RegulationJan 9 2013

Leave no stone unturned in effort to reform Libor

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To its credit, the UK government wasted little time responding to the recommendations of the Wheatley Review.

In late November, the Treasury published a consultation paper outlining the legislative amendments necessary to implement the Wheatley Review in three key areas. First, making the setting and administration of Libor regulated activities; second, introducing criminal sanctioning powers for misconduct in relation to benchmarks to allow the regulator to investigate and prosecute such behaviour; and third, making it possible for the government to bring additional benchmarks within the scope of regulation, although only Libor is presently in scope.

The current absence of regulatory oversight over the setting and administration of Libor, and lack of enforcement powers, have undermined investor confidence and public trust. Legislative measures to close these gaps are therefore welcome and should help repair the credibility of Libor. For example, in a recent survey of investment professionals, 82 per cent of respondents supported giving regulators the powers to pursue criminal sanctions over instances of Libor manipulation.

Formal regulatory oversight, particularly with criminal sanctioning powers for the Financial Conduct Authority (which replaces the FSA in 2013), should provide a more credible deterrent to market abuse and will help to strengthen investor and consumer protection.These measures will also be complemented at the European level, where the European Parliament has been updating the EU’s market abuse legislation to define manipulation (actual or attempted) of benchmarks explicitly as a form of market abuse.

The third aspect of the Treasury’s paper – the possibility for bringing other benchmarks within the scope of regulation – dovetails with another initiative at the European level that examines the regulation of indices serving as benchmarks in financial contracts more generally. That initiative is currently under consideration following the recent completion of a public consultation exercise launched by the European Commission, which examined the purpose, production, and use of financial benchmarks generally, in addition to governance and transparency considerations associated with benchmarks. Although it is too early to tell whether the European Commission’s initiative will lead to a new directive or other legislative action, the UK government’s approach is prudent by allowing sufficient flexibility in UK legislation to widen the scope of regulation to other benchmarks if necessary.

Another international initiative that could affect the UK’s legislative and regulatory framework is the International Organization of Securities Commissions’ task force on financial market benchmarks. That task force, co-chaired by Martin Wheatley of the FSA and Gary Gensler of the US Commodity Futures Trading Commission, is developing global policy guidance and principles for benchmark-related activities, and will soon launch a public consultation on its proposals. Given the widespread adoption of Libor internationally, a global framework of key principles or best practices for internationally used benchmarks should help engender sound governance and oversight in all jurisdictions. On top of this initiative, the Bank for International Settlements, under the coordination of the Financial Stability Board, has agreed to set-up a group of senior officials to examine reference rates used in financial markets.

This flurry of regulatory initiatives at the European and global levels highlights both the zeal for reform and the desirability of achieving some level of international co-ordination. These are important steps to ensure that similar benchmarks carry similar standards of governance, transparency and oversight wherever they are used.

Where does all this leave the Wheatley Review? In addition to recommendations for strengthening regulatory oversight and sanctioning powers, and calling for international principles for global benchmarks, the Wheatley Review has called for banks’ Libor submissions to be supported by actual transaction data wherever possible, a new code of conduct over submissions to establish standards over the rate-setting process, and a new administrator who will take over from the British Bankers’ Association. Other measures included limiting the production of Libor to only those currencies and tenors where there is a liquid underlying market and giving the regulator reserve powers to compel banks to participate in the Libor submission process, in order to ensure a sufficiently large panel and reduce the influence of any one bank in the calculation of the benchmark.

Of all these measures, greater transparency over the calculation and production of benchmarks and indices such as Libor, particularly where such indices are based on subjective or judgmental inputs, is a key element to uphold market integrity. Greater transparency underscores market discipline and helps mitigate conflicts of interest. To that end, the recommendation for individual banks’ Libor submissions to be corroborated by actual transaction data is a key step. But where estimates are used (such as where transaction data is not available), it would also be beneficial if the basis of those estimates were also made transparent, in order to provide the necessary market discipline.

Other important measures to ensure the integrity of benchmarks should include robust internal controls, policies, and procedures surrounding the assimilation and contribution of data for the calculation of benchmarks; adequate management reporting and supervision over the provision of inputs; conflicts management policies; and appropriate regulatory oversight.

The government has endorsed each of the recommendations in the Wheatley Review. In addition to the Treasury paper, the FSA published a consultation at the start of December examining how other aspects of the Wheatley Review should be implemented, focusing on the role of benchmark administrators, submissions to benchmarks, and broader participation in Libor such as the potential to require firms to participate. The consultation builds off the premise established by the Wheatley Review that the setting of Libor should remain an industry-led activity, but the submission to, and administration of, the rate should be regulated.

The frenzy of initiatives by international policymakers and regulators to reform Libor and potentially other benchmarks are encouraging, if belated. Allied to a greater emphasis among financial institutions on ethical practices and a renewed focus on putting clients interests’ first, it is hoped that these measures can help begin the long process of rebuilding confidence and integrity in our capital markets. Public trust depends on their success.

Rhodri Preece is a director of Capital Markets Policy for the CFA Institute

Key Facts

Late last year the Treasury published a consultation paper outlining the legislative amendments necessary to implement the Wheatley Review.

Formal regulatory oversight, particularly with criminal sanctioning powers for the Financial Conduct Authority should provide a more credible deterrent to market abuse and will help to strengthen investor and consumer protection.

The government has endorsed each of the recommendations in the Wheatley Review.

Treasury Libor paperWhy was the Wheatley Review launched?To stop rogue tradingTo deal with insider dealingTo address manipulation of the Libor market3What has undermined investor confidence in Libor?It was set by the banking trade associationThe absence of regulatory oversight over the setting and administration of Libor, and lack of enforcement powers,The setting of it was opaque2Which other institution is looking at regulating benchmarks?The ECThe SECThe CVM1What will create greater market integrity?Greater transparency over the calculation and production of benchmarks Reform of the banks’ bonus systemRigourous enforcement of internal Chinese Walls1“Adequate management reporting and supervision over the provision of inputs” will also help, true or false?TrueFalse1When did the FSA publish its consultation?NovemberDecemberJanuary2