A benchmark is defined as “a standard or point of reference against which things may be compared”. Such things can be salaries, consumer goods, mortgages or the financial performance of an industry or sector. For example, the return made by an investment fund focusing on UK equities might be measured against the FTSE 100. The return of a fund is generally based on the fair value of its investment portfolio. The inputs to fair values can include benchmarks to price in performance measures such as risk free rates.
Benchmarks are vital in facilitating the effective functioning of markets and therefore the accuracy and integrity of benchmarks is hugely important. Although some member states have adopted rules on benchmarks, there was no harmonised framework within Europe to ensure the accuracy and integrity used in providing and measuring benchmarks.
Recent controversies involving the manipulation of benchmarks such as LIBOR and EURIBOR, as well as allegations that other benchmarks could have been manipulated, demonstrate that benchmarks can be subject to conflicts of interest. In Europe, the European Commission has introduced a new regulatory regime governing the provision of, contribution to and use of benchmarks within the EU.
The European Union (“EU”) regulation on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (the “Benchmark Regulation” or “BMR”) has applied since 2016 and became effective on 1 January 2018. Whilst effective since January of 2018, the BMR is subject to transitional arrangements.
This article explores the impact of the new regulation on providers, contributors and users of benchmarks within the EU. Whilst the BMR is not aimed specifically at investment funds, certain investments fund entities are impacted including:
The purpose of the BMR is to have a harmonised EU framework to improve the governance and controls over the benchmark process, primarily to avoid conflicts of interest by administrators and to improve the quality of input data and methodologies used in developing benchmarks. The BMR also seeks to protect consumers and investors through greater transparency and adequate rights of redress.
The scope of BMR is purposefully designed to be broad so as to create a preventative regulatory framework for benchmarks across the EU. It imposes regulatory requirements on providers (“administrators”), certain contributors (“supervised contributors”) and users (“supervised entities”) including UCITS, UCITS management companies, AIFMs. Most of the regulatory requirements are imposed on benchmark administrators, the extent of which is dependent on the significance or economic importance of the benchmark (although the obligations on supervised contributors could be problematic considering this is largely a voluntary activity).
What is considered a benchmark under BMR?
The BMR defines a benchmark as any index that:
There are different categories of benchmarks including, “critical benchmarks”, “significant benchmarks” and “non-significant benchmarks”. The category of benchmark is determined based on quantitative and qualitative considerations.
The quantitative thresholds are >€500bn, >€50bn and less than these amounts respectively.
The qualitative considerations include the importance or the number of unique alternative benchmarks. The European Commission has declared the biggest interbank interest rate benchmarks EONIA, Euribor and LIBOR as being critical benchmarks.
Now let’s examine the impact further.
An administrator is a body that has control over the provision of a benchmark, and in particular, administers the arrangements for determining the benchmark. The BMR introduces a new authorisation and supervision regime for benchmark administrators. ESMA will establish and maintain a public register of authorised and registered administrators.
Subject to transitional arrangements, the BMR imposes a ban on supervised entities including UCITS, UCITS management companies, AIFMs using benchmarks that are not included in the ESMA’s register or provided by administrators who are not included in the register.
Administrators are subject to a significant number of governance and control arrangements. These arrangements are primarily designed to avoid or manage conflicts of interest and to ensure the accuracy and integrity of data.
Similar to administrators but to a lesser extent, supervised contributors must put in place governance and control measures that are designed to avoid conflicts of interest and the manipulation of data.
Supervised entities or users of a benchmark
Most investment funds that are impacted by the BMR will fall into the category of “supervised entities”. Supervised entities are defined in the BMR and include UCITS, UCITS management companies, AIFMs and MiFID firms. Such supervised entities will need to determine if they are “users” of a benchmark.
A supervised entity will be considered a user of a benchmark if it uses a benchmark to measure its performance for the purpose of:
There is a ban on supervised entities using benchmarks that are not included in ESMA’s register. Therefore it is necessary for relevant funds to assess the impact of this.
The other obligations imposed on investment funds include:
The written contingency plan must be reflected in contractual arrangements with clients and is not subject to the transitional arrangements therefore this aspect of the BMR became effective on 1 January 2018.
The prospectus disclosure must be made in the prospectus of funds the next time updates are made but not later than 12 months from 1 January 2018. The prospectus disclosure requirement is not imposed on AIFs.
The applicable transitional arrangements will depend on whether the benchmark administrator is located inside or outside the EU and the date on which it first began providing benchmarks within the EU. For example, administrators providing benchmarks in the EU on 30 June 2016 will have until 1 January 2020 to apply for authorisation or registration under the BMR and during this period, funds may continue to use benchmarks provided by such index providers later than 1 January 2019.