“…necessary to include a power for the relevant competent authority to require mandatory contributions from supervised entities to critical benchmarks in order to preserve the credibility of the benchmark in question.”

The systemic importance of financial benchmarks in the global financial structures cannot be emphasised enough. Considered as critical components in the pricing of many financial instruments from simple loans to complex derivatives, benchmarks are vital for the real economy. It is not surprising that regulators around the world are proactively seeking to restore investor confidence. The European Benchmarks Regulation is one such activity which distinguishes itself from other regulatory initiatives through the enormity of its scope, coverage and detail.

On one hand, the regulation seeks to strengthen the benchmark reliability and robustness through comprehensive guidance to all the stakeholders including competent authorities (aka regulators), Benchmark administrators, calculating agents, data contributing financial institutions and consumers. On the other hand, it aims to protect markets, economy and investors through directives on continuous and accurate benchmark determination and distribution. A representation of such directive is embedded and can be clearly seen in Article 23 of EU Benchmarks Regulation.

Article 23 (Mandatory Contribution of Critical Benchmarks) is included with the twin objectives of 

•  Reliability: Ensuring that the Critical benchmarks are true representations of the underlying market and,
•  Continuity: Ensuring that there are no material disruptions to the determination and dissemination of the Critical benchmark

The regulation (through Article 23.2) mandates that administrators of critical benchmarks must submit an assessment of the capability of the benchmark to measure the underlying market or economic reality every 2 years to respective competent authority. This is a key directive in maintaining the reliability of the benchmark. While the reliability of the benchmark itself is depends on a positive assessment result, the assessment in return will be contingent upon (i) necessity of putting robust infrastructure and governance structures in place (ii) having a clear and transparent determination methodology blueprint (iii) accurate, timely and representative input information from contributing financial institutions (iv) sufficient oversight of calculation agents (v) control frameworks for distribution and (vi) escalation and whistle-blowing policies at each of the said levels. 

Conclusion 1: From a markets and investor point of view, there will be transparent and regular update acting as a gauge of the overall health of the benchmark. Markets and investors can take informed decisions while consuming these benchmarks.

The critical nature of benchmarks makes them an integral part of the efficient and robust financial markets. When these critical benchmarks are driven by submissions provided by contributors such as banks and financial institutions (e.g., LIBOR), any changes to the composition of panel banks or drop in the volume of submissions will disrupt the viability and accuracy of the benchmark.  Given that the submissions are usually based on institution’s transactions in the underlying market that the benchmark represents, there is a high risk that the banks and financial institutions which are part of contributing panel may wind up positions in such underlying market and thus may not be willing to contribute input data. The regulation through Article 23 aims to combat this structural risk through an elaborate process which would provide enough room for administrators and competent authority to find alternatives to plug the gap.

The contributing bank must provide in writing its decision to cease submission of input data to the administrator of the benchmark. The administrator while informing the bank’s decision to the competent authority, must also conduct an assessment of benchmark viability and accuracy. As an additional layer of confirmation, the competent authority would also be required to conduct an assessment of benchmark in its ability to represent underlying market or economic reality. If the conclusion of assessment is adverse, competent authority can mandate contributions from the bank/financial institution till the time alternative eligible contributor is identified. However, the outgoing contributor’s interests are also protected. One, they are not mandated to trade in the underlying markets and two, the maximum cumulative period for mandatory submissions cannot exceed 24 months from the date of intimation. 

Conclusion 2: The regulation insures against the market disruptions that might result in discontinuation of submission contributions from panel banks/financial institutions.

While the focus of this article is limited to Article 23, it is perceptible that the regulation is clear in its intent and action to protect investor interests and integrity of markets. The scope of this Regulation is built on the idea that it “should be as broad as necessary to create a preventive regulatory framework” while balancing the nuances involving various stakeholders of benchmark value chain from contribution to calculation and finally consumption.

Disclaimer: The views and opinions expressed herein are those of the author and do not represent the views and opinions of the Associates in Capital Markets (ACAPM) or any of its subsidiaries or affiliates or clients.