The European Commission’s spotlight on data transparency has panned out to cover benchmarks and indices. Following the Libor scandal and the Commission’s move to amend proposals for market abuse regulation and criminal sanctions to clarify that any manipulation of benchmarks is illegal, it has issued a consultation paper on the production of benchmarks and market indices.
Among its many suggestions for improvement, it states: “Increasing the transparency of any input data and the calculation of the index – in particular where discretion is exercised – will increase confidence in benchmarks, reduce the scope for abuse and ensure that users are adequately informed to make any decisions about whether and how to use an index. In addition, the level of transparency should increase in line with the amount of judgment exercised.”
The Commission initiated a consultation on 5 September 2012 and has invited stakeholders to comment on possible new rules for the production and use of indices serving as benchmarks in financial and other contracts. The consultation is wide ranging, covering all benchmarks, and runs until 15 November 2012. It aims to identify possible shortcomings at every stage in the production and use of benchmarks, and has the ultimate objective of ensuring the integrity of benchmarks. Any solution, states the Commission, should guarantee that benchmarks are not subject to conflict of interest, reflect the economic reality that they are intended to measure and are used appropriately.
At the start of the consultation period, Michel Barnier, commissioner for internal market and services, said: “Doubts about the accuracy and integrity of indices can undermine market confidence, cause significant losses to consumers and investors, and distort the real economy. It is therefore essential that steps are taken to ensure the integrity of benchmarks and the benchmark-setting process. The Commission has already acted quickly to amend its legislative proposals on market abuse. However, changing the sanctions regime alone may not be sufficient: wider work is required to regulate how indices and benchmarks are compiled, produced and used.”
The consultation document – Consultation Document on the Regulation of Indices: A possible framework for the regulation of the production and use of indices serving as benchmarks in financial and other contracts – comprises five chapters covering:
- the scope, process and nature of indices and benchmarks
- governance and transparency in the use of actual transaction data
- the purpose and use of benchmarks
- the provision of benchmarks by private or public bodies
- the impact of potential regulation, including transition, continuity and international use issues.
Chapter 2 of the document, Calculation of Benchmarks: governance and transparency, considers how indices are produced from underlying data and notes potential problems such as the collection of subjective underlying data. “In cases where the underlying data is not objective, a degree of discretion rests with the contributor of the data. If this discretion is not exercised appropriately, this will impact the integrity of the index,” states the Commission. Decisions by the index calculator on what underlying data should be included in the calculation can also affect the integrity of the benchmarks and the extent of any discretion used in the calculation of the underlying data can influence accuracy.
Commenting on outcomes of the use of discretion, the document states: “Conflicts of interest will arise where someone exercising this discretion also has an interest in the value of the benchmark. Any resulting inappropriate, dishonest or incompetent exercise of this discretion will harm the integrity of the index, undermine confidence in markets and result in losses to stakeholders.”
With a view to avoiding such situations, the Commission counsels increasing the transparency of any input data and improving the calculation of the index, in particular where discretion is exercised. It suggests: “If the exercise of discretion is unavoidable, a suitable framework is necessary to ensure the appropriate exercise of any discretion, in particular to mitigate against any conflicts of interest and make certain that users of the benchmark understand how any discretion is being exercised.”
The consultation document recognises a degree of risk related to the level of discretion required in producing an index, and notes the preferable solution of indices that use only objective and verifiable data, and may therefore help ensure the integrity of benchmarks. While this may be preferable, issues of available data, the purpose of the benchmark and how frequently it needs to be produced often lead to a less favourable result based on estimates. The document states: “Changing an index from one based on estimates of underlying data to transaction based data may raise difficulties due to a lack of data, or the inappropriateness of what data is available.”
Solutions proposed include changing an index by reducing its frequency, where its use allows, perhaps from daily to weekly. This could make the use of actual data possible. Alternatively, the scope of what is included in an index could be changed, or the base of a benchmark could be changed to align with markets that are more likely to provide actual transaction data.
Interesting ideas in an ideal world, but the Commission acknowledges: “Changing the base, scope or frequency of a benchmark fundamentally changes the benchmark and this may mean it no longer meets its intended purpose and therefore might not be useful to the present users of the benchmark.”
On this basis it suggests a hybrid construction system that would go some of the way towards meeting the needs for data transparency and benchmark integrity.
The Commission explains: “An alternative may be to construct a hybrid system, for example requiring the producer of a benchmark to use actual transaction data where available, but substituted with alternative measures when actual transactions are unavailable. This could follow a tiered approach, where contributors of data are required to submit actual transaction data, provided that it is available. If it is no longer available, then any submission should be based on models using appropriate data. The specification and use of this model should be documented and made transparent. If appropriate data is not available and it is otherwise not possible to use a model, judgement may be exercised but this judgement should be well founded and the basis for this judgement should be documented and made transparent. Finally, where no judgement can be exercised, the contributor of data should be entitled to refuse to make a submission.”
Based on the Commission’s suggestions of how the production of indices could be improved to avoid further manipulation of benchmarks, data contributors and index calculators are expected to join the consultation process. But as the Commission concludes: “Work is required at a Union level due to the global nature of benchmarks. Member states acting without an EU framework in this area could lead to a patchwork of rules, could create an unlevel playing field within the single market, result in an inconsistent and un-coordinated approach and reduce the Union’s ability to influence outcomes and achieve an internationally consistent regime at a global level.”