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Benchmark reform
March 2015
www.pwc.co.uk
PwC
01 Background
02 Evolving regulation
03 Industry reform
04 Deustche Bank’s experience
05 Industry response
06 Your presenters
Contents
2
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Section 1
Background
Benchmark reform
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Why are we talking about this topic? Enforcement - A major industry issue
Financial Times – 24th July 2014
Lloyds to pay up to £300m Libor fines
BBC– 19th December 2013
UBS fined $1.5bn for Libor rigging
Bloomberg – 14th December 2013
SocGen Blames Single Trader After $607 Million Rate-Rigging Fine
Financial Times – 4th December 2013
EU fines Royal Bank of Scotland £324m over Libor rigging
Bloomberg – 3rd March 2015
Barclays Takes $1.2bn Charge in Currency-Rigging Probe
Financial Times – 27th June 2013
Barclays fined a record £290m
Financial Times – 29th September
UBS warns of ‘material’ fines after forex probe
Financial Times – 10th October 2014
FCA forex probe to accuse banks of control failings
Financial Times – 15th October 2014
JPMorgan sets aside $1bn as penalties loom
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LIBOR and EURIBOR manipulation
• Investigations by the FSA, the US Department of Justice and the Commodity Futures Trading Commission (CFTC) discovered that traders had tried to manipulate LIBOR and other benchmarks for financial gain.
• In the UK, the regulatory findings resulted in the Wheatley Review, which recommended retaining LIBOR but making the administration and submission to LIBOR a regulated activity.
• Changes were introduced through the Financial Services Act 2012 to regulate LIBOR and make the manipulation of LIBOR a criminal offence.
• FCA investigations have resulted in multiple enforcement actions and its into the manipulation and other benchmarks are ongoing.
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LIBOR submissions (01 August-31 December 2008)
0
1
2
3
4
5
6
01/08/2008 01/09/2008 01/10/2008 01/11/2008 01/12/2008 01/01/2009
LIBOR Barclays Lloyds HSBC HBOS
8 Oct: Global central banks cut interest rates
27 Oct: Paul Tucker, Deputy Governor of the Bank of England speaks to at least one bank’s CEO
15 Sept: Lehman Brothers files for bankruptcy
Based on 3 month USD LIBOR. Source: BBA
Perc
en
t
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Section 2
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Evolving regulation
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Regulatory timeline
Q4
2015 2014 2016 &
beyond Q2 Q1 Q4 Q3
UK
E
U
Known date Estimated date
Glo
ba
l
28 October: FEMR consultation published
Autumn 2014: EP to resume consideration of Benchmarks Regulation text
November 2014: FSB presented recommendations on interest rate benchmarks and FX benchmarks to G20 Leaders Summit
December 2014: ESMA-EBA were scheduled to review application of Principles
Spring 2015: FCA Thematic Review on trader controls around benchmarks
June 2015: FEMR final report to be published
Ongoing until at least 2015: FCA and SFO LIBOR, FX and ISDAFIX investigations
Q2 2016: Estimated possible implementation of Benchmarks Regulation
3 January 2017: MiFID II in effect
Ongoing EC EIRD and YIRD cartel investigations
3 July 2016: MAR/MADII in effect
25 Feb 2015: IOSCO published report on implementation of Benchmark Principles
During 2015 EMMI expects firms to provide third party EURIBOR reports for 2014
23 October 2014: HMT benchmark consultation closed
End-2015: FSB deadline for IBOR administrators to consult on IBOR+ changes
Q2 2016: FSB deadline for developing at least one IOSCO- compliant risk-free rate
Compliance date
31 December 2014: Provisional date for Extension of criminal sanctions to further benchmarks
1 April 2015: Further benchmarks likely to come into UK regulatory scope
30 September 2014: FSB published final report on reforming FX benchmarks
19 December: IBA LIBOR consultation closes
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What is a benchmark?
Prices, estimates, rates, indices or values that are: a) Made available to users, whether free of charge or for payment;
b) Calculated periodically, entirely or partially by the application of a formula or another method of calculation to, or an assessment of, the
value of one or more underlying Interests;
c) Used for reference for purposes that include one or more of the following: • determining the interest payable, or other sums due, under loan agreements or under other financial contracts or instruments; • determining the price at which a financial instrument may be bought or sold or traded or redeemed, or the value of a financial
instrument; and/or • measuring the performance of a financial instrument.
Source: IOSCO Principles for Financial Benchmarks
Type Example
Interest rate LIBOR
FX WMR 4pm
Credit CMBX
Fixed income GEMMA Gilts
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Regulatory environment: UK
• The UK benchmark regulatory framework was developed in light of LIBOR manipulation and comprises FCA rules for benchmark administrators and submitters, and the criminal offence of manipulating a specified benchmark.
• The FEMR is bringing in additional benchmarks into the scope of UK regulation from 1 April 2015.
Wheatley Review of LIBOR (2012)
FCA MAR 8 (Regulatory rules
for benchmark administrators and
submitters)
FS Act 2012 (Manipulating benchmarks
criminal offence)
IBA LIBOR Code of Conduct
Fair and Effective Markets Review
(announced June 2014)
Resulted in
Current UK benchmark regulatory framework
HMT bringing additional
benchmarks into regulatory scope
• SONIA
• RONIA
• ISDAFIX
• WMR 4pm London
• LBMA Gold Price
• LBMA Silver Price
• ICE Brent Index
Into scope 1 April 2015
Government reviews
Ongoing FCA and SFO investigations
FCA MAR 8 Consultation Paper (closed 30 January 2015)
Requires modifications to FCA Handbook
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Regulatory environment: EU
• Compared to the UK, the regulatory reaction to benchmark manipulation has been more fragmented in the EU across a number of different initiatives. However, the European Commission has sought to address some of the gaps this has created through a common European Benchmark Regulation.
• While other legislative initiatives will remain in place or remain in concurrent development, the Benchmark Regulation is the sole legislative initiative exclusively dedicated to benchmarks.
• The Benchmark Regulation will bring EURIBOR into the scope of regulation.
Regulation on Energy Market Transparency
(REMIT)
Market Abuse Regulation (MAR) and Criminal Sanctions for Market
Abuse (CSMAD)
Prospectus Directive
Undertakings for Collective Investments in Transferrable Securities
Directive (UCITS)
Markets in Financial Instruments Directive II
(MiFID II) Benchmark Regulation
EURIBOR Code of Conduct
ESMA-EBA Principles for Financial Benchmarks
Wider European benchmark regulatory framework
Initiatives with some benchmark component Initiatives exclusively dealing with benchmarks
Key
Principles Legislation
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• IOSCO is the International Organisation of Securities Commission and is a worldwide association of national securities regulatory commissions, such as the SEC (US), the FCA (UK) and about 100 other similar bodies.
• IOSCO develops, implements and promotes adherence to internationally recognised and consistent standards of regulation, oversight and enforcement. However it is not a regulator in its own right and does not have the power to enforce or fine.
• It issued its “Principles for Financial Benchmarks” in July 2013. The Principles stated that administrators should publically explain the extent of their compliance within a year.
• In February 2015 IOSCO issued a report on how the market had reacted to its July 2014 deadline. It concluded that Administrators had used both internal and external auditors, with over a fifth stating that they made use of external accountants or law firms. The use of third parties varied; some Administrators reported that their auditors have stated they are in full compliance, whereas others offered assurance that the published statements of compliance are fairly stated.
• The reviewing Task Force concluded that further steps may need to be taken by IOSCO, but concedes that it is too early to say what those steps should be.
Who is IOSCO and what are their Principles………?
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Regulatory environment: International
• At the international level, IOSCO has focused on taking steps to improve standards for administering and submitting to existing benchmarks.
• The FSB has focused its attention on devising recommendations for changing the construction and use of benchmarks.
IOSCO Principles for Oil Price Reporting Agencies
(2012)
IOSCO Principles for Financial Benchmarks
(2013)
FSB Interest Rate benchmark
recommendations (July 2014)
FSB Foreign Exchange recommendations (September 2014)
Statement on application (September 2014)
Statement on application (February 2015)
IBOR administrators must work to create ‘IBOR+’
Supervisors must work to create and promote risk
free rates ‘RFRs)
WM must implement changes to the way the WMR rate is calculated
Market participants must implement changes around
conduct
International benchmark regulatory framework
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Section 3
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Industry reform
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Industry reform
• From Barclays CFTC settlement through to EU regulation
• Benchmarks v2.0
• The IOSCO/ESMA challenge
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Section 4
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Deustche Bank experience
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Deutsche Bank’s experience
• The philosophy
• Importance of benchmarks
• Dedicated teams across 1st, 2nd and 3rd lines of defence
• Scope drift: benchmarks, indices and beyond
• Generals and proportionality
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Section 5
Industry response
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Definition and number of benchmarks
Key Majority of Industry currently lie within this spectrum Future Bank
No recognised definition of a
benchmark
Bespoke definition that does not reference IOSCO
or ESMA
Broad definition based upon IOSCO definition. No attempt to provide a
business specific interpretation (e.g. type of benchmark, role of the
institution, application of proportionality)
Broad definition based upon ESMA definition. No attempt to
provide a business specific interpretation (e.g. type of
benchmark, role of the institution, application of proportionality)
Definition encompassing IOSCO and ESMA definitions, with specific
interpretation capturing a range of submission types, roles and
application of proportionality
General Precise Bespoke
• Most institutions based their definitions of a benchmark on the IOSCO definition, with limited or no attempt to provide a more detailed interpretation
• Organisations have interpreted the IOSCO definition inconsistently. This has resulted in variation across organisations regarding their inventory of recognised benchmarks. Some organisations for example do not recognise more ‘passive’ submissions as benchmarks. Over time, we expect these ‘passive’ submissions to become more widely recognised
• Almost all organisations do not include their role in the benchmark (e.g. submitter to, administrator, calculation agent and user of) in their definition
• The number of benchmarks that organisations acknowledge as participating in varies across the industry, depending on their interpretation of the IOSCO and /or definitions
• Some only recognise LIBOR. Others only recognise IBOR-type benchmarks and TOTEM, with some excluding EONIA and FX fixings from their definition, although this is likely to change over time
• The typical number of benchmarks the organisations we considered participate in is between 14 and 40. One organisation with the broadest definition recognises over 80 benchmarks, including ‘passive’ type submissions
0 80+ 40 20 60
Number of benchmarks recognised Industry Direction of travel
Definition of benchmarks
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As the level of expert judgement and manual intervention decreases, the risk of manipulation shifts from the submission process to market behaviour
• Majority of the benchmarks that have been reviewed are survey based benchmarks
• Even though high risk benchmarks, such as EURIBOR, LIBOR and TIBOR are based on a level of expert judgement, controls frameworks have been extended to reduce risk of manipulation in the submission process
• Some FX or Market based benchmarks are defined as survey, involving expert judgement, although the benchmarks are based on live pricing feeds and no expert judgement
• Organisations are moving towards more automated solutions to reduce or remove reliance on expert judgement
Benchmark based solely on expert
judgement
Fully automated and based solely on transactions
(including passive submissions)
Benchmark based on input data or transactions with
defined calculation methodology
Manual submission based on clearly identified input
data or transactions
Benchmark based solely on transactions but requiring some manual intervention
in process
The sliders below show analysis of the approach to submissions by different benchmark types:
IBOR type benchmarks
Other Survey type benchmarks
Active type benchmarks e.g. EONIA, Polonia
Passive type benchmarks e.g. SONIA, WM Reuters
Considerable variation exists even within benchmark type
Considerable variation exists even within benchmark type
Approach to submission
Key Majority of Industry currently lie within this spectrum Future Bank
Approach to submission
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The Conflict policy of 7 Banks and the Index rule documentation of 3 Index Administrators has been reviewed:
Conflicts of Interest: Reporting & Quality of controls
Quality of conflicts of interest controls
0 1 2 3 4 5 6 7
Does the index rule documentationaddress conflicts fully?
Do index administrators have anindex rule documentation?
Does the benchmark conflict policyreference IBOR and Non-IBOR
benchmarks?
Do they have a separatebenchmark conflict policy?
Do they have a group wide conflictpolicy?
Exists fully
Exists partially
Does not exist
Unknown
• All organisations have a Conflicts of Interest policy at the Group level, however the level of detail included in the policy varies significantly
• Some institutions maintain a high level generic policy whilst others have targeted specific benchmarks and challenged themselves to think about specific conflicts and the controls required to mitigate
• The majority of organisations have more specific Conflict of Interest policies for high risk benchmarks such as LIBOR. There is partial coverage for non-IBOR indices, with no organisations having detailed policies for passive type benchmarks
• ‘Future Bank’ would have a specific ‘Conflicts of Interest’ framework for both IBOR and Non-IBOR benchmarks
• Index administrators typically have less obvious conflicts than banks, however disclose these in index rule documentation. However, the degree of detail captured is varied
No formal process or document to identify and monitor benchmark related conflicts
Basic MI available to identify conflicted parties. Ad hoc action taken to enforce controls, but no clear process or documentation
There is a formal process and document to identify conflicted parties, who is conflicted, how they are conflicted, mitigating
controls, and clear escalation mechanism
IBOR type benchmarks
Other Survey type benchmarks
Active & Passive type benchmarks
Ba
nk
s
Ind
ex
A
dm
inis
tra
tor
s
Conflict of interest reporting
Key Majority of Industry currently lie within this spectrum Future Bank
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Market manipulation: Surveillance controls
The landscape of the market is moving away from siloed, manual monitoring and control toward a highly automated, integrated surveillance and supervision environment
Key Majority of Industry currently lie within this spectrum Future Bank
Quality of MI
Sophistication of infrastructure
Ad-hoc Reporting/
Analysis
Sustainable KPI
Dashboards
Continuous Transaction Monitoring
Predicative Analytics/
Pattern Recognition
Gold Standard
No longer sufficient
Industry Standard
Leading Banks
Ad-hoc/ Non standardised
Reporting
Standardised Manual
Reporting inc. Dashboards and
Analytics
Benchmark Portal with Automated
Feeds & Attestations
Centralised market manipulation surveillance
Front office market manipulation supervision controls
• Whilst the current industry standard for IBOR type benchmark surveillance and control is based around KPI dashboards and manual reporting, the Non-IBOR controls are far less robust
• The market is rapidly moving up the maturity curve towards a ‘big data’/ intelligent analytics based approach, in particular for IBOR and high market reputational risk benchmarks
• These approaches characteristically include:
• Linking data from a range of benchmark control and supervision functions including risk, finance and HR
• Reviewing a large number of data points from a variety of systems
• Intelligent analytics to extract meaningful information from the data
• Benchmark portal where the relevant independent control functions able to review relevant control reports and affirm that they have carried out the required pre-post submission review checks
Non-IBOR benchmarks
IBOR benchmarks
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Administration: Independence, governance and oversight
Market participant J
Key Majority of Industry currently lie within this spectrum
Future Bank
Index administration not separated from trading activities
Level of independence from trading activity
Index administration separated from trading
activity by physical location only
Index administration undertaken by an
independent division within the organisation,
physically/logically separated from trading
activity
Index administration resides in separate
Legal Entity from other business activity,
physically/logically separate from trading
activity
Index administration business outsourced or
divested with governance
mechanisms in place to ensure independence
from trading activities
There is no independent party providing oversight of administration activities
An internal forum exists to provide oversight of
administration activities undertaken, but this is made up primarily of
in-house representatives
An internal forum exists to provide oversight of
administration activities undertaken by the
administrative function. Cross-functional
representation provides some level of independence.
No external or internal audit reviews occur
A designated, empowered
independent function exists to provide oversight of any Administration
activities, including periodic reviews &
internal audit. Administration
activities not subjected to external audit
A designated, empowered
independent function exists to provide oversight of any
administration activities, including
periodic reviews. All activities subject to
external and internal audit
All organisations have separated their administrative activities from the trading business. One organisations sold off their index business in 2009, and another is currently considering selling their index business to a 3rd party. However, organisations that divest this function often continue to develop an in-house index business over time, therefore any risk management benefits can often reduce over time
Some form of independent oversight exists for administration activities undertaken by organisations. The more mature organisations incorporate periodic, unscheduled reviews by the oversight function as well as internal audit reviews over administration activities
Independent oversight and governance
A B C D E F
G
C D F G
A B E
* Specialist index administration businesses have been excluded from this section as they do not undertake any trading activity
Not applicable*
H I J
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Industry attestation to IOSCO standards
Of those organisations releasing a public attestation as to their alignment with the IOSCO principles, the level of detail and extent of stated compliance varies. 3 of the institutions included in our analysis have not released a public statement. Only 2 of the institutions engaged an independent party to support their attestation statement.
Proportionality
• Application of proportionality varies widely and has been applied to satisfy individual interpretations
• Used as rational to exclude specific activities as ‘out of scope’ under IOSCO
Changes to be Implemented
• Upgraded financial methodology and controls
• New third party oversight functions (IOSCO Principle 5 – Internal Oversight)
• Cessation of specific benchmarks where adherence to the principles compliance is unobtainable
Benchmarking Function
• Majority hold separated legal entity /function in order to mitigate potential conflicts of interest
• Customised definitions of a financial benchmark derive the size of the benchmark inventory
External Validation
• Some organisations under greater public/regulatory scrutiny have engaged independent third-parties to support their attestation statement
• However, only 2 organisations from our analysis have sought external validation
Level of detail of Attestation
Addresses Principles in a high level of detail/includes supporting documentation
Addresses Principles with a low level of detail/no supporting documents
Addresses Principles with a moderate level of detail/some supporting documents
Global view
• The largest proportion of attestation statements have come from European domiciled organisations or those global institutions with a significant European presence, where regulatory pressure is currently stronger & the development of regulatory reform more advanced
*Definition: Extent of Compliance
• Extent to which proportionality has been applied
• Extent to which external validation was undertaken (Index function vs. Group)
• Breadth of attestation (e.g. Group wide or administration function only)
• Acknowledgement of level of change to be undertaken
Ex
ten
t o
f C
om
pli
an
ce
*
Fully
None
Key
Size = no. of indices
J
H
E
A
B
C No attestation made
I D
G
F
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Findings from IOSCO’s implementation review (February 2015)
• Compliance - of the 22 Administrators who provided responses or have published public statements, just over a third either state explicitly that they consider themselves to be fully compliant with the Principles or state that they have implemented policies and procedures which are aligned with the Principles and have practices which meet their objectives.
• Progress - almost half of the Administrators who provided information are in the process of either implementing procedures in order to comply with the Principles or are still addressing their compliance.
• Public statements – of the sample, just under half had published public statements or copies of documents or reports which explained their level of compliance. Of these, about a third do not describe in detail how they have implemented the Principles or how they have used proportionality and are very brief, often less than a page long.
• Proportionality - around half of the Administrators reviewed stated they had applied proportionality in their implementation of the Principles. This was most frequently applied to Principle 14 (Submitter Codes of Conduct). The Review found that there was divergence in how the concept of proportionality had been applied.
• Changes to administrators - Around a fifth of the Administrators reviewed were reported to be either currently or recently in the process of transitioning to a new Administrator or winding-down.
• Equity benchmarks - Administrators of equity benchmarks reported the highest levels of compliance, with most having published a statement of compliance.
• Governance - The biggest change was reported in relation to governance arrangements with significant work also performed around benchmark design. Examples of changes to governance included the introduction or strengthening of oversight committees, new or formalised policies and training on conflict of interest management and whistleblowing. Boards were reported to have heightened levels of interest in the benchmark setting process.
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ESMA-EBA Principles – beyond administrators and submitters
Whereas the IOSCO Principles focus on benchmark administrators, the ESMA-EBA Principles set out requirements for a wider range of actors.
Benchmark submitters
Benchmark calculation
agents
Benchmark publishers
Benchmark users
The EU Benchmarks Regulation is likely to include requirements for these groups when it is finalised (including some benchmark users).
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Controls areas over benchmark submitters and administrators
Governance
Effective Senior Management oversight, review and challenge
Training and qualifications
Training on responsibilities, processes, systems and controls
Sufficiently skilled and qualified personnel
Policies and procedures
Clearly documented and approved submission methodology/criteria
Guidelines on expert judgement application
Record keeping
Retention of submissions and supporting electronic and voice
information
Conflicts of interest
Policy on identification and management of conflicts
Segregation of Duties
Staff KPIs and targets
Independent review
∙ Audit and Compliance reviews
Oversight of outsourcing
arrangements
Formal selection criteria
Service level agreements
IT controls
∙ Access and change management
∙ Protection of integrity and confidentiality of data
Business continuity
Arrangements enabling continuity of submission
Data Integrity Checks
Consistency/credibility checks and escalation of errors
Whistleblowing
Whistleblowing and complaints mechanisms and policy
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Section 6
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Your presenters
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Your presenters
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Lisa Kleinman
PwC – Benchmarks & Indices
Adrian Munday
Deutsche Bank – Head of Benchmark & Index Control Group
Thank you
This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the
information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the
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© 2015 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to the UK member firm, and may sometimes refer to the PwC
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