View from Europe: Countdown to the application of the Benchmarks Regulation
For many firms the Benchmarks Regulation (BMR)1 is the next big regulatory compliance hurdle to leap at a time when regulatory resources are already stretched with MiFID II2/MiFIR3 and PRIIPs4 also applying as of the beginning of January 2018.5
This article provides a snapshot in Q&A form of some of the key risks in the context of the Benchmarks Regulation. In particular, some firms may not fully appreciate:
the jump between IOSCO compliance and the BMR;
the breadth of the BMR regime in terms of its product scope, geographical scope and its impact on a wide range of market participants (not just large investment banks); and
the scale of BMR compliance work.
The BMR entered into force on 30 June 2016 and a few provisions, primarily relating to critical benchmarks, were applied as of that date. The majority of provisions of the BMR apply as of 1 January 2018. Much of the detail in the BMR is contained in the Level 2 regulatory technical standards/delegated acts (the RTS) however they are not expected to be finalised until the end of June 2017.
Allen & Overy’s Benchmarks Group has been actively following the evolution of the Benchmarks Regulation since 2012 and is advising a wide range of clients on implementation and compliance.
Q1: Our benchmarks are compliant with the IOSCO Principles6 so presumably complying with the BMR will be straightforward?
A1: Whilst there is overlap between the IOSCO Principles and the BMR, in practice it is not a case of simply bolting on a few additional steps to a firm’s IOSCO compliance to achieve BMR compliance.
This is because the definition of “benchmark” in IOSCO and the BMR is not identical. The BMR also regulates users and not just administrators and contributors. Whilst the BMR does contain some proportionality (for example, the distinction between critical, significant and non-significant benchmarks and specific regimes for commodity benchmarks, interest rate benchmarks and regulated-data benchmarks), it is not comparable to that in the IOSCO Principles which has a “comply or explain” concept (ie complying could include explaining why certain principles are not feasible). Whilst the IOSCO Principles are recommended practices and firms should publically disclose the extent of their compliance with these (and in some jurisdictions are actively encouraged by regulators to do so), the BMR is hard regulation which requires strict compliance with significant administrative sanctions and fines for breach. Member States may also provide for higher levels of sanctions than those established in the BMR or even criminal sanctions.
Q2: The BMR is intended to address the fallout from -IBOR manipulation cases and is only relevant for systemically important benchmarks, isn’t it?
A2: The term “benchmark” requires there to be a regularly published figure and also a financial instrument, financial contract or investment fund (each as defined) that use this figure in a relevant way. The definition is wide and in many circumstances bespoke proprietary indices will also be “benchmarks”.
The BMR was developed in the wake of -IBOR manipulation scandals and is intended to create a preventative regulatory framework introducing strict governance and control requirements to avoid conflicts of interest, and opportunities and incentives to manipulate benchmarks. However, the definition of “benchmark” in the BMR is very wide and there is a risk that some firms may underestimate the scope of the regime. In many circumstances bespoke proprietary indices will fall in scope of the BMR where they are used in financial instruments (defined in the BMR), financial contracts (defined in the BMR to cover consumer credit agreements) or to measure the performance of an investment fund (defined in the BMR as a UCITS or an 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 fees.
The term “financial instrument” cross refers to the financial instruments listed in Section C of Annex 1 of MiFID II for which a request for admission to trading on a trading venue (as defined in MiFID II) is made or which is traded on a trading venue or via a systematic internaliser (as defined in MiFID II). This requirement for the financial instrument to be traded on a trading venue or via a systematic internaliser limits the scope of the BMR as compared to the term “financial instrument” used in the definition of “benchmark” in the IOSCO Principles; however some firms are still likely to have hundreds or even thousands of in scope benchmarks.
The requirement for a benchmark to have a level that is published or “made available to the public” and “regularly determined”, may take some indices out of scope of the BMR. However, guidance from ESMA suggests that both terms are likely to be construed widely. For example, ESMA has clarified that “it is the accessibility of an index value (as a figure) through the use of an index as a benchmark that determines its being made available to the public”.7 In ESMA’s view the use of an index value in determining coupons, strike prices, differentials and values of financial instruments and investment funds referencing it, can be a means of making available index values since the investor “can isolate the index value” therefrom. Hence ESMA considers that the availability of index determinations to one or more supervised entity users can imply its availability to an indeterminate number of recipients, rendering the index to be a benchmark fully in scope.8 It is also clear from ESMA’s guidance that the means by which a level is made available and whether it is available only for a fee are both irrelevant to the assessment of whether it has been “made available to the public”.
In the context of including a requirement for a benchmark to have a figure that is “regularly determined”, ESMA notes that including a minimum frequency according to which a benchmark must be calculated could create a major loophole. To date, ESMA has therefore not published any definitive guidance on this point but it is likely any regular determination, even for example an annual determination, would meet this requirement.
Q3: What about administrators and contributors located outside the EU? Presumably there is no risk they will be in scope?
A3: The BMR regulates the provision of benchmarks, the contribution of input data to a benchmark and the use of a benchmark in the EU however it will nevertheless apply to administrators and contributors located outside the EU in certain circumstances.
The BMR applies to the provision of benchmarks, the contribution of input data to a benchmark and the use of a benchmark within the Union. It does not therefore regulate these activities outside of the Union. However, this does not mean that an entity located outside of the Union does not need to worry about the BMR at all. For example, if an administrator located outside of the Union wishes a benchmark it provides to be “used” by supervised entities (as defined in the BMR) in the Union, it must obtain recognition, the benchmark must be endorsed by an EU administrator/EU supervised entity or there must be a valid equivalence decision. Further details apply but, in general, it seems likely that any administrator located outside of the EU will have to comply with provisions equivalent to the requirements of the BMR in order to obtain recognition, endorsement or equivalence. There are also some important interpretational questions in relation to the extent to which a non-EU entity has to comply with the BMR. For example, if an entity located outside the EU obtains equivalence or recognition does it have to comply with the BMR only in respect of those benchmarks it wishes to offer for use in the Union or in respect of all benchmarks it provides? Is the definition of “supervised entity” in the BMR only intended to capture entities authorised/registered in the EU or not? What about the exemptions in Article 2(2): do these extend to non-EU central banks, public authorities and CCPs providing reference or settlement prices? How does the BMR apply to branches of EU entities located outside the Union and branches of non-EU entities located in the Union?
Firms located outside the EU that contribute to benchmarks provided by an entity located in the Union will be expected to comply with the code of conduct for contributors developed by the administrator.9
Q4: What are the particular risks of the BMR for fund managers?
A4: The BMR will be a significant piece of legislation for the asset management industry. The definitions of “benchmark” and “use of a benchmark” both refer to “investment funds” (defined in the BMR as UCITS or AIFs). It is likely many UCITS and AIFs will be brought into scope of the BMR through their “use of a benchmark”. UCITS and AIFs and their managers may also contribute to benchmarks. The key question however is whether or not they will also be administering benchmarks as the heaviest regulatory burden under the BMR falls on administrators. Looking at the typical activities of funds, many tracker funds will be “using” a benchmark and there are areas where fund managers are at risk of being considered administrators if certain levels they produce are “benchmarks” as defined in the BMR. For example, the prospectus for a UCITS subfund may state that it compares fund performance against a synthetic reference index composed 50% of one market index and 50% of another market index. For comparison purposes the fund publishes and calculates that blended level. If the level is used for defining the asset allocation of a portfolio or computing the performance fees or for “measuring the performance of an investment fund with the purpose of tracking the return of such index” then the fund or its manager would be acting as an administrator and will require regulatory authorisation.
Q5: The BMR may apply as of 1 January 2018 but the transitional provisions will mean that firms have significantly longer to comply, won’t they?
A5: Some of the transitional provisions may be of assistance; for example, Article 51(5) is applicable to certain benchmarks provided by third country administrators. In other instances, the transitional provisions will not apply at all, or are likely to be of only limited assistance.
This will be very fact-dependent. There are some transitional provisions in the BMR which may be of assistance. For example, Article 51(5) provides an indefinite transitional provision for the use by supervised entities of benchmarks provided by third country administrators that have not obtained endorsement, equivalence or recognition where the benchmark is “already used” in the Union as a reference for financial instruments, financial contracts, or for measuring the performance of investment funds (together, the Financial Products) and for such Financial Products that already reference the benchmark in the Union or add a reference to such benchmark prior to 1 January 2020. It is not clear however whether this transitional provision will apply to new Financial Products created on or after 1 January 2018 but before 1 January 2020 that add a reference to such benchmarks “already used” in the Union.
Some of the other transitional provisions are likely to be of only limited assistance. For example, although Article 51(1) gives index providers located in the EU providing a benchmark on 30 June 2016 until 1 January 2020 to apply for authorisation or registration, ESMA has suggested that compliance with the BMR is still required as of 1 January 2018 with only the formal application for registration/authorisation being permitted to be delayed until 1 January 2020. Furthermore, whilst ESMA has given some helpful guidance on the transitional provisions in the context of its November Technical Advice, there are still some outstanding interpretational questions.
Q6: So what are firms doing now?
A6: Firms will first need to identify exactly how the BMR impacts their business and then take steps to meet their obligations under the BMR. Firms are likely to have to reach a reasoned conclusion in relation to open interpretational questions in the BMR, pending any further guidance from ESMA/the European Commission.
For many firms significant groundwork is necessary to identify all benchmarks that are within the perimeter of the regulation, which role(s) they perform in relation to those benchmarks (ie administration, contribution or use) and exactly what they will therefore have to do to meet their obligations under the BMR. The next step is bringing benchmarks into compliance with the BMR. For firms that have a large number of benchmarks in scope of the BMR this will, among other things, require a substantive review/papering exercise.
In relation to how to proceed with so many outstanding interpretational questions, ESMA/the European Commission are expected to publish Level 3 Q&A addressing some of these. However, it is not clear exactly what any such Q&A will cover and ESMA have indicated that any such Q&A will not be available until after the Level 2 work is finalised at the end of June 2017. In most cases it is possible to reach a reasoned conclusion in relation to these open questions (as an interim measure if further relevant guidance is forthcoming) and it is likely that firms will have to do this given the timeline until application of the BMR. While there is a potential benefit in engaging with industry bodies to ensure firms’ concerns are understood in the Level 2 and 3 workstreams, this will not be a substitute for full implementation work.
Just as this Risk Note went to press, ESMA published its Final Report: Draft technical standards under the Benchmarks Regulation (30 March 2017/ESMA70-145-48). If appropriate we may be commenting on this in the next edition of the Risk Note.
1. Regulation (EU) 2016/1011 (the Benchmarks Regulation or BMR).
2 Directive 2014/65/EU (MiFID II).
3 Regulation 600/2014 (MiFIR).
4 Regulation (EU) 1286/2014 (PRIIPs).
5 MiFID II/MiFIR will apply as of 3 January 2018, with the exception of a few provisions that apply as of a different date. PRIIPs will apply as of 1 January 2018.
6 Principles for Financial Benchmarks – Final Report – FR07/13, July 2013 (the IOSCO Principles), as recently supplemented by IOSCO’s Report on Guidance on the IOSCO Principles for Financial Benchmarks FR 13/2016.
7 Paragraph 15 of ESMA’s Final Report – Technical Advice under the Benchmarks Regulation (ESMA/2016/1560) (the November Technical Advice) available here.
8 Paragraph 21 of ESMA’s May Consultation Paper (ESMA 2016/723).
9 Article 16 of the BMR. Recital 30 of the BMR states: “The administrator should be satisfied that contributors adhere to the code of conduct. Where contributors are located in third countries, the administrator should be satisfied to the extent possible”.
This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch – firstname.lastname@example.org, or tel +44 20 3088 3710.
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