Benchmarks – do you understand the risks?
Aimed at Heads of Risk, Heads of Compliance and Front Office management and staff, this paper is designed to give a clearer understanding of benchmarks. A few years ago no one would have predicted the amount of press coverage and regulatory attention being given to benchmarks. Hardly a week passes without news of another allegation, investigation or fine related to the manipulation of a benchmark.
Estimates indicate that there are more than one million benchmarks in the UK alone – ranging from the price of milk to the London Interbank Offered Rate (LIBOR). Imagine that number multiplied by the number of financial centres around the world, the number of benchmarks is very large indeed.
The majority of benchmarks either 1) track assets in the real economy such as commodities, or 2) were developed to facilitate borrowing and investing for retail, corporate or institutional clients. The direct relationship between financial benchmarks and the real economy fuels the public, political and regulatory interest in those benchmarks and also fuels the hostility regarding their potential manipulation. Financial benchmarks play a fundamental role in valuing millions of financial instruments and amounts of payments under many financial contracts such as interest rate swaps, student loans, personal loans and mortgages. The Investment Management Association (IMA) estimates that its members manage over £4.5 trillion of assets, a significant portion invested in funds which track specified benchmarks.
Precisely what constitutes a benchmark depends on who you ask. Markets in Financial Instruments Directive (MiFID) and Market Abuse Regulation (MAR) use one definition, Section 22 of the Financial Services and Markets Act (FSMA) a different one, and EU Benchmark Regulation differs again. Broadly speaking a benchmark is defined as “any rate, index or figure made available to the public or published that is periodically or regularly determined by the application of a formula to, or on the basis of the value of one or more underlying assets, or prices, including estimated prices, actual or estimated interest rates or other values, or surveys and by reference to which the amount payable under a financial instrument or the value of a financial instrument is determined”.
What went wrong?
The underlying allegations, which resulted in investigations and fines, suggest that conflicts of interest were overlooked and data and submissions were manipulated for personal gain. In the case of LIBOR it is alleged that individuals from numerous firms colluded in providing improper submissions to move the benchmark for their benefit.