A broad reach

The entry into force of the EU’s Benchmarks Regulation on January 1 will have a major impact on markets, asset classes and transactions

1 Minute read

Financial benchmarks are key to market participants’ contracts and pricing of a variety of transactions. According to the author, the financial crisis has impacted investor confidence in these benchmarks, a situation which recent EU reforms are attempting to remedy. The EU’s new Benchmark Regulation (BMR), which is set to enter into force in January, aims to improve data quality and conduct of business standards and make benchmarks less susceptible to manipulation. The BMR unifies all EU regulation on financial benchmarks, and also provides some key guidance on what constitutes a critical benchmark.

Benchmark rates and indices matter. Financial benchmarks play a central role in market participants' contracts and pricing of transactions. These include transactions in or referencing interest rates, currencies, financial instruments and commodities used by professional market participants, through to financial products and transactions with retail clients as well as non-financial end-users in relation to a range of reference prices. The financial crisis has shown that failure of confidence in the accuracy and integrity of rates undermines market confidence. This in turn can cause losses to consumers, investors and the real economy. The EU's reforms aim to improve data quality and conduct of business standards and make benchmarks less susceptible to manipulation.

The remaining bulk of the provisions of the EU's Benchmarks Regulation (BMR) will enter intro force on January 1 2018, and will have transformative effects across markets, asset classes and transaction types. It will also distinguish between activity that is regulated and supervised in the EU, and activity that is outside the EU, ie in a third country and which will need to be permissioned for access into the EU or for use by those that, as per the BMR, are an EU supervised entity (subject to EU sectoral legislation like a bank or insurer etc). This will be of particular importance once the UK leaves the EU and becomes a third-country.

In terms of impact, these rules go beyond cleaning-up so-called interbank offered rates (Ibors) like the interbank bid and/or offer rates that shot to prominence in the Libor and Euribor fixing scandals and now have policymakers searching for replacement rates. The following paragraphs explore the impact of the EU's new regime on benchmarks along with some of the practical considerations that affected market participants may wish to consider against what is set to be a busy 2018, a tumultuous Brexit-filled 2019 and very packed 2020. To further complicate matters, against this backdrop of new rules, a number of private and public sector participants are each finalising their proposals in what is emerging as a race for new as well as replacement benchmark rates.

The BMR brings existing EU regulation on benchmarks into one place and also has common definitions on what constitutes a benchmark, and what rules the BMR will require depending on the benchmark's systemic importance. Those that qualify as critical benchmarks will also be subject to new supervisory powers that impose an obligation of the benchmark's continued running and/or continued submissions from contributors. The BMR also replaces rules in national regimes, notably those in the UK, and introduces a whole new compliance approach for some jurisdictions where benchmarks and related activity were not regulated.

In practical terms, this means that benchmark rates, once identified, will be subject to a requirement to publish methodologies and perform periodic reviews to ensure they and the input data reflect the market or economic reality that are measured, or be modified to meet BMR requirements. Certain material changes to benchmarks will require consultation with benchmark users. Certain transitional arrangements allow for existing rates to be phased up to BMR compliance, but this does not switch off or put a supervisory stop on other BMR compliance obligations.

Regardless of a relevant jurisdiction and irrespective of whether one is a benchmark administrator, contributor or user, the BMR may impact how financial products and transactions are structured, documented and concluded. This will be more than a repapering exercise, a provision of policies, procedures and processes or a systems upgrade: it changes business compliance deliverables before tackling run the business compliance deliverables. All of this may feed through to (various) costs being passed on to those market participants and issuers that use a benchmark. Those costs may also translate to lower returns for end users and possibly the real economy.

Change is invariably costly. But the regulatory and supervisory policymakers' view on this is that the upside of the BMR's reforms will be that the new EU maximum harmonisation regime will improve data quality and methodology behind benchmark rates and provide a more level playing field. Moreover, the European Securities and Markets Authority (Esma) will, as regulatory gatekeeper and supervisory coordinator in this area, maintain a centralised register of benchmark administrators with an aim of offering greater transparency and certainty of choice.

Whilst most market participants' resources have been focused on meeting changes in sectoral legislation, notably the new Markets in Financial Instruments Directive (Mifid II) and its regulation (Mifir) which apply from January 3 2018, the BMR could have far wider transformative effects for financial and non-financial markets. Failing to comply with BMR will not only carry supervisory penalties, including for individuals, it may also provide contractual challenges and disruption to existing or new documented arrangements. This may in turn prompt economic and documentary renegotiation of a wide range of asset classes and transaction types.

For those that the BMR classifies as EU supervised entities, this translates into having to firstly assess what BMR in-scope benchmarks and indices it uses, it contributes to and it potentially administrates. This BMR benchmark inventory review is then likely to be followed by firms assessing, analysing and deciding whether and how to amend documentation, products and transactions to meet BMR standards.

This review extends to those that use or rely on industry/market standard definitions, which reference benchmarks, including those used in master agreement documentation suites. A similar exercise applies to those using bespoke benchmarks. The latter is likely to particularly affect funds or the insurance sector along with those firms engaged in lending to consumers and regulated mortgages where the borrowing rate references or provides a mark-up or spread over an index or benchmark. Some entities will also need to assess whether their activity in itself constitutes control over the provision of a benchmark thus causing these to potentially become a benchmark administrator for purposes of the BMR.

The BMR's catalogue of penalties and supervisory enforcement powers is split between those harmonised at EU level, those that exist at the national level and those that remain within the power of the national courts for a breach of BMR or any other relevant national or EU level legislation. They also map over to the EU's Market Abuse Regulation, which like the BMR and the new Mifid framework, was finalised during 2014. Penalties and enforcement powers that were required to be adopted into national law were supposed to be notified to the European Commission prior to January 1 2018.

Prospectuses and KIDs approved before January 1 2018 which reference benchmarks in-scope of BMR need to be updated by January 1 2019

It is too early to say how the BMR will be actively policed or how the penalties catalogue will be enforced by constituent EU-level and national members of the European system of financial supervisors. However, given that the BMR only provides a transitional arrangement for the continued use of existing benchmarks until January 1 2020, the pressure will be on EU domiciled administrators and supervised entities (as contributors and/or users) to undertake a quick and orderly transition to BMR compliant arrangements. Prospectuses and key information documents that are approved prior to January 1 2018 and which reference benchmarks in-scope of BMR need to be updated by January 1 2019.

Building upon principles established by Iosco and its own framework for benchmarks, the BMR's drafting delivers by focusing on: identifying, mitigating and managing conflicts of interest, record-keeping, complaints-handling reviewing outsourcing, delegation and own resources for adequate skill and competence, operational separation and introducing harmonised authorisation standards for EU administrators of benchmarks. Many of these will have a Mifid-like feel to them but have BMR bolt-ons. Nevertheless, for a number of market participants, taking action to comply with the BMR may be a new development. This is especially the case where reference rates and their uses have historically been beyond the EU or individual jurisdictions' regulatory perimeter.

Then there are areas that are new and non-Mifid like, such as contributors needing to comply with a set code of conduct, which also includes a requirement to verify input data of a benchmark when it is pulled from a front-office function along with administrators having to publish a benchmark statement describing the key features of each benchmark along with methodology and input data used in calculations.

The BMR's scope of application is broad. It is drafted as product and sector agnostic. This is reflected in its recitals on coverage that aim to be 'as broad as necessary to create a preventive regulatory framework'.

The BMR also reads:

'The critical determinant of the scope of this Regulation should be whether the output value of the benchmark determines the value of a financial instrument or a financial contract, or measures the performance of an investment fund.'

The scope set in its article 2(1) states:

'This Regulation applies to the provision of benchmarks, the contribution of input data to a benchmark and the use of the benchmark within the Union.'

Consequently, the BMR applies to benchmark administrators, contributors as well as users. Benchmark contributors are further refined by reference to a supervised contributor ie a supervised entity that contributes input data to an EU administrator. The wide definition of user in article 3(1)(7) can aso apply to users outside the EU 'where it is party to a financial contract which references an index or a combination of indices'. Whilst this definition does not have a look-through concept behind say a special purpose vehicle etc. compliance obligations might capture a much wider body than anticipated. Notably, it is still unclear (certainly at the time of writing) how the BMR applies to supervised entities that act through non-EU branches.

The BMR provides blanket exemptions in article 2(2). The following are excluded from its application: central banks (but not necessarily fiscal or monetary boards that operate independently and do not otherwise qualify as a central bank), public authorities including national statistics agencies, central counterparties in certain circumstances, trading related circumstances with single reference pricing where no calculation is conducted, the press when publishing or referencing a benchmark, publication of variable or fixed rates borrowing rates set by internal decisions in relation to lending to a natural or legal person, certain commodity benchmarks and providers of indices where the index provider could not reasonably have been aware that the index is used as a benchmark.

Another important point for supervised entities (excluding administrators) is that they are required to produce and maintain robust written plans setting out the actions they will take in the event a benchmark materially changes or ceases to be provided (a backup plan). Such BMR backup plans, where possible, are required to nominate one or more alternative and suitable benchmarks as a fallback and provide why such back-up benchmarks are suitable as alternatives.

The plans, and any updates to them have to be disclosed to the relevant competent supervisory authority on request and, as per article 28(2), must reflect them in the contractual relationship with clients. For a number of supervised entities, this may prompt some strategic thinking and possibly negotiation with their own clients.

Article 3(1)(3) defines this as:

'Any index by reference to which the amount payable under a financial instrument [i.e., those defined per Mifid II/Mifir] or a financial contract [credit per Consumer Credit Directive or Mortgage Credit Directive], or the value of a financial instrument, is determined, or an index that is used to measure the performance of an investment fund [Ucits or AIF] with the purpose of tracking the return of such index or of defining the asset allocation of a portfolio or of computing the performance fee.'

Article 3(1)(4) also introduces the concept of a family of benchmarks ie 'a group of benchmarks provided by the same administrator and determined from input data of the same nature which provides specific measures of the same or similar market or economic reality'.

The definition of input data is drafted in an agnostic manner as the BMR's aim in this area is to improve the quality of data and methodologies across all relevant asset classes. That definition reads:

'The data in respect of the value of one or more underlying assets, or prices, including estimated prices, quotes, committed quotes or other values, used by an administrator to determine a benchmark.'

The drafting of this definition means that the BMR is flexible if the intended scope of its coverage is expanded further.

Put simply, the BMR's coverage carries with it breadth and depth. It will apply to a wide range of rates, including private sector offered replacement rates to Libor and the UK's Sterling overnight index average (Sonia), Euribor/Eonia in the eurozone, other non-eurozone rates, and FX benchmarks such as the WM/Reuters 4pm London closing spot rate or the relevant commodity benchmark rates calculated in the London market for gold or silver. It also will apply to indices and a breadth real economy rates. It remains to be seen whether supervisors might extend the BMR to say cryptocurrency. Whilst EU opinion is still out as to whether this is a financial instrument ie within the meaning of Mifid II/Mifir, the BMR could capture existing regulated activity that follows cryptocurrency and/or other digital assets that do not presently qualify as financial instruments.

The BMR distinguishes between commodity benchmarks, interest rate benchmarks and regulated data benchmarks. A commodity and an interest rate benchmark are quite self-explanatory. Importantly, the BMR introduces additional conduct of business standards and minimum requirements as to what these two benchmark types must include in their methodology.

A regulated data benchmark is defined in the BMR and where the input data is contributed entirely and directly from any of the following locations, each of which are defined and regulated by:

• the Mifid II/Mifir framework: a trading venue, an approved publication arrangement or an approved reporting mechanism;

• in the relevant sectoral legislation that an electricity, natural gas exchange, auction platform or a service provider to whom data collection in accordance with article 10 BMR has been outsourced; or

• the net asset value of investment funds.

Among these benchmark types, the BMR categorises these as either critical, significant or non-significant. A regulated data benchmark, even if used extensively, is capable of being critical as per article 3(1)(25). Non-significant benchmarks are those that are neither critical nor significant. The other two are defined as below:

The UK will become a third country regime upon it leaving the EU

The categorisation matters as it will determine the level of proportionality of the BMR's rules required to be applied by benchmark administrators. It will also determine whether a person intending to act as an administrator must apply for authorisation or merely the much less complex process of registration.

Euribor and Eonia were both recognised as critical in 2016 and 2017 respectively. Critical benchmarks are specified on a list established by the Commission which has to be reviewed and updated every two years, and equally requires a capability assessment from the administrator as to how the critical benchmark they provide measures and captures the underlying market or economic performance.

Esma will be tasked with assigning and steering benchmark colleges of supervisors for critical benchmarks. It will also have the power to require mandatory contributions from supervised entities to critical benchmarks (but not critical commodity benchmarks) for a period not exceeding 12 months, which can be extended for a further 12 months to a maximum 24 months in total. Supervised entities are selected by the competent supervisory authority of the critical benchmark's administrator according to a methodological framework introduced in June 2017. This is a significant change to current EU and national laws and regulatory regimes where contribution to a benchmark is voluntary.

Article 29 prohibits supervised entities from using indices as benchmark in the EU unless they are produced by an EU administrator included on Esma's register of administrators or have otherwise been qualified ie permissioned for use in the EU under the BMR's third country regime. A third country benchmark or family of benchmarks may be permissioned for use in the EU where it is subject to:

• An equivalence decision: assessed by the Commission, in consultation with Esma as equivalent and the third country administrator is authorised or registered and subject to supervision. An equivalence decision also requires Esma and the third country competent authorities have a supervisory cooperation arrangement in place and operational.

• Until such time an equivalence decision is granted, the third country administrator applies for or arranges:

• recognition in a relevant EU member state of reference and appoints a legal representative to act on its behalf vis-à-vis the authorities and any other person with regard to the BMR's obligations; or

• endorsement of a third country benchmark by an EU benchmark administrator that is authorised or registered in accordance with article 34, or another supervised entity in the EU that has 'a clear and well-defined role within the control or accountability framework of a third-country administrator' that is able to monitor the third country administrator's provision of a benchmark may apply to a competent authority to endorse that third country benchmark or family of benchmarks subject to comparable regulatory standards in that third-country, necessary expertise of the relevant parties and that there is 'an objective reason to provide the benchmark or family of benchmarks in a third country and for said benchmark or family of benchmarks to be endorsed for their use in the Union'.

This pre-supposes that firstly, a third country administrator and/or its regulatory authority would be willing to comply to make a benchmark available for use in the EU. Secondly, it would need to find or establish a legal representative to comply with the BMR obligations in terms of recognition or, in the alternative, a suitable EU benchmark administrator that would endorse the third country benchmark. In any event, the third country rules of the BMR come with set deadlines on timing. Given the range of work that the Commission, Esma and the relevant national authorities will have on the road to 2020, timing will be of the essence for those setting up a presence in the EU and becoming an EU benchmark administrator inasmuch as those that will remain in third countries and will want access to the EU.

The UK will become a third country regime upon it leaving the EU. At the time of writing it is not clear what this might mean for UK-run benchmarks. This applies to new post-Brexit benchmarks inasmuch as those that were UK BMR compliant. Irrespective of the difficult divorce talks, there is an anticipation that there would be an interest on both sides of the Irish Sea and the English Channel that the Commission evaluates the UK's domestic benchmark regulation regime as equivalent, not least because it builds upon the Iosco principles (but because the UK will likely retain BMR on its statute books on departure.

2018 is set to be a busy year with a number of financial services regulatory reforms entering into force. The BMR is a big task in its own right with more than a handful of change the business and run the business compliance, business, systems and strategic workflows to be dealt with. Even if the EU27 and the eurozone 19 have a firmer vision of the desired end state of how financial services should be regulated and supervised, the likelihood of an EU regulatory rulemaking pause let alone a reprieve or relaxation is slim at best. For market participants, the BMR introduces some immediate compliance steps as well as longer-term strategic decisions, including whether:

• Benchmark users are sufficiently aware of which benchmarks they use and the nature of how they operate as well as the relevant alternatives. The BMR benchmark inventory review is therefore relevant, not only in terms of ensuring this information is explained in client facing documentation including prospectuses and offering documents, but also in terms of describing and activating a BMR back-up plan and what that means for trading and order management systems along with those of relevant control functions and how terms have been documented in contracts and standard form definitions.

• One is directly or indirectly conducting activity that would constitute provision of a benchmark? If one qualifies as a benchmark administrator or a benchmark contributor are the relevant governance, accountability design and disclosure requirements introduced by the BMR drafted and embedded across the business? Does the firm have a sufficiently holistic view of its benchmark activities and who is accessing or submitting what data, where, how and with what motivations?

• Is the contributor code of conduct sufficiently detailed and adequately understood including with respect to validation of data that is pulled from a front office function?

• Are the policies, procedures and process of benchmark administrators, notably in relation to identification, mitigation and management of conflicts of interest as well as operational separation, compliance and governance appropriately detailed, disclosed and communicated within the organisation as well as to those persons upon whom the provision of a benchmark relies and whether these are reviewed with sufficient frequency?

• Is the use of non-EU benchmarks still permitted for supervised entities? This will also be susceptible to Brexit-driven changes once the UK leaves the EU.

• Has the BMR back-up plan been disclosed to clients including by way of robust contractual fall-back clauses?

• Is the BMR back-up plan Brexit-proof and/or capable of operating in the event a particular rate is replaced?

• Has a provider of credit under a Consumer Credit Directive or Mortgage Credit Directive in-scope agreement or arrangement been provided sufficient pre-contractual information on the names of the benchmarks and their administrators etc?

• Is a market participant comfortable with potentially becoming and/or remaining subject to mandatory contribution of input data to a critical benchmark?

• Has a firm exiting from its benchmark activities given due consideration as to whether that exit is orderly and how it might have wider implications on the market?

With any regulatory change come a number of market-led solutions. Some of these focus on outsourcing administration of benchmarks to specialist BMR-compliant firms. It is at present unclear whether these outsourcing arrangements themselves will become subject to specific supervisory scrutiny, but in the context of Brexit-driven relocations and/or other changes, market participants are being cautious and firms may need to take closer heed of the EU's supervisory principles on relocations (SPoRs). The SPoRs set clear and concise supervisory expectations that the various EU supervisory authorities and the European Central Bank expect relevant authorities apply in the discharge of their supervisory mandates.

The BMR is big both in the breadth of its impact as well as in its depth of what it demands of EU domiciled administrators, contributors and users as well as those outside of the EU. With the road to 2020 set to be busy, those affected by the BMR will want to ensure that the momentum to meet its compliance obligations continues to accelerate, even past January 1, especially as the race to introduce new and/or replacement benchmark rates itself continues to gather speed. A benchmark inventory review may thus become a much more permanent and ongoing monitoring process prompting compliance actions.

Significant benchmark Satisfies criteria in article 24(1) BMR In summary, a significant benchmark will include those where any of the following apply: The value of the business (financial instruments, financial contracts and investment funds) underlying the benchmark is at least €50 billion (approx. $59.1 billion). The benchmark has no or very few appropriate market-led substitutes. There would be a significant and adverse impact on market integrity, financial stability, consumers, the real economy or the financing of households and businesses in or more member states if the benchmark ceases to be provided. Critical benchmark Satisfies criteria in article 20(1) BMR and included on a centralised list established by the Commission. In summary, a critical benchmark will include those where any of the following apply: The value of the business (financial instruments, financial contracts and investment funds) underlying the benchmark is at least €500 billion. The majority of benchmark contributors are concentrated in one member state and the benchmark has been recognised as critical. Those with an underlying market of more than €400 billion but less than €500 billion, where the benchmark has no or few appropriate market-led substitutes and where there would be a significant and adverse impact on market integrity, financial stability, consumers, the real economy or the financing of households and businesses on or more member states if the benchmark ceases to be provided.

Michael Huertas Counsel Baker McKenzie (Frankfurt)