FIA Europe Benchmarks Regulation

-Real Life Scenarios-

29 September 2015

Overview

FIA Europe members would like to highlight their concerns about the impact of the European Commission’s, Council and Parliament’s proposed Benchmark Regulation on indices used as benchmarks in financial instruments and financial contracts. The main areas of concern are set out as follows:

• Third Country;• Scope; and• Definition of Benchmark.

FIA Europe members would like to illustrate the potential unintended consequences of the proposed Benchmark Regulation through the use of real life scenario examples.

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Third CountryA third-country administrator will be deemed acceptable under the proposed Benchmark Regulation if it complies with either:

Article 20, Equivalence: the Commission text proposes that an EU supervised entity can use a “third country” benchmark (i.e. a benchmark whose administrator is outside the EU) if it satisfies specific criteria.

In practice it seems unlikely that many third country benchmarks could qualify under this regime, given the different approaches taken to regulation in other jurisdictions. Further, a third-country benchmark may have no incentive to seek recognition under the regime.

Article 21a, Recognition: the Council text proposes an alternative framework that is intended to allow EU supervised entities to use third country benchmarks provided that the third country administrator obtains recognition from the national regulator in the EU Member State of reference. Under this recognition regime, the non-EU administrator has to comply with most of the obligations applicable to EU administrators while also appointing an EU representative.

Non-EU administrators may face difficulty in determining which Member State is the appropriate reference country because the data that would enable the administrator to make this judgment (e.g. data identifying where most trade activity is occurring) may not be available to it at the time of seeking recognition. The burden of compliance with the recognition regime could dissuade non-EU administrators from seeking recognition.

Article 21b, Endorsement: the Parliament text endorsement regime is primarily intended to allow EU administrators to endorse non-EU benchmarks that are produced by their non-EU affiliates for use in the EU for a period up to five years following the entry into force of the Regulation.

The EU administrator would need to apply to its national regulator to be allowed to endorse benchmarks provided by its non-EU affiliate. Further, the applicant firm has to be able to demonstrate on an ongoing basis that the non-EU benchmark fulfils requirements at least as stringent as those set by the Regulation.

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ScopeThe Commission text of the proposed Benchmark Regulation is extremely broad in scope covering a wide range of index levels and potentially many basket or portfolio levels that are regularly determined.

The Parliament has recently proposed 4 distinct categories of benchmarks to address issues around proportionality:1) Critical: reference value of at least €500bn, 80% of contributors are based in a single Member State and were covered by

national benchmarks legislation prior to 1 January 2016 and which are in majority based on contributions from supervised contributors

2) Systemically important: benchmarks that are not based on contributions from entities that are in majority supervised and the reference value is at least €500bn or the benchmark had previously been in the significant benchmark category and was designated as a critical benchmark

3) Significant: reference value of at least €300bn or the benchmark has been designated a significant benchmark by the relevant NCA

4) Standard: all benchmarks not captured by any of the other categories

In contrast, the UK FCA have only identified 8 “critical” UK-based financial benchmarks in the fixed income, commodity and currency markets. They are as follows

5) LIBOR (London Interbank Offered Rate)6) SONIA (Sterling Overnight Index Average) 7) RONIA (Repurchase Overnight Index Average), 8) WM/Reuters London 4pm Closing Spot Rate9) ISDAFIX10) London Gold Fixing11) LMBA Silver Price12) ICE Brent Index

The UK’s approach to regulating only “critical” benchmarks and applying a “comply or explain” approach to other benchmarks would be more productive.

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Scope cont.

Indices includes interest rates, currencies, commodities and even factors with no obvious underlying.

The definition of “index” has, raised the question as to whether it might extend to commercial banks’ own published lending rates. Investment banks also routinely produce customised “baskets” of reference assets for a wide range of derivatives and other products and these could all be affected by the proposed Benchmark Regulation.

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Definition of Benchmark

‘…Any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument is determined, or an index that is used to measure the performance of an investment fund.’ (European Commission)

Supervised entities: the Regulation imposes direct obligations on users and contributors that are “supervised entities.” This term covers a large constituency of different categories of financial institution referred to in EU legislation including banks, investment firms, insurers, reinsurers, clearing houses, hedge funds and regulated funds.

The Regulation does not make clear whether the obligations of supervised entities also apply to entities exempted from the scope of that other EU legislation or non-EU entities that meet the definition of the relevant category of financial institution but which are not supervised in the EU. The fact that the restrictions on the “use” by supervised entities of benchmarks apply to use “in the Union” implies some territorial limit on these obligations.

The definition of “index” has raised the question as to whether it might extend to commercial banks’ own published lending rates. Investment banks also routinely produce customised “baskets” of reference assets for a wide range of derivatives and other products and these could all be affected by the Regulation.

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Benchmark- Real Life ScenariosEXAMPLE A

UK Corporate A has a number of Asian businesses, the biggest of which is in Korea. UK Corporate A funds this entity centrally so it can obtain the lowest cost of funds. However, this leads to a currency mismatch as UK Corporate A Plc has GBP as its base currency, but its Korean operations need KRW. Therefore UK Corporate A enters into a KRW [1]-denominated inter-company loan, which it hedges back to GBP. This means UK Corporate A Plc does not take any currency risk, and UK Corporate A's Korean entity receives the funding it requires in the correct currency.

To hedge the currency risk UK Corporate A enters into a GBP-KRW Cross Currency Swap with Bank Z in Seoul. This swap is cash settled in GBP, as KRW is a non-deliverable currency. At every interest payment date and maturity of the swap, the KRW amount that is due on the swap is actually settled in GBP. The GBP amount is determined by using the index KFTC18 USD-KRW fix crossed with the index 8am WMR fix for GBP-USD.

If the KFTC18 fixing source was not available, UK Corporate A would not be able to hedge its FX risk in putting in place a KRW denominated loan. This would mean UK Corporate A would not be able to put in place inter-company funding and so would have to fund its Korean business through local debt facilities.

If companies were no longer able to hedge these FX risks, it would open them up to a huge amount of market risk, and therefore they would have to either accept this risk or decide not to enter into the underlying contract.

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Benchmark- Real Life Scenarios

EXAMPLE B

On the asset side, Company C provides financing to clients in local currency. Interest is calculated using local fixing, and then interest and principal are both paid to Company C in the local currency. This company therefore needs to swap these revenues back into USD (its functional currency).

On the liability side, Company C funds its overseas businesses in local currency where possible, in order to achieve the lowest cost of funds. The currency mismatch at the parent level is then hedged through cross currency swaps back into USD. Currently Company C has AUD [2], CAD [3], INR [4], MXN [5] fixed or floating bonds (non-exhaustive list).

On a daily basis, this company's balance sheet management, enters into multiple cross-currency basis swaps in order to manage its currency exposure arising from its daily activity.

The lack of access to benchmarks for the hedging of risk could have a negative outcome in the real economy.

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Benchmark- Real Life Scenarios

EXAMPLE C

The 3 month Certificate of Deposit (CD) Swap Fixing Rate in Korea is the main benchmark for the Korean interest rate swap market. The Korean Won IRS market is one of the largest and most liquid emerging market non-deliverable currency IRS market. Onshore/Offshore Banks use this benchmark to swap floating interest rates against fixed rate deposits and to hedge their Korean bond holding risk. It is also used by market participants inside the EU to gain exposure to Korean markets.

Under the current third-country regime of the Commission’s proposal, Korea is unlikely to be deemed equivalent in the EU. This benchmark could therefore be prohibited from use in the EU, causing significant disruption and competitive disadvantage for EU users.

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Benchmark- Real Life Scenarios

EXAMPLE D

Submitter/Contributor

Market participants are concerned about being incorrectly classed as a “contributor” or “submitter” to a benchmark. As a result of the broader increase in regulatory focus on the determination of benchmarks, many firms have significantly increased the intensity with which the benchmarks contribution process, and individuals within that process, are monitored and supervised. Whilst the increased scrutiny may be entirely appropriate where there is a genuine contributor/administrator relationship, there is a risk that incorrectly classified individuals could be subject unnecessary scrutiny that could restrict or alter trading behaviour.

The definition of “contributor” in the Benchmark Regulations is:

“a natural or legal person contributing [the value of one or more underlying assets…or other values, used by the administrator to determine the benchmark”.

This is a very wide definition and would capture individuals and members who simply trade an instrument, where trading data is used in order to determine a benchmark. In order to avoid the consequential scrutiny and the regulatory requirements, there is a potential that firms may choose to trade OTC or outside of the Union.

It is therefore important that greater clarity is introduced into the definition of “contributor” and “input data” in order to be able to clearly distinguish data that is collected with the specific purpose of determining a benchmark and trading data that are the result of normal trading behaviour and which are then used to determine a benchmark.

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Benchmark- Real Life Scenarios

EXAMPLE D cont.

Usage

Some exchanges determine a number of prices solely for use by its clearing house for risk management purposes. For example, an Exchange’s Closing Prices are used for the clearing house to assess the level of margin that it requires to manage the position held by the members. The Closing Prices are determined based on trading data and are sent to the clearing house. These are also published through its data feed and are available to the market. Therefore, it is not beyond doubt that the prices could be used for the purpose of valuation of financial instruments.

The benchmark regulations are silent on the need for an administrator to have “actual or presumed” knowledge of the Benchmark’s use, it is unclear whether the Exchange should treat such values as benchmarks or not. This issue can be resolved through a change to the definition of “Benchmark” whereby there is a need for an administrator to have knowledge or awareness of the index’s use.

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Benchmark- Real Life ScenariosEXAMPLE E

Pre-Trade Transparency

The benchmark definition contained in the European Regulation is broadly based on the IOSCO definition. The ongoing implementation of the principles in the UK has shown how a vague definition can lead to significant confusion amongst industry participants on how wide the scope of the benchmarks’ regulation should be.

The key concern is the delineation between pre-trade transparency, i.e. making prices for financial instruments available to the market to enable price discovery, and benchmarks – whose primary goal is to provide a reference source to price financial instruments.

Trading venues, market data vendors, and brokers all offer market level price reporting for individual financial instruments. This is explicitly encouraged by MiFID II where great focus is put on encouraging pre-trade transparency by either displaying firm quotes and offers, or indicative quotes. By labelling pre-trade pricing sources as benchmarks, the scope of the benchmarks regulation would be significantly widened.

A single data vendor would then have to publish potentially millions of benchmark prices under this broad definition. This is because pre-trade pricing screens are constructed by using aggregate transaction data (in the case of very liquid instruments) or by inter- and extrapolating between transacted price points to estimate the price level of a given instrument. Confusingly, where a transaction occurs in that exact instrument, the benchmark (previously based on interpolation or aggregation) would suddenly seize to be a benchmark and transform into a price.

FIA Europe members believe that interpolation, aggregation and indeed extrapolation, for pre-trade indications of interest and/or implied prices, go further than what was intended by the IOSCO definition of “calculation”. FIA Europe members recommend more clarity in the context of the European Benchmarks regulation.

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Benchmark- Real Life Scenarios SummaryImplementation challenges: the new rules could lead to the transformation or even disappearance of some benchmarks.

Compliance: the compliance burden for firms that administer, use and contribute to financial benchmarks will also be substantial and the Regulation will pose special challenges for EU market participants that rely on non-EU benchmarks.

Definition: the vague and wide scope can lead to significant confusion amongst industry participants. Clarification is needed to provide guidance to market participants.

Access to benchmarks: the inability of companies to access benchmarks to hedge FX risks, would open them up to a huge amount of market risk. Subsequently, companies would have to either a) accept this risk or b) not to enter into the underlying contracts which would have a negative impact in the real economy.

Third –country: under the Commission’s proposal, a third-country is unlikely to be deemed equivalent in the EU. A third-country benchmark could therefore be prohibited from use in the EU, causing significant disruption and competitive disadvantage for EU users. This is further compounded by the lack of regulation in other jurisdiction. FIA Europe members supports the Parliaments reliance on IOSCO compliance and recommends this as being a good way forward.

“Contributor and submitter” classification: of individuals could restrict or alter trading behaviour. The wide definition of “contributor” would capture individuals and members who simply trade an instrument, where trading data is used in order to determine a benchmark. Firms may subsequently choose to trade OTC or outside the Union.

“Actual or presumed knowledge”: of the benchmarks’ use by the administrator is silent under the Regulation. Further, it is unclear whether an Exchange should treat such values as benchmarks. Clarification as to the definition of benchmark is needed.

Pre-trade pricing sources: labelled as benchmarks would significantly widen the scope. Confusingly, where a transaction occurs in that exact instrument, the benchmark (previously based on interpolation or aggregation) would suddenly seize to be a benchmark and transform into a price. Clarity is needed in the context of the European benchmarks regulation.

Central Counterparties (CCPs): will have to comply with the requirements for users in addition to their obligations under EMIR. The Benchmark Regulation may undermine the CCPs willingness and ability to offer new financial products for clearing and settlement, particularly from trading venues or administrators located in Third Countries.

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