Now that the Wheatley report has recommended a reform, rather than the scrapping of Libor it seems that everyone is getting into the review and regulation of benchmarks game.
The recent financial scandal, Libor fixing, has led to a familiar result – a review of the system and possible increased regulation. Yet Martin Wheatley’s review of Libor is just the tip of the iceberg and now broader financial benchmarks are coming under regulatory scrutiny, including those used for securities. This potentially could leave fund managers and advisers scratching their heads over finding a comparative tool for relative performance; it could also have significant implications for funds and investment products.
Wheatley’s review into Libor ended with his autumn report calling for reform of Libor, reorganising its governance with the regulator at the heart of the process. As a well-established global benchmark, the conclusion of reform as opposed to scrapping the benchmark altogether has been a welcome one.
A reformed Libor should give the regulator a central role and create a more robust and transparent governance structure, according to the IMA. However, the trade association says Wheatley’s suggested changes to long-standing criminal offences will need to be carefully reviewed for unintended impacts.
Guy Sears, IMA director of wholesal,e said: “We do not support a rush to alterations to criminal offences without more work on potential impacts. Current powers, including fines and the ability to ban individuals from working in the industry, should in the short term be significant deterrents.”
For the funds industry the impact of the proposed Libor changes are not that clear. There are numerous financial instruments that use contracts or instruments that are linked to Libor.
According to the Wheatley report, the estimated value of such contracts in the public domain range from $300trn to $800trn. Among these are derivative contracts in the form of interest rate swaps, which some funds may use to hedge out interest rate risks. In addition, Libor is used by many retail funds, particularly absolute return products, as a performance target. However, as this is merely a language issue it may have no material impact on such a fund’s underlying assets or returns.
Sears says going forward the market will form a proxy for Libor and its use will be replaced in a number of areas so its current dominance will likely be cut back.
More concerning to the IMA and fund providers is the expansion of the Libor review into other areas. It would seem as if everyone is getting into the review and regulation of benchmarks game.
The Bank for International Settlements is taking forward Wheatley’s Libor recommendations but is also considering issues regarding “other important financial benchmarks.” The European Commission issued a discussion paper in September seeking consultation on Libor but also needed changes for wider indices. Among the areas the EC is looking at are: the governance and transparency of benchmarks, their uses and whether or not this should be controlled, as well as the organisations that produce them.
The International Organisation of Securities Commission has a dedicated task force looking into identifying benchmark related issues across securities and derivatives sectors. IOSCO aims to define the types of benchmarks relevant to financial markets and propose how these should be scrutinised and overseen.
With so many bodies assessing the same area, Wheatley’s report has recommended the FSA also review important benchmarks, coordinating with internationally decided standards.
“Whenever the legislation process starts, the question becomes – is its scope clear? When the AIFMD was started with the aim of covering hedge funds, the risk became how to define a hedge fund and the directive has ended up encompassing far more product types than was originally envisioned,” Sears noted. “Reviewing benchmarks and its uses and having legislation in this area is fine but where will it end and how will the boundaries be defined?”
For the funds industry benchmarks are mostly synonymous with market indices but can be broader. In many cases portfolios, in particular pension funds, make use of hybrid or bespoke benchmarks, created in part by an amalgamation of different indices.
Toby Hogbin, head of marketing and product development at Marin Currie, says: “If you start to scratch the surface of the importance of benchmarks, it becomes intriguing.”
Its two main uses with regards to retail funds are benchmark-constrained portfolios and those managed on an index agnostic basis but where the performance is measured against a benchmark. However, there are cases where a benchmark or proxy index can impact a fund’s valuation such as when used as part of a fair valuation process, for example, using change in the price of an index future to determine whether fair valuation should be applied, Hogbin explains.
Another common use of benchmarks, or indices, within retail investment products are funds that aim for replication. If proposed legislation ends up affecting the constituency or weightings within an index, it could also mean ETFs and trackers, depending on their level of replication, would have to adjust accordingly.
While Sears says there is less concern as to how these reviews may affect the large providers, such as FTSE and MSCI, for mainstream, liquid indices, there is worry over bespoke benchmarks. Hogbin also points out such reviews could target more esoteric indices or benchmarks where there are fewer common rules for construction and that are perhaps not that transparent.
This in turn could affect funds or products built around such benchmarks and increased regulation could end up changing “what investors are likely to get by a material degree,” Hogbin notes. “The more investors move away from the anodyne, the more aware they have to be. The more atypical indices or those constructed from unusual investment groupings, such as hedge funds, the greater the need to explore its construction and the greater the potential for increased regulation to have an impact.”
As with anything the increase in regulation in this area also has potential cost implications. If greater standards and obligations are imposed on index providers or on the delivery of benchmark information, then there may be an increased risk to their provision. “What would the index providers then charge for that?” Hogbin asks. “There will be cost implications that have to be met and inevitably with such things, it will hit the consumer.”