Explanatory Memorandum to COM(2013)641 - Indices used as benchmarks in financial instruments and financial contracts

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dossier COM(2013)641 - Indices used as benchmarks in financial instruments and financial contracts.
source COM(2013)641 EN
date 18-09-2013
1. CONTEXT OF THE PROPOSAL

4.

1.1. General context, grounds for and objectives of the proposal


An index is a measure, typically of a price or quantity, determined from time to time from a representative set of underlying data. When an index is used as a reference price for a financial instrument or contract it becomes a benchmark. A wide variety of benchmarks are currently produced using different methodologies by different providers, ranging from public entities to independent dedicated benchmark providers.

The settlements reached by several competent authorities with a number of banks concerning the manipulation of the LIBOR and EURIBOR interest rate benchmarks have highlighted the importance of benchmarks and their vulnerabilities. Allegations of attempted manipulation of commodity price assessments provided by commodity price reporting agencies (PRAs) are also under investigation by the competent authorities and IOSCO has carried out a review of oil price assessments by PRAs. The integrity of benchmarks is critical to the pricing of many financial instruments, such as interest rate swaps, and commercial and non-commercial contracts, such as mortgages. If a benchmark is manipulated this will cause significant losses to some of the investors that own financial instruments whose value is determined by reference to the benchmark. By sending out deceptive signals about the state of an underlying market it may distort the real economy. More generally concerns about the risk of benchmark manipulation undermine market confidence. Benchmarks are susceptible to manipulation where conflicts of interest and discretion exists in the benchmark process and these are not subject to adequate governance and controls.

The first part of the Commission’s response to the alleged manipulation of LIBOR and EURIBOR was to amend the existing proposals for a market abuse Regulation (MAR) and criminal sanctions for market abuse Directive (CSMAD) to clarify that any manipulation of benchmarks is clearly and unequivocally illegal and subject to administrative or criminal sanctions.

However, changing the sanctioning regime alone will not improve the way in which benchmarks are produced and used; sanctioning does not remove the risks of manipulation arising from the inadequate governance of the benchmark process where conflicts of interest and discretion exist. Secondly, in order to protect investors and consumers, it is necessary that benchmarks are robust, reliable and fit for purpose. In the light of these considerations, this proposal for a regulation has four main objectives that aim to improve the framework under which benchmarks are provided, contributed to and used:

– to improve the governance and controls over the benchmark process and in particular ensure that administrators avoid conflicts of interest, or at least manage them adequately;

– to improve the quality of the input data and methodologies used by benchmark administrators and in particular ensure that sufficient and accurate data is used in the determination of benchmarks;

– to ensure that contributors to benchmarks are subject to adequate controls, in particular to avoid conflicts of interest and that their contributions to benchmarks are subject to adequate controls. Where necessary the relevant competent authority should have the power to mandate contributors to continue to contribute to benchmarks; and

– to ensure adequate protection for consumers and investors using benchmarks by enhancing transparency, ensuring adequate rights of redress and ensuring suitability is assessed where necessary.

5.

1.2. Existing provisions in the area of the proposal


Union law currently addresses certain aspects of the use of benchmarks:

– The proposals for a Market Abuse Regulation (MAR) in Articles 2(3)(d) and 8(1)(d) and for a Criminal Sanctions for Market Abuse Directive (CSMAD) (MAR has been the subject of a political agreement by the European Parliament and the Council in June 2013) clarify that any manipulation of benchmarks is clearly and unequivocally illegal and subject to administrative or criminal sanctions.

– The Regulation on Energy Market Integrity and Transparency (REMIT) provides that the manipulation of benchmarks that are used for wholesale energy products is illegal.

– The Markets in Financial Instruments Directive requires that any financial instruments admitted to trading in a regulated market are capable of being traded in a fair, orderly and efficient manner. The Implementing Regulation of that Directive further specifies that the price or other value measure of the underlying must be reliable and publicly available.

– Article 30 of the European Commission Proposal on the Markets in Financial Instruments Regulation (MiFIR) (which is currently being negotiated by the European Parliament and the Council) contains a provision requiring the non-exclusive licencing of benchmarks for clearing and trading purposes.

– The Prospectus Directive and Implementing Regulation[7] provide that where a prospectus contains a reference to an index, the issuer should set out the type of the underlying and details of where information on the underlying can be obtained, an indication of where information about the past and the further performance of the underlying and its volatility can be obtained, and the name of the index. If the index in question is composed by the issuer, the issuer also needs to include a description of the index. If the index is not composed by the issuer, the issuer needs to clarify where information about the index can be obtained, and where the underlying is an interest rate the issuer needs to provide a description of the interest rate.

– The Undertakings for Collective Investment in Transferable Securities Directive[8] provides that UCITS funds may only hold a maximum share of instruments issued by the same body in their portfolio. Member States may raise the limits that apply to how much of its total portfolio a UCITS may hold to a maximum of 20% for investment in shares or debt securities issued by the same body when it concerns an index which the UCITS wants to replicate, provided the composition of the index is sufficiently diversified, the index represents an adequate benchmark for the market to which it refers and it is published in an appropriate manner.

Contents

1.

RESULTS OF CONSULTATIONS


6.

WITH INTERESTED PARTIES AND IMPACT ASSESSMENTS


7.

2.1. Consultations


A three month public consultation was launched on 3 September and closed on 29 November 2012. 84 contributions were received from contributors, benchmark providers and users including exchanges, banks, investors, consumer groups, trade bodies and public bodies. Stakeholders acknowledged the weaknesses in the production and use of benchmarks, and broadly supported action at EU level. Respondents also emphasised the need for international coordination, and careful calibration of the scope of any initiative.

ESMA and the EBA jointly investigated shortcomings in the provision of EURIBOR by the EBF-EURIBOR and on 11 January 2013 launched a consultation on the Principles for Benchmarks-Setting Processes in the EU[9]. In a letter dated 7 March 2013 the EBA, ESMA and EIOPA provided advice on the content of this proposed legislation in light of this work. The Commission services participated in an ESMA-EBA open hearing on 13 February 2013[10] on these Principles for Benchmarks-Setting Processes. The Commission services also participated in the public hearing on tackling the culture of market manipulation - global action post LIBOR/EURIBOR held by the European Parliament on 29 September 2012.

8.

2.2. Impact Assessment


In line with its 'Better Regulation' policy, the Commission conducted an impact assessment of policy alternatives. The policy options encompassed options to limit incentives for manipulation, minimise discretion and ensure benchmarks are based on sufficient, reliable and representative data, ensure internal governance and controls address risks, ensure effective supervision of benchmarks and enhance transparency and investor protection. Each policy option was assessed against the following criteria: impact on stakeholders, effectiveness and efficiency.

The following fundamental rights of the Charter of Fundamental Rights are of particular relevance: respect for private and family life, protection of personal data, freedom of expression and information.

Limitations on these rights and freedoms are allowed under Article 52 of the Charter. The objectives as defined above are consistent with the EU's obligations to respect fundamental rights. However, any limitation on the exercise of these rights and freedoms must be provided for by law and respect the essence of these rights and freedoms. Subject to the principle of proportionality, limitations may be made only if they are necessary and genuinely meet the objectives of general interest recognised by the Union or the need to protect the rights and freedoms of others. In the case of benchmarks, the general interest objective which justifies certain limitations of fundamental rights is the objective of ensuring market integrity. The need to protect the right to property (Article 17 of the Charter) also justifies certain limitations of fundamental rights, as investors are entitled to see the value of their property (e.g. loans, derivatives) protected from losses caused by market distortions.

The right to freedom of expression and information requires that the freedom of the media shall be respected. This Regulation should be interpreted and applied in accordance with this fundamental right. Therefore where a person merely publishes or refers to a benchmark as part of his or her journalistic activities but does not have control over the provision of that benchmark, that person should not be subject to the requirements imposed on administrators by this Regulation. This therefore leaves journalists free when performing journalistic activities to report on financial and commodities markets. Accordingly the definition of the administrator of a benchmark has been tightly defined to ensure that it encompasses the provision of a benchmark but does not capture within its scope journalistic activities.

2.

LEGAL ELEMENTS OF THE PROPOSAL



9.

3.1. Legal basis


The proposal is based on Article 114 of the Treaty on the Functioning of the European Union (“TFEU”).

10.

3.2. Subsidiarity and proportionality


The Commission proposal to regulate benchmarks is in line with the principle of subsidiarity as laid down in Article 5 of the Treaty on European Union (TEU), which requires the Union to take action only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Union.

While many benchmarks are national, the benchmark industry as a whole is international in both production and use. While action at national level in relation to national indices may help ensure that any intervention is appropriately tailored to the problems at a national level, this may lead to a patchwork of divergent rules, could create an un-level playing field within the single market and result in an inconsistent and un-coordinated approach. Benchmarks are used to price a wide variety of cross border transactions, in particular in the interbank funding market and derivatives. A patchwork of national rules would impede the opportunity to produce cross border benchmarks and therefore impede these cross border transactions. This problem has been recognised by the G20 and FSB which charged IOSCO with producing a global set of principles to apply to financial benchmarks. An EU initiative will help enhance the single market by creating a common framework for reliable and correctly used benchmarks across different Member States.

While in most Member States there is currently no regulation at national level on the production of benchmarks, two Member States have already adopted national legislation on interest rate benchmarks in their national currencies. Moreover, IOSCO has recently agreed principles on benchmarks which are to be implemented by its members. However these principles provide flexibility as to the scope and means of their implementation and in relation to certain terms. In the absence of a harmonised European framework for benchmarks, some Member States are likely to adopt legislation at national level which would be divergent. For example, at this point of time, the scope of the legislation of one Member State would appear as wide as IOSCO’s while the legislation of the other Member State that has introduced rules regarding benchmarks only covers interest rate benchmarks. These divergent approaches would result in fragmentation of the internal market, since administrators and users of benchmarks would be subject to different rules in different Member States. In the absence of a Union legislative framework, the individual national actions would also be ineffective, as there is no obligation or incentive on Member States to cooperate with each other and the absence of such cooperation leaves scope for regulatory arbitrage.

Certain aspects of investor protection in this field are generally covered by MiFID. In particular, there is the requirement under MiFID for firms to carry out an assessment of appropriateness. This test shall determine whether the client has the necessary experience and knowledge in order to understand the risks involved in relation to the product or investment service offered or demanded. Thus, it provides a sufficient level of investor protection.

Concerning consumer protection, the Consumer Credit Directive includes rules on the disclosure of adequate information, as well as the soon to be adopted Mortgage Credit Directive which also includes the requirement to recommend suitable credit agreements. However, those EU consumer protection rules do not address the particular issue of the suitability of benchmarks in financial contracts. Furthermore, unequal bargaining power and the use of standard terms means that consumers may have a limited choice about the benchmark used. Consumers lack the necessary knowledge or experience to appropriately assess benchmark suitability. Therefore this proposal should complement the existing EU legislation in this area by ensuring that the responsibility for assessing the suitability of benchmarks for retail contracts rests with the lenders or creditors. This will also ensure harmonised EU consumer protection rules on the use of benchmarks to reference financial contracts. A common regulatory framework for consumers and creditors in relation to financial contracts is also required to enable the use of cross border benchmarks rather than a fragmented national approach. As a result of consumer complaints and litigation relating to the use of unsuitable benchmarks in several Member States, it is likely that divergent measures on consumer protection would be adopted at national level. This could result in fragmentation of the internal market.

The proposed Regulation is also proportionate, as required by Article 5 of TEU. It targets only those indices that are used to reference financial instruments, or financial contracts such as mortgages, because these are the benchmark that may have a direct and certain economic impact if they are manipulated. In addition, the proposed Regulation contains provisions to tailor its requirements to different sectors and the different types of benchmark such as commodity, interbank interest rate and benchmarks that use exchange data. A proportionate approach is ensured since the vast majority of obligations are imposed on the administrator of the benchmark. Many administrators of benchmarks already comply with at least some of these requirements, implying that the administrative burden should not increase disporportionately. Moreover, processes for internal governance and control are only required from supervised contributors, meaning that the impact on non supervised contributors to a benchmark, for example a nonregistered trader, will not be substantial. Finally, in all important parts, this Regulation is aligned with the internationally agreed IOSCO Principles for financial benchmarks published on 17 July 2013, which has been extensively consulted with stakeholders. This will limit adaptation costs.

Against this background, EU action is appropriate in terms of the principles of subsidiarity and proportionality.

11.

3.3. Choice of instrument


A Regulation is considered to be the most appropriate legal instrument to introduce uniform rules concerning the provision of benchmarks, the contribution of input data to those benchmarks, and the use of benchmarks in the Union. The provisions of this proposal are laying down certain requirements for administrators, contributors and users of benchmarks. The cross border nature of many benchmarks creates a need for maximum harmonisation of these requirements. Since the regulation of benchmarks involves measures specifying precise requirements that relate to data and methodologies, even small divergences in the approach taken could lead to significant impediments in the cross border provision of benchmarks. The use of a Regulation, which is directly applicable without requiring national legislation, will restrict the possibility of divergent measures being taken by competent authorities at national level, and will ensure a consistent approach and greater legal certainty throughout the EU.

12.

3.4. Detailed explanation of the proposal


13.

3.4.1. Scope (Article 2)


The proposed Regulation applies to all published benchmarks that are used to reference a financial instrument traded or admitted to trading on a regulated venue, or a financial contract (such as mortgages) and benchmarks that measure the performance of an investment fund.

Where there is discretion in the benchmark process which is subject to a conflict of interest, there is a risk of manipulation in the absence of adequate governance and controls. Therefore indices which involve discretion should be subject to regulatory measures. While the degree of discretion varies, all indices involve some discretion. Therefore, the scope should include all benchmarks, regardless of the method of calculation or the nature of the contributions.

The scope should include all indices, including published indices, since any doubts about the accuracy and reliability of such indices are likely to inflict more damage on a wider population than indices which are not public.

Where benchmarks are used as a reference price for a financial instrument or contract, any manipulation causes economic loss. In the case where the contributor also uses the financial instrument that references it, an inherent conflict of interest exists and there is an incentive to manipulate. Furthermore, were benchmarks are used to measure the performance of financial instruments, they may be subject to conflicts of interests and their manipulation will lead to suboptimal investment choices by investors. Therefore, it is important to target all benchmarks that price a financial instrument or consumer contract or that measure the performance of investment funds.

For widely used benchmarks, even a minor manipulation may have a significant impact but the vulnerability and importance of a benchmark varies over time. Restricting the scope by reference to important or vulnerable indices would not address the risks that any benchmark may pose in the future.

Given all these considerations and in order to ensure a clear and comprehensive application of the Regulation, the scope is also not dependent on the nature of the input data i.e. whether the input data is an economic (e.g. a share price) or non-economic (e.g. a weather parameter) number or value. This is because the critical element when determining the scope is how the output value determines the value of a financial instrument, financial contract or measures the performance of an investment fund. In this context, once a value is used to reference a financial contract or instrument, its previous non-economic nature becomes irrelevant.

As regards the administrators of benchmarks, all administrators are potentially subject to conflicts of interest, exercise discretion and may have inadequate governance and control systems in place. Thus, they need to be subject to appropriate regulation. Moreover, as they control the benchmark process, an authorisation requirement is imposed on all benchmark administrators as supervision is the most effective way to ensure the integrity of benchmarks.

Concerning contributors to benchmarks, these are also potentially subject to conflicts of interest, exercise discretion and so may be the source of manipulation. Contributing to a benchmark is a voluntary activity. If any initiative requires contributors to significantly change their business models, they may cease to contribute to the benchmark concerned. However, for entities already subject to regulation and supervision, (so-called supervised contributors), requiring good governance and control systems is not expected to lead to substantial costs or disproportionate administrative burden. It is therefore appropriate to include all supervised contributors within the scope of this Regulation.

For contributors not subject to regulation and supervision (non-supervised contributors), authorisation or otherwise becoming subject to rules could impose significant costs and administrative burden. Regulators would also be ineffective supervising firms for which they have no expertise. Imposing supervision on currently non-supervised entities and persons would therefore impose significant costs and provide minimal benefits. Nonetheless, certain parts of this Regulation, as for example the need to provide accurate and reliable input data are indirectly relevant for all contributors since they remain subject to the Market Abuse Regulation and will be contractually bound to comply with the requirement of the administrator’s code of conduct under this Regulation.

The proposal exempts from its scope central banks that are members of the European System of Central Banks.

Finally, in some cases a person may produce an index but not be aware that this index is a benchmark because, for example, it is used as a reference to a financial instrument without the knowledge of the producer. The regulation therefore provides a mechanism to notify the producers that their index has or may become a benchmark and give them the power to refuse that it be used as a benchmark. If the producer consents, he will become subject to the proposed Regulation in respect of that benchmark. If he refuses, the index may not be used as a benchmark and the administrator requirements in this Regulation will not apply.

14.

3.4.2. Governance and Control of Administrators (Article 5-6)


The proposal ensures that conflicts of interest are avoided and ensures that governance and controls are effective. These are addressed by requirements on governance and controls, with more detailed requirements included in the annex.

15.

3.4.3. Input Data and Methodology (Articles 7)


The proposal sets out three requirements, detailed in the annex, in respect of the input data and methodology used to produce a benchmark to reduce discretion and enhance integrity and reliability:

– the input data should be sufficient and accurate so that it represent the actual market or economic reality that the benchmark is intended to measure;

– the input data should be obtained from a reliable and representative panel or sample of contributors; and

– the administrator should use robust and reliable methodology for determining the benchmark.

16.

3.4.4. Contributor Requirements (Articles 9 and 11)


The administrator is required to draw up a contributor code of conduct which clearly specifies the obligations and responsibilities of the contributors when they provide input data for the determination of the benchmark. Where the contributors are already regulated entities they are also required to avoid conflicts of interest and implement adequate controls.

17.

3.4.5. Sectoral Requirements (Article 10 and 12-14)


In order to ensure proportionality and ensure that the proposal is adequately tailored to different benchmark types and sectors, annexes II and III contain more detailed provisions on commodity benchmarks and interest rate benchmarks. Additional requirements are imposed on critical benchmarks, including the power for the relevant competent authority to mandate contributions. Benchmarks whose input data is provided by regulated venues are also released from certain obligations to avoid dual regulation.

18.

3.4.6. Transparency and Consumer Protection (Articles 15-18)


Investor protection is enhanced through transparency provisions. Administrators are required to provide a statement setting out what the benchmark measures, its vulnerabilities, along with the publication of underlying data to allow users to choose the most appropriate and suitable benchmark. This statement also provides notice that the users should make adequate provision in the event that the administrator ceases to provide the benchmark. Finally a suitability assessment is imposed on banks in their dealings with consumers in financial contracts such as loans secured by mortgages.

19.

3.4.7. Supervision and Authorisation Procedure for Administrators (Articles 22 -37)


The activity of the provision of benchmarks will be subject to prior authorisation and on-going supervision. The proposal lays down the conditions and the procedure for administrators of benchmarks located in the Union to obtain authorisation from the relevant competent authority. The proposal creates a mechanism to ensure effective enforcement of the Regulation. It gives competent authorities the necessary powers to ensure that administrators comply with the Regulation.

For critical benchmarks colleges of supervisors should be formed to enhance the exchange of information and ensure uniform authorisation and supervision.

3.

BUDGETARY IMPLICATION



The proposal has implications for the Community budget.

The specific budget implications of the proposal relate to task allocated to ESMA, as specified in the legislative financial statements accompanying this proposal. The new tasks will be carried out with the human resources available within the annual budgetary allocation procedure, in the light of budgetary constraints which are applicable to all EU bodies and in line with the financial programming for agencies.

Notably, the resources needed by the agency for the new tasks will be consistent and compatible with the human and financing programming for ESMA set by the recent Communication to the European Parliament and the Council – Programming of human and financial resources for decentralised agencies 2014-2020' (COM(2013)519).

Specific budgetary implications for the Commission are also assessed in the financial statement accompanying this proposal.In summary, the main budgetary implications of the proposal are:

a) DG MARKT staff: 1 AD staff member (full-time) for drafting delegated acts, as well as for the evaluation, monitoring of the implementation and potential review of the initiative. The total estimated costs are € 0.141 M yearly.

b) ESMA:

(i) Staff costs: two temporary agents for participating and mediating in the colleges of supervisors for critical benchmarks, providing technical advice to the Commission on the implementation of this Regulation, coordinating the development of cooperation arrangements with third countries, drafting guidelines to promote convergence and cross-sector consistency of penalty regimes and maintaining registers of notifications on the use of benchmarks and a list of registered benchmark administrators.

The total yearly costs of these 2 temporary agents would be of €0.326 M, towards which the Commission would contribute 40% (€ 0.130 M) and Member States 60% (€ 0.196 M) yearly.

(ii) Operational and infrastructure costs: an initial expense of € 0.25 M is also estimated for ESMA, towards which the Commission would contribute 40% (€ 0.1 M) and Member States 60% (€ 0.15 M) in 2015. This expense relates mainly to IT systems for ESMA to fulfil the requirements of:

- Maintaining a list of administrators registered in accordance with this Regulation and third country firms providing benchmarks in the Union.

- Receiving notifications of the use of a benchmark in a financial instrument or financial contract within the Union, and maintaining a register and ensuring that administrators are aware of this use.

ESMA will also need to produce a report on the application of this Regulation by 1 January 2018 with a total cost of € 0.3 M towards which the Commission would contribute 40% (€ 0.12 M) and Member States 60% (€ 0.18 M) in 2017.