Regulating financial benchmarks

The Financial Conduct Authority (FCA) recently published a consultation paper seeking views on its proposed regulation of seven additional benchmarks. Tom Dane, a partner at Nabarro LLP, takes a look at the proposals and their potential ramifications.

Original news

FCA consults on further benchmark regulation, LNB News 22/12/2014 125

The FCA will, from 1 April 2015, regulate seven additional UK-based financial benchmarks in the fixed income, commodity and currency markets. This extends the FCA’s initial regulation of LIBOR, as introduced by HM Treasury in 2013, and implements the recommendations of the Fair and Effective Markets Review. In light of this extension, the FCA is consulting on extending its approach to regulating LIBOR to the firms that administer and contribute data or information to the other benchmarks it will regulate in 2015, including Sonia and Ronia, WM/Reuters London 4pm Closing Spot Rate and ISDAFIX. Those wishing to respond to this consultation should do so by 30 January 2015.

What are the FCA’s proposals in this consultation?

Following the misconduct identified in relation to the setting of the London Interbank Offered Rate (LIBOR) benchmark in 2012, the FCA was given power to regulate the setting of LIBOR from April 2013.

The proposals in the FCA Consultation Paper 14/32 relate to the basis on which the FCA will regulate seven additional major UK-based financial benchmarks in the currency, fixed income and commodity markets from 1 April 2015. The proposed extended scope of regulation implements recommendations in the government’s Fair and Effective Markets Review (a review which is currently ongoing).

The proposals relate to firms that (i) administer and (ii) submit data for the purposes of compiling benchmarks. The seven additional benchmarks are as follows:

• WM/Reuters London 4pm Closing Spot Rate, being the dominant global foreign exchange benchmark
• London Gold Fixing and the LBMA Silver Price, which determine the price of gold and silver in the London market
• ISDAFIX, being the principal global benchmark for swap rates and spreads for interest rate swap transactions
• SONIA (Sterling Overnight Index Average) and RONIA (Repurchase Overnight Index Average), which both act as reference rates for overnight index swaps
• ICE Brent Index, traded on the ICE Futures Europe (IFEU) exchange, which acts as the crude oil futures market’s principal financial benchmark

The consultation paper acknowledges that there are practical differences between the ways in which various benchmarks are set. Accordingly, the current provisions of Chapter 8 of the FCA’s Market Conduct Sourcebook (MAR) that were originally implemented to regulate LIBOR will need to be amended to cater for the seven new benchmarks.

The proposals include the following:

Benchmark administrators

Benchmark administrators will be required to:

• implement credible governance and oversight measures—this is to include an oversight committee and establishment of practice standards to ensure robust administration of the benchmark
• monitor, scrutinise and keep records of benchmark submissions to identify breaches of practice standards and/or potentially manipulative behaviour and to ensure a proper audit trail
• maintain sufficient financial resources to ensure the administrator can cover operating costs for up to nine months to ensure viability and continuity of benchmarks
• appoint an FCA approved individual to oversee and ensure compliance with the FCA’s requirements
• where the benchmark in question is not compiled on the basis of submissions from a regulated ‘benchmark submitter’, administrators will be required to treat as a ‘submission’ any data or information made available by any person other than a benchmark submitter that is considered by a benchmark administrator for the purposes of determining its benchmark

Benchmark submitters

The provisions implemented for LIBOR (found in MAR 8.2) to ensure benchmark submitters have specific systems and controls, including conflict of interest management, are considered suitable to apply to the seven new benchmarks. However, of the seven benchmarks above only SONIA, RONIA, London Gold Fix and ISDAFIX currently have ‘submitters’ that would fall to be regulated and certain of these are changing their methodologies so may not have ‘submitters’ by the time legislation comes into force.

The criminal offence in the Financial Services Act 2012, s 91 of manipulating a ‘relevant benchmark’ will extend to the seven new benchmarks.

What is the purpose of the proposals?

The FCA has an overall objective to ensure markets work well. Benchmarks are used in a wide range of markets for reference purposes (eg to determine sums payable in relation to investments, the price at which investments are bought or sold, or to measure the performance of investments).

The setting of benchmarks has not previously been regulated. Following the LIBOR scandal in 2012, the UK government moved quickly to regulate that process in an attempt to reassure the world as to the integrity of LIBOR as a global benchmark. Regulation is now being extended to the seven benchmarks above to ensure that market participants have confidence in the way all key benchmarks are administered. At their heart, the proposals are aimed at demonstrating to the outside world that London has cleaned up its act and investors can have confidence in the integrity of London as a financial centre.

What are the next steps?

The FCA consultation closes on 30 January 2015. The FCA will consider responses with a view to publishing amendments in its policy statement and handbook text in the first quarter of 2015. It is expected that the FCA will regulate the seven additional benchmarks with effect from 1 April 2015.

It is important to note that in parallel with the FCA consultation, the European Commission is also currently considering legislation to regulate the setting of financial benchmarks at a European level. The FCA recognises that in due course the EU legislation will replace the UK regulatory framework. However, as the EU legislation is not expected to be in place for some time the UK government has decided to press on with more immediate changes to ensure the relevant benchmarks are regulated in the UK as soon as possible.

How should lawyers and their clients prepare for the proposed changes?

The principal parties affected by the proposed changes are the firms that will administer benchmarks and submit data used to compile benchmarks.

It is likely that these firms will already have considered and responded to the FCA consultation. Concerns are likely to include the proportionality of the costs involved in complying with the proposed new system, particularly in circumstances where any UK rules may be replaced by different EU rules in the near future. However, it seems clear that the UK government is intent on delivering a regime whereby stakeholders can have confidence in the setting of benchmarks given what has gone before in certain markets.

There will be a three month transition period for affected firms but those impacted will be taking immediate steps to review existing systems and make arrangements for complying with the new regime as it appears unlikely that material changes will be made to the current proposals before implementation in the coming months.

Interviewed by Alex Heshmaty.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.