ISDA & EDHEC Respond to Benchmarks Paper

The European Securities and Markets Authority and the European Banking Authority have together provided the world with their views on benchmark-setting procedures. The ESMA/EBA document sets out a basic definition of benchmarking, also acknowledging that “benchmark administration, calculation, and publication activities may be performed by distinct legal entities.”  It then expounds principles – best practices for now, hints for regulators later, – with regard to such activities, starting with the notion that “actual market transactions should, as a matter of preference, be used as a basis for a benchmark, where appropriate.”

The consultation paper says among much else that any firm that contributes to the creation of a benchmark should have a conflicts of interest policy, and offers a list of matters that might be included:

  • Procedures to prevent or control the exchange of information among staff in a position to affect the submitted benchmark data where that exchange might involve conflicts;
  • Rules to avoid collusion;
  • Measures to prevent any individuals from exercising undue influence over the data to be submitted; and
  • The removal of any direct connection between the remuneration of staff members involved in the submissions and that of other staff members engaged in other activities, if a conflict of interest may arise in connection with those other activities.

This consultation paper has produced intriguing responses from, among others, the International Swaps and Derivatives Association and the EDHEC-Risk Institute.

EDHEC and Transparency

EDHEC agrees with ESMA/EBA on much. It agrees for example that “methodologies for the calculation of a benchmark should be documented, scrutinized, and controlled for reliability.” The documentation is in the first instance it says the responsibility of the benchmark administrator, though it contends that “scrutiny and control should be publicly exercisable by (would-be) benchmark users and other stakeholders.”

[Analogously, the EC recently issued a consultation document of its own on the production and use of indices that suggested that a benchmark should begin with a “clear and transparent specification of what the benchmark measures, how its accuracy can be evaluated, what its shortcomings are and what it should and should not be used for.”]

But EDHEC’s concern is that regulators might end up trading lower levels of transparency in order to get stricter anti-conflict standards. The stricter standards might create a false sense of confidence. Transparency, not governance-oriented rules, is the right path to take.

With regard to the possible conflicts of interest that participants face, EDHEC considers that ESMA/EBA has only scratched the surface.

Beneath-the-Surface Conflicts

It reviews some conflicts to which it believes the consultation paper had not paid enough heed: changes in constituents of an index, or their weightings, have possible price impact and as such they are valuable privately held information, raising the danger of insider trading on the basis of such information.

When an index provider is under the same institutional roof as a prop desk or manager of portfolios, that creates the possibility of front-running at the expense of the index-provision clients.

Relatedly: an entity that provides research or advice services to clients as a separate profit center under the same roof as the benchmarking “it could also be tempted to make clients privy to the index changes.”

Or, the index methodology itself might be compromised by conflicts of interest.  In this connection, EDHEC references the inclusion of Solvay, the Belgian chemical company, in two distinct indexes sponsored by NYSE Euronext. Solvay has a large footprint in France, and it is now in the indices both for Paris based and for Brussels based blue chips. This illustrates that some index providers allow their committees a lot of discretion in the national classifications that are part of index creation, the non-systematic leeway this creates in benchmarking, and the concerns that can create about conflicts.

ISDA on the Definitional Question

ISDA’s response raises issues about the ESMA/EBA definition of benchmarks. The CP defined benchmarks to include “any commercial indices” and ISDA thinks this too broad. Such a definition might result in future regulations that are “impractical, costly and potentially disproportionate to” the market significance of some of the private indices.

“Some of our members publish thousands of indices and a protocol that may have been drafted from the perspective of survey based public indices may not be appropriate for all benchmarks.”  Some of these private indexes are used solely for the pricing of customized bilateral transactions, and it would be appropriate to exclude them from the sort of rules or principles ESMA/EBA propounds in the CP.

ISDA supports the use of actual trade data in the computation of benchmarks where appropriate, but it makes two important qualifications: first, that algorithms and human judgments will continue to fill in where the trade data leaves gaps; second, that even where trade data is available, expert judgment has a role.

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