Benchmark Compliance: A Proactive Approach

Twenty years ago the term 'benchmark' was still a verb - a term which described the activity of relative performance measurement. Recent regulatory reforms following the 2012 Libor scandal have redefined the term to mean a 'value' which is referenced by an instrument, contract or performance measurement.

Global regulators have embarked on a broad and ambitious reform agenda designed to restore public confidence by mitigating any potential future misconduct. The scope of this reform is comprehensive and covers the entire lifecycle of a benchmark, including contributions to benchmarks (submitters), calculation and publication of benchmarks (administrators) and also the 'use' of benchmarks (the rest of the planet), which is likely to be of particular significance to asset managers.

Passive investment trends have given rise to a proliferation of proprietary indices designed to provide investors with unique exposure and customised return patterns. Many of these indices are also dependent on underlying indicators, indices or signals which inform the index strategy and trigger dynamic portfolio shifts. These product innovations offer investors exposure to new types of investment styles, enhanced transparency and low cost alternatives to active management.

IOSCO has established the foundation for the emergence of global benchmark regulation, and new EU benchmark regulations have been introduced which cover products and benchmarks provided to customers in the EU no matter where the provider is domiciled. In its thematic review, the FCA emphasised the scope and urgency of reform and continues to encourage immediate action rather than a wait-and-see approach. In Asia the Australian Securities and Investment Commission (ASIC) published its 440 review. We have also seen enforcement actions taken by the Financial Conduct Authority (FCA) here in the UK and by the Securities Exchange Commission (SEC) in the US.

An industry already overwhelmed with regulatory change is trying to gauge how and when to respond. The complexity and broad use of benchmarks touches an array of business activities. The lead times associated with these significant change programmes require months and, in some cases, years to implement the necessary controls required to support what is now a cultural change.

At a recent conference in London, participants and regulators gathered to discuss best practice approaches to managing benchmark risk. Some benchmark providers have chosen to divest these assets to avoid the cost and risk while others continue to seek alternative approaches.

The IOSCO principles offer guidance for mitigating the inherent conflicts for benchmark administrators who deal in products which reference their own benchmarks or reference the benchmarks for attributing performance and risk. IOSCO suggests separating the administrator function as good practice by relinquishing control of the index methodology to a control function - typically an internal compliance team. The practical issue for going this route is their lack of specific experience necessary to effectively administrate.

Regulators have acknowledged their main dilemma of imposing reforms which aim to 'treat the cancer without killing the patient.' Mandatory contributions will require submitters to critical benchmarks to continue participation in order to prevent systemically important benchmarks from being starved to death. For all other benchmarks, their fate remains unclear - thereby threatening the transparency these benchmarks provide for otherwise opaque and illiquid markets.

However, all is not lost! Benchmark reform is a global concern and one which requires a successful collaboration across regional jurisdictions. Benchmark providers are looking to support the adoption of new regulation by working closely with clients and regulators early in the legislative process. For those with roots in OTC credit derivatives and deep expertise in the tradable products and benchmarks support can be provided. Investments in an IOSCO compliance framework designed to support their own benchmark and non-benchmark products as well as those of their clients are key to an independent administrator service. The industry is best served and best practices are best defined through this spirit of partnership.

An independent provider can assume the role of administrator for investible indices. As the administrator the provider controls the index methodologies, while the client retains ownership of the index and the associated intellectual property. An alternative to divesture, transferring index administration to an independent provider allows firms to focus on their core business of delivering innovative products to clients, while retaining ownership of the indices' intellectual property (IP).

Will independent administration prove to be an industry best practice and an effective means of delivering on the intent of regulatory reforms without compromising market transparency?

Although EU benchmark regulation is not due to come into force for another 18-24 months, the process of transferring administration takes time and requires that the administrator reconstruct each index and run in parallel for extended periods before the transfer. This onboarding process also delivers the benefit of validating each of the data inputs and methodologies and updating documentation where required.

Benchmark indices play a critical role in the financial markets. It's time that market participants work proactively with global regulators to ensure that their common objectives are achieved.

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.