Benchmark Compliance: A Proactive Approach

Twenty years ago the term ‘benchmark’ was still a verb – a term which described the activity of relative performance measurement.  Recent regulatory reforms following the 2012 Libor scandal have redefined the term to mean a ‘value’ which is referenced by an instrument, contract or performance measurement.

Global regulators have embarked on a broad and ambitious reform agenda designed to restore public confidence by mitigating any potential future misconduct. The scope of this reform is comprehensive and covers the entire lifecycle of a benchmark, including contributions to benchmarks (submitters), calculation and publication of benchmarks (administrators) and also the 'use' of benchmarks (the rest of the planet), which is likely to be of particular significance to asset managers.

Passive investment trends have given rise to a proliferation of proprietary indices designed to provide investors with unique exposure and customised return patterns. Many of these indices are also dependent on underlying indicators, indices or signals which inform the index strategy and trigger dynamic portfolio shifts.  These product innovations offer investors exposure to new types of investment styles, enhanced transparency and low cost alternatives to active management.

IOSCO has established the foundation for the emergence of global benchmark regulation, and new EU benchmark regulations have been introduced which cover products and benchmarks provided to customers in the EU no matter where the provider is domiciled. In its thematic review, the FCA emphasised the scope and urgency of reform and continues to encourage immediate action rather than a wait-and-see approach. In Asia the Australian Securities and Investment Commission (ASIC) published its 440 review. We have also seen enforcement actions taken by the Financial Conduct Authority (FCA) here in the UK and by the Securities Exchange Commission (SEC) in the US.

An industry already overwhelmed with regulatory change is trying to gauge how and when to respond. The complexity and broad use of benchmarks touches an array of business activities. The lead times associated with these significant change programmes require months and, in some cases, years to implement the necessary controls required to support what is now a cultural change.  

Regulators have acknowledged their main dilemma of imposing reforms which aim to ‘treat the cancer without killing the patient.’ Mandatory contributions will require submitters to critical benchmarks to continue participation in order to prevent systemically important benchmarks from being starved to death. For all other benchmarks, their fate remains unclear - thereby threatening the transparency these benchmarks provide for otherwise opaque and illiquid markets.

At a recent conference in London, participants and regulators gathered to discuss best practice approaches to managing benchmark risk. Some benchmark providers have chosen to divest these assets to avoid the cost and risk while others continue to seek alternative approaches.

The IOSCO principles offer guidance for mitigating the inherent conflicts for benchmark administrators who deal in products which reference their own benchmarks or reference the benchmarks for attributing performance and risk. IOSCO suggests separating the administrator function as good practice by relinquishing control of the index methodology to a control function – typically an internal compliance team. The practical issue for going this route is their lack of specific experience necessary to effectively administrate.

An independent administrator assumes control of the index methodologies while the owner of the index continues to enjoy the commercial benefits of ownership.  As an alternative to internal compliance oversight or possibly even divesture, transferring the benchmark administration to an independent provider is an efficient means of achieving best practice compliance. However, it is critical that the independent administrator is capable (and willing) of assuming the liabilities that come with the role and that the administrator has the depth of benchmark and relevant asset class expertise to effectively manage the benchmark. By reducing the burden of benchmark compliance, index providers are left to focus only on product innovation so best to choose an administrator who is able to quickly scale and support rapid product releases.

Benchmark reform is a global concern and one which requires a successful collaboration across regional jurisdictions. EU benchmark regulation has been published and applies to any benchmark provider or user with an EU client. Although EU benchmark regulation is not due to come into force for another 18-24 months, IOSCO has given us plenty to move forward on and most benchmark providers know that there is plenty to do and conflicts of interest are being enforced now.  Benchmark providers, users and administrators should support the adoption of new regulation by being proactive and helping to shape best practices.  It’s time that benchmark providers and users work proactively with global regulators to ensure that their common objectives are achieved.