EU Benchmark Regulation – Flying Under the Radar

In recent months, the EU’s Markets in Financial Instruments Directive (MiFID 2), the US Department of Labor’s Fiduciary Rule, and Brexit have dominated the headlines and minds of global asset managers. As 2018 approaches, there’s another significant regulatory shift on the horizon that should not be forgotten.

With MiFID 2, and the Securities and Exchange Commission’s Reporting Modernization rules slated to go live in January, global asset managers are expecting 2018 to be another busy regulatory year. With so much focus on these changes, it’s easy to overlook some of the less-heralded regulations. The upcoming EU Benchmark Regulation (BMR) has received relatively little attention but has short and long-term implications for global asset managers.

In 2013, the International Organization of Securities Commissions (IOSCO) published Principles for Financial Benchmarks. While these principles have largely been adopted by benchmark administrators and users, the European Securities Market Authority (ESMA) has chosen to codify the principles with formal regulation next year with the EU Benchmark Regulation (BMR).

Benchmarks Are Growing in Importance

Benchmarks, or indexes, underpin huge volumes of financial contracts globally. The number of indexes has grown significantly and the number of market indexes has now surpassed the number of US stocks.[1]

To truly appreciate the scale of benchmarks globally, take a quote from the latest S&P Dow Jones earnings conference call, where it was stated there are $11.7 trillion in assets tracked to its indexes. The growth can be largely attributed to the thriving exchange-traded funds (ETFs) sector, which is primarily based on benchmarks. In 2017, the global ETF market surpassed $4 trillion[2] in assets and PWC predicts it will reach $5 trillion by 2020.[3] Given the scale and expected growth, it is logical that regulators would have an interest in ensuring benchmarks are appropriately governed.

Raising the Bar

Benchmarks are compiled using one of two methodologies—objective or subjective. Objective benchmarks use publicly available market data and defined rules to calculate benchmark composition. Subjective benchmarks rely on input from panels of experts and the methodology is not disclosed. The fact that their inputs and calculation methodologies remain hidden means there is a greater risk they may be manipulated.

BMR will enhance the standards of producers, contributors, and users of benchmarks. Asset managers are considered benchmark users if they measure performance against an index whether by tracking the return of the index, setting portfolio asset allocations, or calculating performance fees.

Like most EU regulations, it will also impact non-EU entities in countries that provide benchmarks to users within the EU. Under BMR, EU managers and funds may not use unregulated benchmarks and ESMA will impose financial penalties to those in violation of the new rules.

Preparing for January

Asset managers should focus on the following areas to ensure they are prepared for the 1 January deadline:

Benchmark Inventory Review

BMR demands asset managers have robust benchmark inventory management systems in place to ensure only benchmarks compliant with BMR and from eligible providers are used. This requirement will be necessary ahead of implementation and thereafter on an ongoing basis.

Contingency Planning

Under BMR, benchmark users must maintain written procedures detailing their plans to manage significant changes or instances where an index is no longer available for use. Firms need to prepare internal procedures, backed with robust contractual fallback clauses to address such cases. Benchmark contingency plans must be made available to clients and regulators upon request.

Documentation

All funds that invest in—or base their performance against—a benchmark must state that the appointed benchmark administrator is included on ESMA’s approved register in their prospectuses and offering documents.

Third-Country Providers

Asset managers may only use non-EU benchmarks that have been cleared by ESMA. It is important for asset managers to engage with third-country benchmark providers to assess their readiness for BMR. Benchmark providers can adhere to the regulation by seeking direct equivalency or partnering with an approved EU sponsor to endorse their benchmarks. Certain regional providers may choose to discontinue service to their EU clients rather than expend resources to adhere to supervisory requirements of ESMA under BMR.

No Delay Expected

Under BMR, ESMA can discontinue benchmarks or issue severe financial penalties to both providers and users of benchmarks who contravene the regulation. EU asset managers need to ensure they only utilize BMR-compliant benchmarks and that benchmarks currently relied upon will remain available for use after the effective date.  If not, alternative benchmarks or providers may need to be sourced in advance. There is no expectation of a delay and asset managers should be working to comply with BMR to ensure they can continue with business as usual at the start of the new year.

 

[1] Bloomberg News, There Are Now More Indexes Than Stocks, 12 May 2017.

[2] Financial Times, Global ETF assets reach $4tn, 10 May 2017.

[3] PWC, ETFs: A roadmap to growth, January 2016.