EU Benchmark Regulation (“EU BMR”)

The EU Benchmark Regulation (“EU BMR”) became effective on 1 January 2018 with the relevant transitional provisions for EU and third country benchmark administrators. In February 2019, there was a political agreement to extend the transitional provisions for critical and third country benchmark administrators for a further 2 years, until 1 January 2022.

To complement the implementation of EU BMR, the European Securities and Markets Authority (“ESMA”) publishes Regulatory Technical Standards (RTS). Further to the outcome of the European Supervisory Authority (“ESA”) review¹ in December 2019, the regulation was amended to create a mandate for ESMA to develop five draft RTS, to be submitted to the European Commission (“EC”) by 1 October 2020. The RTS relate to provisions in the Regulation relating to governance arrangements, benchmark methodology requirements, the reporting of infringements, and the mandatory administration of a critical benchmark and non-significant benchmarks.

ESMA published a Consultation Paper (“CP”)² on their draft RTS on 9 March 2020, which sets out the background information, the approach and different proposals for each of the five chapters covering the provisions noted above. The CP also consists of a draft of each of the RTS themselves, and a supporting cost-benefit analysis. We note the timing of issuance of the CP, which has been published in a similar timeframe to a Dear CEO letter³ from the FCA to benchmark administrators, covering their expectations on a variety of similar topics.

In addition, further to the ESA review, the EC published its inception impact assessment⁴ on the EU BMR review on 18 March 2020 subject to a four-week consultation period⁵. Two notable points were identified by the publication. Namely, the transition of panel-based critical interest rate benchmarks to risk-free rates published by central banks, and secondly, the need to ensure a level playing field for third country benchmarks. 

This blog explores our views and thoughts on the CP and accompanying RTS. Benchmark Administrators are encouraged to review and respond to this CP by the 8 June 2020. ESMA will consider responses from relevant stakeholders when developing the draft RTS for submission to the European Commission for adoption in the final legal text.

Governance Arrangements – Article 4

The draft RTS clarifies and reinforces the importance of clear and well-defined governance arrangements, and to ensure there is appropriate management of conflicts of interest and the integrity of the benchmark.

The draft RTS further outlines the need for administrators to have procedures regarding composition and structure of all governance committees, which should include the following detail:

• Clear and well-documented roles and responsibilities among the various functions involved in the provision of benchmarks including the committees;
• Accountability and traceability for decision-making;
• Relationship between the various individuals from the management body and committees including reporting lines;
• Proactive identification and management of conflicts of interest within the benchmark administration organisation, the overall group structure and externally;
• Clear and transparent processes around discretion and expert judgement; and
• Maintaining independence of the governance arrangements.

The addition of this detail emphasizes the expectation of administrators to have more active and effective governance arrangements. It provides an opportunity for more effective oversight of the benchmark determination activity by governance fora, as opposed to their existence being one which exists primarily to satisfy regulatory requirements.

Firms may find the implementation of this RTS challenging, particularly where members of governance committees have dual or multiple roles within the organisation (for example providing day-to-day control operation, but at the same time also forming part of an oversight function) which may lead to potential or actual conflicts of interest. Considerable investment and effort from benchmark administrators may be needed to help ensure that they have the appropriate infrastructure in place in order for this to function properly. Training, and a firm’s control culture, continue to play an important part in ensuring any governance arrangements put in place operate effectively.

Benchmark administrators would benefit from a periodic review of their governance arrangements by their compliance and/or audit function in order to help assess their effectiveness and appropriateness relative to the size of their business.

Methodology – Article 12

The draft RTS calls for further transparency and traceability in the use of discretion or expert judgement, whether it is exerted by administrators, or from their contributors.

In summary, a generic clause within the benchmark methodology noting when discretion is used will now need to be more specific and detailed, in setting out clear rules to identify how and when discretion may be exercised. The draft RTS requires firms to be clear on how, and at what stage of the calculation process, discretion is used. It also requires firms to be clear on whether the discretion is based on an algorithm or a pre-defined methodology. 

While providing greater transparency to benchmark users, this level of detail could be a challenge to define up front for administrators, where instances of the use of discretion tend to be infrequent and determined on a case-by-case basis, rather than having a pre-defined process to do so. However, having an effective governance and control infrastructure will help to manage and provide the additional clarity needed in such cases.

The draft RTS elaborates further on back-testing of the benchmark methodology, setting out an expectation on the frequency of testing required, and outlining a requirement to have results of testing subject to review. Administrators that tend to align back-testing mainly with the benchmark launch and/or with methodology review may need to establish an ongoing back-testing process and have a more formalised process to review the relevant results. This may help create efficiencies in the methodology review exercise and support it in being more effective in their operation.

Having a team separate from the calculation team performing the back-testing will strengthen the control framework and help to identify any anomalies or errors that may exist.

Furthermore, the draft RTS calls for stronger hypothetical stress testing of the methodology under various market conditions, in order to assess the resilience of the benchmark, for it to be better prepared and able to tackle such situations to provide continuity and stability of the benchmark in the market. Administrators may want to consider running these tests initially alongside the launch of new benchmarks, and thereafter as part of the ongoing review of the benchmark methodology.

Reporting of Infringements – Article 14

While Article 14 of the EU BMR sets out the requirements in relation to reporting of infringements, the draft RTS provides greater clarity and focus on the protection of data integrity in the identification and reporting of anomalous or suspicious input data to detect and prevent market abuse.

The draft RTS clarifies the need to have robust controls and checks over input data verification, and to have a formalised and embedded process to review, report and escalate such events to the oversight function. Active engagement and oversight is required by the oversight committee members in order to help ensure timely and prompt reporting of suspicious input data to the relevant competent authority.

These requirements further highlight the need for clearly identifiable surveillance controls, for the monitoring of input data for anomalies and the detection of manipulation through the data itself as well as communications (where relevant).

The draft further defines “manipulation” referring to the definition of manipulation or attempted manipulation of a benchmark under Market Abuse Regime (MAR). Pursuant to Article 12(1)(d) of MAR, market manipulation of benchmarks relates to “transmitting false or misleading information or providing false or misleading inputs in relation to a benchmark where the person who made the transmission or provided the input knew or ought to have known that it was false or misleading, or any other behaviour which manipulates the calculation of a benchmark.”

While this definition relates more to input data from contributors or any other manipulating behaviour in the calculation of the benchmark which is of importance, it does not appear to consider input data that is obtained from transaction data that may be suspicious in itself, or subject to other forms of manipulation. As many administrators use transaction data, there is no clear link made to those transactions that may deem suspicious, either through suspicious transactions reporting or other in the relevant market (e.g STOR in the UK).

Further clarity is provided in the RTS in relation to the need to maintain adequate systems and controls. The RTS requires a risk assessment to be performed in order to satisfy the requirements of the regulation. Embedding a risk assessment for each benchmark family, which considers various factors to determine a risk rating/score, will help in the management of risks including manipulation, as well as providing a useful tool to determine the control infrastructure required for such benchmarks across the lines of defences. Such risk assessment could be conducted initially as part of the benchmark launch, and may be subject to review on an ongoing basis, in line with the benchmark methodology review.

Having the appropriate reporting and escalation mechanism in order to deal with manipulation incidents remain key, in supporting the timing and action taken by firms if such events occur or are identified. The process should be implemented in such a way that incidents are easy to report to relevant governance and external authorities (where relevant), and dealt with in a timely manner. The process should be well documented and communicated to the right individuals. A clear audit trail of such events, with each step being clearly tracked and evidenced, remains of importance. Firms need to consider how they will handle these events with confidentially and with a high level of security due to their sensitive nature, as with any other conduct related matters.

The draft RTS highlights the importance of training and culture within an organisation in determining how these incidents are managed and dealt with. The RTS does not outline the specific requirements on the training programmes required but rather confirms the need for effective training to be tailored to each administrator based on its structure, system and size.

Finally, the RTS outlines that the systems and controls put in place for data integrity and manipulation are to be appropriately documented either in the form of a data integrity policy or otherwise in order to demonstrate its compliance with requirements of Article 14 of the EU BMR.

To that end, significant effort may be needed by administrators to further develop their surveillance capability in-house or with an external vendor, in order to satisfy the data integrity protection requirements.

Mandatory administration of a critical benchmark – Article 21

The draft RTS further elaborates on the specific powers of competent authorities of critical benchmarks that allow them to compel administrators to continue the publication of such critical benchmarks for a defined time-period, until they are satisfied the following conditions are met:

• the provision of the benchmark has been transitioned to a new administraton;
• the benchmark can cease to be provided in an orderly fashion; or
• the benchmark is no longer critical.

The RTS clarifies that the assessments performed by both the administrators and the relevant competent authorities required upon the notification of a change or cessation of a critical benchmark This requirement is important for firms and market participants to note, particularly in the context of cessation triggers in relation to LIBOR discontinuation. Related to this, the EC’s impact assessment of the EU BMR Review notes that one of its main objectives is to equip competent authorities with supervisory powers to ensure the orderly cessation of a critical benchmark, including the power to mandate the continued provision of a critical benchmark using a different methodology or the provision replacement rate.

The draft RTS also clarifies and confirms the need for firms to go through the authorisation process required for the transition of a critical benchmark to a new administrator that is not currently authorised. In the case of LIBOR transition to SONIA (from a GBP perspective), as the latter is administered by the Bank of England, there will be no such requirement as central banks are exempt from the requirements of EU BMR.

The RTS details the criteria to be considered by the competent authority in its assessment of the capability of the new administrator and the cooperation between competent authorities that may be needed when it crosses Member States.

These are all examples of effective measures to help ensure critical benchmarks are transitioned smoothly and diligently, with the aim to maintain financial stability.

Non-significant benchmarks – Article 26

This section of the draft RTS focuses on the various areas that non-significant benchmark administrators may choose to opt out as per EU BMR Article 26(1). It highlights specifically that where those areas have been opted out, non-significant benchmark administrators would need to ensure they have appropriate measures in place to mitigate those risks, and remain transparent in stating the details (for example in the compliance statement) behind why it is appropriate to opt out.

This will be helpful for administrators to track and monitor their compliance with the BMR requirements. The ongoing review of requirements that administrators have opted out of will also remain important in validating that the conditions to opt out, remain as they were.

Conclusion

The draft RTS contains a lot more details on the practicalities expected in the implementation of the relevant EU BMR requirements. Regulatory supervisors also remain focused on similar themes, as noted in the recent FCA Dear CEO letter for UK administrators. We expect Supervisors to query and probe what firms are doing in response to the RTS and how it is being practically implemented. 

Once published, the RTS will require firms to benchmark where they stand presently against the requirements. Some of these requirements are not “easy fixes” and will require investment (people, systems and infrastructure build) by administrators into the control functions, framework and governance arrangements.

[1] REGULATION (EU) 2019/2175 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL

[2] ESMA Consultation Paper: Draft Regulatory Standards under the Benchmarks Regulation

[3] FCA Dear CEO Letter: Benchmark Administrators

[4] European Commission Inception Impact Assessment

[5] Consultation Period