The Game is On: The Buy-Side Tale

When releasing a new record it must be a complete disappointment to go live on the same date as the hottest singer in town, and end up in the shadow of a better-known artist. That is how it must feel for the Benchmarks Regulation (BMR) in 2017, the year everyone is talking about the Markets in Financial Instruments Directive (Mifid) II. 

The BMR was published in the Official Journal of the European Union in June last year, and will apply from Jan. 1, 2018. Although it has perhaps not received as much attention as Mifid II, the BMR sets out to address problems of integrity raised in the much-publicized Libor scandal, when banks were accused of rigging the important benchmark. 

To avoid future manipulation of benchmarks, the BMR introduces a regime designed to improve quality and control of benchmarks, and protect consumers and investors. Andrew Barnett, chief data officer, Legal & General Investment Management, says: “The regulation is a direct reaction to the Libor fixing scandal”, and the firm has had the BMR on the agenda for several years now.

Under the new European Union (EU) regulation, stakeholders will be divided into administrators, contributors and users. Benchmark administrators—providers that calculate indices—will have to apply for authorization, as well as meet new requirements for governance and control. At the RIMES Regulatory Seminar, Preparing for the EU Benchmarks Regulation, held in London in June, Will Dibble, partner, CMS London, said one of the questions the firm has had from clients is: ‘How do we make sure our index stays out of scope of the BMR?’ 

To prepare for the BMR, firms have had to identify which category they fall into, and the way to do this was discussed at the RIMES event. Bruno Piers de Raveschoot, chief operating officer of the regulatory division at RIMES Technologies, advised firms to list all the benchmarks used and to determine where those benchmarks are used to establish if the firm will become an administrator, contributor or user under the new regulation. “It sounds trivial, but it’s not that easy because a lot of firms are using benchmarks and they don’t know what they’re using them for,” he says, “they need a specialist tool such as the one we provide.”

Firms that have the provision of a benchmark or are collecting the data for a benchmark would fall under the administrator category, which Piers de Raveschoot explains would be an administrative burden. The challenge for firms that fall into this category is that administrators, among others, might need to establish a new entity, keep a record of all conversations with suppliers for three years, and ensure oversight to avoid any conflict of interest with the firm itself. “It’s a very, very, very cumbersome process,” he says.

For asset management firms that fall under the user category, the main preparations focus on obtaining a complete overview of existing usage. De Raveschoot explains that benchmark users must ensure the supplier of the benchmark is a registered benchmark administrator under the EU, and that they have applied for and received authority to do that. In addition, he says users must make sure the benchmark is administered by the administrator, and need a robust plan to change to a substitute benchmark if necessary. Those are Articles 28 and 29 of the BMR

In addition to defining the roles, the new regulation also divides benchmarks into three categories—critical, significant and non-significant. For critical benchmarks a college of national supervisors, including the European Securities and Markets Authority (ESMA), will be set up to take key decisions. 

ESMA published the details firms needed for implementing the BMR in a final report with the draft regulatory technical standards (RTS) and implementing technical standards on March 30. Firms had not received essential guidance on how to interpret the regulation until then. In addition, the market is still awaiting local regulators such as the UK Financial Conduct Authority (FCA) to complete the consultation period. FCA is consulting on proposed changes to its handbook to accompany the application of the BMR and, according to the FCA, it will replace some existing UK regulation on specified benchmarks. The FCA “must therefore remove some rules from the handbook, and ensure other rules and guidance are made compatible with the BMR.” In addition, the FCA has announced it proposes to have some domestic rules on benchmark administrators in areas not covered by the BMR. 

It sounds trivial, but it’s not that easy because a lot of firms are using benchmarks and they don’t know what they’re using them for

Bruno Piers de Raveschoot, RIMES Technologies

Timing is one of the challenges that have been highlighted by market participants, as the deadline is fast approaching and guidance is still fairly new—in some cases clarification is yet to be published. At the RIMES BMR event in London, speakers said the combination of the complexity of the BMR and the short time frame firms have to prepare has made this regulation particularly challenging for the market. 

For asset managers, however, the years since talks about new EU benchmarks regulation began in 2013 have meant the use of indices and benchmarks have been in the spotlight. Naomi Clarke, a data management expert with a background in different asset management firms, says it has been a case of looking at benchmark usage. “The regulation has given us an impetus to look at benchmarks and indices across the board,” she says, adding that she thinks the number of benchmarks used could decrease as firms review usage and costs are under scrutiny.

Benchmark usage on the buy side will also vary widely depending on the investment strategies adopted. Barnett says Legal & General has a large passive business, enabling clients to gain direct exposure to indices, and therefore needed to assess its role in the provision, contribution and use of benchmarks going forward, following the announcement of the new regulation. The firm has been discussing with benchmark outsource providers the role of benchmark calculation, benchmark administration and benchmark contribution as necessary to meet the new regulatory requirements. This is where the BMR differs from Mifid II, explains Barnett, as it is possible to leverage external providers to become BMR-compliant, whereas with Mifid II the majority of the work needs to be done internally. 

One of the vendors aiming to help firms with their BMR compliance is RIMES, which has announced plans to offer various BMR services. The first offering is designed to help firms build, enrich and maintain an inventory of benchmarks and gain better control of benchmarks to meet the new regulation. Piers de Raveschoot says RIMES will provide the technology to create the inventory allowing firms to identify affected  indices or benchmarks, and which ones they will be considered administrator, contributor or user for. The service provides a clear picture of the risk exposure of the firm to the BMR. The system will run a number of on-going checks, for example, establish if the benchmark is administered and registered in Europe, and if the firm has a plan B. To offer this service, Piers de Raveschoot says RIMES is contacting benchmark administrators to source compliance information.

The Register

To comply with the new regulation, the onus is on benchmark users to ensure they only use registered benchmarks in new transactions from 2018, and in all products from the end of a two-year transition period. After the go-live date of the BMR, ESMA will create a register with names of authorized European benchmark administrators and individual benchmarks registered by third countries. The ESMA register will help firms assess if a benchmark is BMR-compliant, but users still need to identify whether a European benchmark is managed by an authorized provider, since the register will not include the name of the European benchmarks. “If you find the name, it means all the benchmarks the administrator provides can be used,” says Michele Mazzoni, policy officer, ESMA, explaining that, for third countries, the register will have the name of every benchmark.

Market participants expect the register to be expanded upon by external providers, as there is scope for vendors to provide additional benchmarking data to add more value to users. Before vendor services can be offered and firms can change their pre-execution validation engine, however, there is still a need for information on which benchmark administrators will be compliant. “It’s a Catch-22,” says Clarke, adding that, although firms are now reviewing the benchmarks, nothing is definite until the names of the authorized benchmark administrators have been confirmed.

According to ESMA, the register will be made available during the transition period, but cannot be expected in January 2018. An executive from the Information Provider User Group (IPUG) in the UK says there is concern there is no published information yet on the ESMA website that lists the specific benchmarks and names of authorized benchmark providers. “Even if the benchmarks contracts are listed in the inventory and reconciled with the middle-office teams as part of this BMR project, the delay from ESMA to release its standard application programming interface (API) is making it very difficult for benchmark users to finalize preparations as no one has any information on this list until ESMA launches it,” he says.

In fact, it is not only the detailed benchmark and benchmark-provider classification register that is needed, but also the ESMA-issued API that will make it possible for benchmark users to download the data on a daily basis and integrate it into their trading workflows. “We need to have the ability to integrate and download the information into our pre-trade execution system,” says the IPUG executive, adding: “The portfolio managers and structurers need a tool that automatically checks the ESMA benchmark list updated daily.” As firms rely on automated trading systems, he explains, it is not sufficient to have a web-based look-up tool or manual processes to identify a BMR-approved benchmark prior to issuing a fund or quoting to a client, especially when in competition for a deal.

The Cost Dilemma

Making changes to the pre-trade process, however, is only one of the costs firms are likely to have to swallow as part of the regulation. Asset management firms have also, in some cases, been presented with higher index fees, and the increased cost of doing business is a concern for low-margin products. 

The new regulation puts a larger overhead on benchmark administrators, resulting in changes to the index provider market and challenges for banks that used to offer the data at no additional cost. Several banks have sold index businesses to exchanges or data vendors, demonstrating that some banks have wanted to get out of the index business following the Libor scandal and the tightening of regulation. 

Benchmark users have already started to see the impact, with providers announcing they will charge more for index administration. “It becomes an expensive activity to add that 30% surcharge to what you [asset management firms] are doing, and seems counterproductive where regulation has clear objectives to benefit the investor,” explains Barnett. The question then becomes whether to review alternative benchmarks gaining similar exposures. Consideration will focus on both index and asset manager brand strength, coupled with the complexity of the exposure especially where the retail market is concerned.

Tackling Third-Country Readiness

The expectation from some asset management firms appears to be that their index providers are compliant, but the question is whether the BMR is on the agenda for third-country administrators too. ESMA’s Mazzoni says they are “fairly convinced the European ones are up to speed,” but there is “less awareness in third countries, especially in small jurisdictions.” ESMA has been in direct or indirect contact with a small number of emerging economies, but European stakeholders have been the priority for the regulator. “As awareness of asset managers increases, then they will start asking [third-country benchmark providers] questions and the process will be triggered,” he says. In the meantime, there is a risk of European asset managers using benchmarks in emerging countries where authorities may not be aware of the European regulation. “That’s where there is room for improvement,” says Mazzoni.

In fact, IPUG also suggests more needs to be done here. The European IPUG groups representing Swiss, French, Dutch, Belgian, Scandinavian, UK and German user firms have teamed up with other associations such as the European Fund and Asset Management Association, the French Asset Management Association (Association Française de la Gestion Financière) and the German Investment Funds Association, and estimated there are around 250 benchmark providers in the world that the firms use. Around 80 of these are government benchmarks exempt from the BMR, meaning there are around 170 benchmark providers that market participants would like to see on the BMR register.

The IPUG executive says educating providers about the BMR is the problem. Many of the providers were yet to hear about the BMR regulation when contacted in the first quarter of 2017, he says. Even after the publication of the RTS on March 30, 2017, the providers could not fathom that users would have issues remaining compliant as of January 2018 because no information has so far been uploaded, hampering the issuance of any new financial product referencing their benchmarks as a result. “They don’t have the pressure from the buy side yet,” he says, highlighting the reality that firms will not be able to use them anymore and could stop using—or even cancel—contracts under the BMR remit if the situation does not change.

The challenges firms are facing with educating third-country benchmark providers has been one of the hot topics in the lead-up to the BMR. For buy-side firms, Mazzoni says: “I think the most difficult area [of the regulation] is if they use third-country benchmarks.” ESMA assumes there could be hundreds of single, third-country benchmarks that will be BMR-compliant, but this is just an estimate and it is too early to gain an indication of the true number because of the uniqueness of the new regulation. “There is no [other] regulation like this across the globe,” he says, and explains that it is “not straightforward to understand what indices are in its scope.” 

Another challenge in the use of third-country benchmarks is the timeline. In fact, the differences between the timeline of implementation for third-country benchmarks versus European benchmarks is one of the topics ESMA has been most questioned about recently. Article 51 provides for transition of provision, and ESMA has “received a number of questions from different stakeholders about how this will actually work.” 

European and third-country administrators and users want to understand how to use benchmarks lawfully in 2018 and 2019, and question whether the transition period will apply to third-country or European benchmarks. ESMA has recently provided clarification on the transition period, and may be providing more guidance in the future. During the transition period, benchmark users can continue with the indices already used in Europe before Jan. 1, 2018, while, for benchmarks created after that date, firms could look at the ESMA Q&A to gain more clarity. “The aim of the two-year transition period is to avoid market disruption,” says Mazzoni.

 Still, the deadline for using BMR-approved benchmarks for issuance of new products is fast approaching, and it is no surprise that benchmark users who will be liable for ensuring they use the BMR-approved benchmarks want to know who they are. The IPUG executive stresses that firms will not want to be in breach of the regulation and would have to stop using a benchmark until it has been listed on the register as BMR-approved. 

While waiting for the information on approved benchmark administrators, asset managers still working on internal preparations are also expected to spend the coming months identifying benchmarks used and speaking to administrators. 

The game is on, and it seems as if now is the time for the asset management industry to pick up the phone and start calling around. The January 2018 BMR deadline still stands, and the world needs to know what is happening in Europe.

 

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