ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.
July 2, 2020
There’s been a lot of recent attention on LIBOR and other interbank offered rates, but there are a multitude of other interest rate, credit, FX, equity and commodity benchmarks that are absolutely vital in enabling firms to manage their day-to-day business activities – from hedging risk to converting overseas revenue and repatriating funds. Under the European Union’s Benchmarks Regulation (BMR), however, EU end users, including pension funds, insurance companies, industrial corporations and investors, could suddenly lose access to many of these benchmarks after the end of 2021. We think this needs to change in order to avoid putting EU institutions at a severe competitive disadvantage and leaving them with potentially no alternative means to manage their exposures.
Earlier this week, ISDA, along with the Asia Securities Industry and Financial Markets Association, the Futures Industry Association and the Global Foreign Exchange Division of the Global Financial Markets Association, published a set of recommendations for changes to the BMR that are intended to reduce the potential for disruption and uncertainty for EU firms, while respecting the overarching aims of the regulation. The proposals would ensure the highest standards of governance and transparency apply to benchmarks that pose systemic risk, while enabling EU firms to continue accessing the non-systemic benchmarks they rely on to manage their day-to-day exposures.
According to estimates from the Index Industry Association, there are just under 3 million benchmarks in use globally, the vast majority of which pose no systemic risk. However, the BMR contains a general prohibition on EU supervised entities from using any benchmark that does not specifically qualify under the regulation, whether in new or existing transactions. For benchmarks provided by non-EU administrators (so-called ‘third-country benchmarks’), this means having to having to qualify under one of three routes – equivalence, endorsement or recognition – before December 31, 2021. However, significant flaws in this regime, and the high cost and compliance burden involved, mean we are concerned many third-country benchmark administrators will be either unable or unwilling to qualify their benchmarks for use in the EU.
This could result in an unknown number of third-country benchmarks becoming unavailable, even though some may be widely used by end users in the EU to make investments, manage risk or calculate payments. Depending on the number and nature of those affected, prohibiting multiple benchmarks at the same time could result in significant disruption for EU entities. In contrast, investors outside of Europe could continue using these benchmarks, putting EU firms at a significant competitive disadvantage.
Our proposals are aimed at narrowing the scope of the BMR to ensure the focus is squarely on those benchmarks that will have the biggest systemic impact if they fail. To that end, we recommend reversing the general prohibition on use, so the starting assumption is that all benchmarks can be used unless they are explicitly prohibited. A central authority – for example, the European Commission or the European Securities and Markets Authority – would be charged with designating which systemically important EU and third-country benchmarks are in scope, based on pre-defined qualitative criteria. Non-significant EU and third-country benchmarks, regulated data benchmarks and public utility benchmarks (for example, FX rates used in non-deliverable forwards) would be exempt from mandatory compliance.
Nonetheless, administrators of non-designated EU and third-country benchmarks would be able to opt into the rules, enabling them to be labelled BMR compliant – acting as an incentive for administrators to meet EU standards on governance and transparency.
But what happens if a designated benchmark fails to qualify or, having qualified, is subsequently disqualified? Under current rules, investors could be left in limbo, unable to properly manage, value, margin, capitalize or reduce their exposures. Under our proposals, firms wouldn’t be able to put on net new exposure, but could continue to use a benchmark for certain, limited purposes, regardless of whether that involves entering into new transactions. For example, the benchmark could continue to be used to manage and reduce existing exposures by novating positions to a third party or entering into an offsetting trade to close out a position on a net basis.
The BMR was established to meet an important objective – to avoid disruption and to protect EU investors from badly run or failing benchmarks. We believe the recommended changes will help achieve that objective. The end result will be a proportionate regime that provides a robust safeguard against the failure of systemically important benchmarks, while creating a level playing field for EU investors.