Benchmark Overhaul Finally Moves Up a Gear

Terry Flanagan

Regulators continue to grapple with ways to overhaul financial benchmarks in the wake of the Libor rate-setting scandal, as a lack of regulatory oversight in the process persists in eating away at investor confidence.

Since the scandal broke in June last year, calls have grown for changes to the rate-setting system of Libor and other industry-led benchmarks—which underpin the pricing of a vast array of financial instruments—but the pace of change has been slow due to an apparent lack of enforcement powers held by watchdogs across the globe.

“Financial benchmarks—including commodity price indices—are in most cases de facto public goods,” said Benoît Lallemand, senior research analyst at Finance Watch, a Brussels-based group that aims to serve as a counterweight to the financial industry.

“Their social benefits should be maximized and the possibility for their mis-use tightly scrutinized. We would like to see a regulatory regime for the way benchmarks are produced and used to promote the core economic purpose of benchmarks and to safeguard their integrity.

“In light of the recent high-profile problems with Libor and certain commodities benchmarks, a key question for regulators is what business model will best reduce conflicts of interest in this area.”

Traders have long suspected that Libor, which is supposed to represent the interest rates banks pay each other for short-term loans, was rigged. And the benchmark, which is used in more than $300 trillion worth of derivatives contracts, is currently in a sort of state of limbo as, increasingly, fewer banks are now involved in the rate-setting process—all of which continues to eat away at its status.

Barclays, UBS and the Royal Bank of Scotland have all either been, or will be, fined over Libor and other banks are set to be implicated.

Earlier today, Iosco, an umbrella group of global securities regulators, published its own consultation report on the matter, seeking comment from the industry regarding the future of financial benchmarks.

“Restoring confidence in the benchmarks widely used in the world’s financial markets is a matter of urgency in maintaining the integrity, efficiency and stability of the global financial system, and in protecting the interests of borrowers and investors,” said Masamichi Kono, chairman of the Iosco board.

The report wants to ascertain the appropriate level of regulatory oversight for the process of benchmarking, standards that should apply to methodologies for benchmark calculation,  credible governance structures to address conflict of interests in the benchmark-setting process within the reporting financial institutions as well as in the oversight bodies, and   the appropriate level of transparency and openness in the benchmarking process.

The consultation is also considering issues that market participants might confront when seeking to make the transition to a new or different benchmark.

Regulators, though, have a difficult decision to make as if Libor was to be totally replaced then it could trigger disputes on all Libor-linked derivatives contracts which in turn could seriously disrupt international capital markets.

Iosco has set a deadline of February 11 for industry responses and after this it aims to develop a framework of robust, globally consistent policy guidance from which national and regional regulators should follow.

In the U.K. where the scandal was unearthed, the U.K. government has since adopted the Wheatley Review, which was set up in the wake of the Libor scandal.

“This Iosco report represents the first global effort to strengthen the credibility and integrity of benchmarks used across the financial markets,” said Martin Wheatley, chief executive designate of the Financial Conduct Authority (FCA), which will become the new U.K. financial services regulator from April. “The U.K. is at the forefront of this work, which is consistent with the findings and recommendations of the Wheatley Review.”

The Wheatley Review recommends streamlining the Libor process, making it regulated by the FCA and opening up the possibility of criminal sanctions to individual offenders. The European Commission, too, is proposing introducing criminal sanctions for market manipulation, including for Libor abuse.

“We are more inclined to support sanction, penalty and criminal charges against individuals who either are engaged in or uncritically overseeing such fraudulent activities,” said Jim Allen, head of capital markets policy for the CFA Institute, the global association for investment practitioners and academics, in a recent blog.

“That is a much better solution than charging the companies and, thusly, their shareowners—particularly those invested by virtue of index funds or broadly diversified pension funds—for the mis-steps of certain members of staff.”

While regulators in Europe today also announced their plans to revamp the Euribor rate, which is used for euro denominated agreements and is set using the same methods as Libor. Euribor, like Libor, has been found to have been altered by banks in the past.

The European Securities and Markets Authority (Esma) and the European Banking Authority (EBA) want to increase the accuracy of the benchmark rate and increase oversight over how banks submit rates to Euribor after discovering major shortcomings. They also want the system revamped within the year.

Although the European watchdogs, unlike their U.K. counterpart, have not demanded direct regulatory control over Euribor, which is overseen by the European Banking Federation, a trade body.

Esma and the EBA also say they do not possess the power to take control of international benchmark rates as it seems a global response—such as that being formulated by Iosco—may be the only way to tackle the problem.

“The proposed principles, which are aligned with on-going European Union and international work, will give clarity to benchmark providers and users, and are an immediate step to be taken in advance of potential wider changes in the supervisory and regulatory framework for financial benchmarks,” said Steven Maijoor, chair of Esma.

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