark is an index that influences on the value of a financial instrument. You will have noticed that I have swapped one general term (benchmark) by another one (index). So what is an index? An index is a figure that is calculated regularly, on the basis of other underlying parameters, and then published. Now we put this together and understand what the regulation intends to cover:

  • Underlying data
  • Regular calculation of a number
  • Number relevant for valuing financial instruments
  • Publishing the number

The nature of the data (economic data or non-economic data such as weather conditions) is not relevant for the scope of application. Thus, the proposal covers a wide range of benchmarks. It includes not only LIBOR / EURIBOR but also other indexes such as commodity indices.

“Today's proposals will ensure for the first time that all benchmark providers have to be authorized and supervised; they will enhance transparency and tackle conflicts of interest. As a result, the integrity as well as the continuity and quality of key benchmarks will be ensured.”
(Michel Barnier, European Commission, 18 September 2013)

What have benchmark administrators to do?

Benchmark administrators gather data, calculate benchmarks, and then publish them.

The European Commission suggests enhancing their internal corporate governance. The detailed proposals include

  • defining organizational responsibilities clearly and consistently;
  • creating an internal oversight function and compliance framework;
  • allowing for outsourcing functions as long as the benchmark administrator keeps control over the provision and supervision of the benchmark.

A benchmark administrator must be authorized by EU regulators. If the administrator stems from a non EU member country, he must still be recognized by the European Commission. This will be an equivalence decision; it basically says that the third country imposes conditions on the administrator, in essence comparable to those applicable in the EU.

For each benchmark, its administrator establishes a benchmark statement summarizing

  • the market or economic reality that the benchmark measures;
  • the purposes for which the benchmark is used;
  • the calculation parameters;
  • the factors that can lead to changes or cessation of the benchmark.

Benchmark data must be transparent. Thus, input data of a benchmark is published. The only exception to this rule is where such publication would have serious adverse consequences, either for the contributors or for the integrity of the benchmark.

Finally, a procedure must be in place that guides changes to or the cessation of a benchmark.

What are the conditions for benchmark data?

Four key criteria apply to benchmark data:

  • Benchmark data should be sufficient and accurate. It must reflect the economic reality that the benchmark intends to measure.
  • A reliable and representative panel or sample of contributors must provide the data.
  • Whenever possible, the benchmark data should consist of real transaction data as opposed to estimates about the right market price. The reason is very simple: Real transaction is what it is – real. Manipulation is only possible in a very restricted way. If non-transaction data is provided and one contributor has more than 50 % market share, the administrator of the benchmark must check that the market is virtually subject to supply and demand forces.
  • The administrator should use a robust, reliable, and transparent methodology to determine the benchmark.

How must benchmark contributors behave?

Benchmark contributors must put in place a code of conduct for each benchmark. The code will specify the administrator’s and contributor’s responsibilities and obligations; both administrator and contributor must sign it.

A benchmark can only be as good as its underlying data. This is why important market participants must contribute their data for a benchmark to be reliable. More specifically, this means that regulators can force market participants to contribute to a benchmark. However, this is limited to a scenario where the benchmark influences on financial instruments with a notional value of at least 500 BEUR and at least 20 % of its contributors are likely to cease contributing to the benchmark.

My impression when reading the Commission’s proposal is that it is both very detailed and very general at the same time. I am wondering whether we really need additional regulation of this topic. Isn’t current legislation (both criminal and anti-trust) clear enough? Isn’t the whole story more about effective application of today’s rules rather than creating new ones?