Benchmark regulation was triggered by the manipulation scandals of major interest rates such as LIBOR and EURIBOR uncovered back in 2012.
Since then various regimes have been implemented to manage and control benchmarks, from the UK’s original Market Abuse Regulation, to the recommended IOSCO Principles for Financial Benchmarks, and finally to the most comprehensive of all - the EU Benchmarks Regulation (BMR).
However, unlike the original scandal, BMR does not focus only on the key banker’s rates, but instead the EU authorities have recognised that all benchmarks can be prone to conflicts of interest and thus the risk of being manipulated.
The result is a comprehensive regulatory framework applicable to a broad definition of benchmark providers, benchmark contributors/submitters and users of benchmarks. Furthermore, the Regulation’s reach goes beyond the EU given that all benchmarks used in the EU must be approved, regardless of their origin. Even if outside the EU (known as a ‘third country administrator’), those administrators must seek approval by the EU in order to be able to continue serving their EU customers.
The benchmark and index industry has changed considerably in the last ten years with a significant breadth of options. Boutique asset classes, smart betas, and emerging technologies have all given rise to competition that has, hitherto, largely been unregulated.
The large global index providers are being challenged on their fees and often questioned on the implementation of their methodologies and inclusion criteria. This has led, in part, to the ‘self-indexing’ phenomenon we see in the ETF industry, which comes with it's own perceived risks, such as conflicts of interest. BMR will address some of these concerns, but is it enough?
The purpose of this article is to reflect on the merits of BMR in dealing with conflicts of interest and discretion in the ETF industry.
A quick refresher on BMR
BMR has been in force since 1 January 2018, subject to transitional arrangements. During this transition, EU benchmark users can continue using non-critical EU benchmarks until 1 January 2020 without their administrator being authorised, or EU critical benchmarks and third-country (non-EU) benchmarks until 31 December 2021. Past these dates, EU users will not be allowed to use benchmarks provided by unauthorised EU or third country administrators.
What’s the BMR's impact on the ETF industry?
Most asset managers are considered ‘users’ under BMR since they use benchmarks provided by external and independent index providers. As users of benchmarks, they have two obligations:
they must put in place written plans to designate an alternative if the benchmark they use materially changes or ceases to be published (i.e. fallbacks); and
they must ensure their prospectuses or fund memoranda include clear and prominent information stating whether the benchmark is provided by an authorised administrator.
However, these asset managers may also offer investment products (e.g. ETFs or passive index trackers) that track indices built in-house in order to reduce costs (that they would have otherwise paid to external index providers).
Hence, these asset managers would also be ‘administrators’ under BMR, since they have control over the provision of a benchmark and use input data to determine the value of that benchmark. The BMR requirements for administrators are diverse and onerous to put in place.
Thus, in order to prevent conflicts of interest, BMR requires benchmark administrators to:
set up and implement governance arrangements that identify, disclose, prevent, manage and mitigate any conflicts in line with a set of prescriptive requirements
create an oversight function that oversees the implementation and effectiveness of those arrangements. The oversight function needs to be carried out by a separate committee, in which stakeholders should be represented in a balanced way and include users and contributors.
disclose existing or potential conflicts of interest to their users, supervisor and contributors
have clear rules for identifying how and when discretion may be exercised in the determination of a benchmark
record the use of judgement or discretion, including the underlying reason(s)
put in place a control framework proportionate to the level of conflicts of interest identified and the degree of discretion the administrator exercises
get authorised and supervised.
In case the administrator plans to outsource the calculation and management of its proprietary index, it also needs to be aware of the prohibition under BMR to do so if the outsourcing materially impairs the administrator’s control over the provision of the benchmark. Otherwise, where outsourcing is allowed, it does not negate the need for the administrator to comply in full with its BMR requirements.
Should self-indexers respond differently compared with commercial index providers?
Not really. The criteria to be approved are the same regardless. The difference may manifest itself in where the provider needs to focus their governance and control (and be prepared to be challenged). For example, BMR requires that the index administrator must be independent and robustly manage actual and potential conflicts of interest.
For self-indexers, i.e. where the index and the ETF are run by the same corporate group, this will need to be openly and robustly addressed and mitigated. For commercial index providers, their unique selling point is in independent and expert management and compliance with a methodology.
Recent claims of discretionary (or even inappropriate) inclusion/exclusion of entities/geographies amongst some of the largest index providers remind us how closely such decisions are watched, and therefore these administrators will need to be entirely transparent with all decision-making and play within the rules. Expert judgement and discretion is barely tolerated under BMR as it is.
With the explosion in the number of exchange traded products and the value of the funds invested in them, movements in underlying benchmarks can have extraordinarily large consequences. Stakeholders (exchanges, issuers, asset managers and the end-investors) are demanding transparency - and BMR is delivering.
What should EU administrators be doing right now?
EU administrators, whose benchmarks are non-critical under BMR (i.e. either significant or non-significant), must get authorised/registered with their respective NCAs by the end of the year; otherwise the use of their benchmarks in new contracts signed after 1 January 2020 will be prohibited. They should submit their application by September at the latest (since the NCA needs up to 90 working days to take a decision).
What should third country administrators be doing right now?
The extension of the transitional period until the end of 2021 was positively received by both third country administrators and their European users. If the extension enables all required benchmarks to become fully approved by 2022, it would minimise disruption to users who would otherwise have had to disorderly replace thousands of benchmarks ahead of 2020.
But, despite that additional relief, administrators will need to go through a lengthy and complex approval process, which could be further complicated by limited equivalence decisions of the EC, changes to BMR itself and/or a no-deal Brexit.
Hence, we recommend third-country administrators to start their preparations for approval in the EU as soon as possible, to avoid any delay that could impede their ability to service their EU customers.
BMR is here to stay and make sure that administrators, submitters and users of benchmarks run their business in a way that ultimately should ensure good outcomes for end-investors in terms of predictable and stable returns. Nowhere is this more true than in the ETF industry.