The European Commission’s Regulation on indices used as financial benchmarks in financial instruments and financial contracts (the Regulation) forms part of the EU’s response to a series of high profile investigations in recent years into the alleged manipulation of key financial benchmarks, including LIBOR. These investigations raised concerns over the reliability and integrity of financial benchmarks, which underpin transactions worth trillions of dollars. The Regulation aims to reduce the risk of manipulation, bolster the reliability of benchmarks administered and ultimately provide a safer environment for the use of benchmarks in the EU.
Timeline and Transitional Arrangements
On 1 January 2018, the Regulation will apply in which gives less than twelve months for entities that are either benchmark administrators, contributors or users to prepare for compliance with the requirements of the Regulation, subject to transitional arrangements.
Transitional arrangements will apply to “existing” benchmarks. This means EU benchmark administrators providing benchmarks up to 1 January 2018 will have until 1 January 2020 to apply to their EU national competent authority (NCA) for authorisation or registration.
However, the treatment of “new” benchmarks, i.e. those created by a benchmark administrator after 1 January 2018, remains unclear in the Regulation. This poses a challenge as to the level of implementation firms are seeking to achieve by the end of 2017.
Entities impacted by the Regulation (including those within and beyond the financial services industry), should remain prudent in their implementation plans by assuming the transitional arrangements will not apply to “new” benchmarks. This would mean administrators will only be able to administer new benchmarks in 2018 when they are authorised or registered by an EU NCA.
A summary of key milestones and expected activities over this year and beyond is shown below:
Level 2 Regulatory Technical Standards (RTS)
ESMA is expected to issue a final draft (for adoption) RTS on the Regulation to the Commission in early April 2017 which will give further guidance on a number of key focus areas of application of the Regulation, such as templates for benchmark and compliance statements.
However as part of the legislative process, it is worth noting that the Commission may choose to make some changes to the text before adopting it. Once the Commission has adopted the text, it will be submitted to the EU Parliament and Council and they will have three months to raise objections (although this period may be extended). Should no objections be raised, the text will be final and will be entered into the Official Journal of the EU. Thus, the full set of final requirements may only be available shortly before 1 January 2018.
Applications to EU national competent authorities
ESMA’s Level 2 RTS will include further guidance on the specific information required in the application forms for the assessment for authorisation and/or registration. Hence once the final standards are published, the baton is passed to delegated EU NCAs to publish their own consultation papers for guidance on applications, likely to be in Q4 2017, and hence we may see a “rush to the finish” with a large influx of applications being submitted at the tail end of 2017.
It is also worth noting that the Regulation is still unclear on the level of compliance of the Regulation needed during the period between application and authorisation/registration. However we would expect the Regulation to allow administrators to continue the provision of benchmarks until the decision is made or at least to have some form of interim permission. In addition, the Regulation allows for administrators to apply within 30 working days of any agreement entered into by a supervised entity to use the benchmark. This means that administrators have up to mid-February 2018 to be able to apply assuming they would want to continue administering these benchmarks come 1 January 2018. However we would advise firms not to leave their applications to the last minute.
Further to existing benchmark regulation and guidance, the Regulation includes a variety of assurance requirements which firms who are impacted by the Regulation should consider as part of their implementation plans. These include:
- Critical benchmarks require annual external audits
- Commodity benchmarks require annual external audits
- Interest Rate benchmarks require external audits every two years starting after 6 months of the code of conduct being issued
- Third country administrators under Recognition need either an external audit or competent authority certification on their compliance of IOSCO principles (where required)
- Administrators require reviews of contributors’ adherence to the code of conduct
- Benchmark methodologies and input data require internal reviews
Thematic Areas of Focus for firms’ implementation plans
1) Governance: Effective Arrangements and Proportionality
The Regulation sets out a wide-range of requirements on governance and oversight arrangements, managing conflicts of interest, accountability and control frameworks, input data and benchmark methodologies and transparency. As a further complexity, these requirements will differ depending on the type and criticality of the benchmark and hence firms are encouraged to have an inventory of benchmarks with a robust process to be able to identify the requirements for each of their benchmark activities.
The Regulation sets out the minimum standards of compliance that firms need to meet and depending on business set up and/or client needs, firms can choose to go above and beyond to establish control framework(s) proportionally to meet the Regulation standards across the organisation. Nevertheless, firms need to prove to their EU NCA that they comply with the Regulation as an organisation.
2) Inventory: Define your in-scope benchmarks
Whether firms are users, contributors or administrators, the need for firms to develop an all-encompassing “live” inventory of benchmarks and to develop a control framework to maintain the inventory in line with the Regulation is important in establishing the perimeter of the application of the Regulation. The Regulation sets out various definitions and classifications which determine the requirements for each benchmark identified and thus we see as a minimum for the inventory to include information such as criticality, benchmark type, location of administration, contributor relationships and the use of benchmarks.
We also draw attention to the fact that the Regulation imposes requirements on supervised entities that are users of benchmarks. Not only do users now need to identify in-scope benchmarks being used across the organisation, users would also need to check regularly that the administrator is on the ESMA register with a benchmark statement published for each of their benchmarks. We would also encourage firms to begin thinking of contingency plans given the possibility for benchmarks to be discontinued or restricted to be used in the EU due to the Regulation.
3) Third Country: The Regime and UK’s planned exit from the EU
There are three options available under the third country regime and each option ultimately requires non-EU administrators to comply with requirements equivalent to the Regulation (IOSCO Principles for Financial Benchmarks and Oil Price Reporting Agencies). Although this provides some flexibility for non-EU firms to apply proportionality to their governance and control framework, the level of awareness of the Regulation by third country administrators with a limited presence in the EU will be a challenge, both in terms of the cost of meeting the requirements of the Regulation, and the feasibility in amending business strategies and models to ensure compliance with the Regulation.
It is worth noting that even with UK’s planned exit from the EU, the Regulation will still apply in the UK before the earliest possible date for UK’s exit from the EU. Thus, we would encourage firms in the UK to continue preparing for implementation of control frameworks to comply with the Regulation as an EU country. Furthermore, it may be seen as a competitive advantage to be an authorised or registered third country benchmark administrator living up to the standards of the Regulation, particularly if the UK regime is not deemed to be equivalent.
Given that 1 January 2018 is fast approaching, and in light of the highlighted complexities and uncertainties of the Regulation, we see the pressing need for firms to identify decisively the perimeter of impact of the Regulation, design plans for implementation, formulate a communication strategy with clients on any potential impact and start to prepare for application to EU NCAs.
Official Journal of the Regulation, http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=OJ:L:2016:171:TOC
Latest ESMA technical paper, https://www.esma.europa.eu/press-news/esma-news/esma-finalises-advice-future-rules-financial-benchmarks