Benchmark Regulation: ESMA settles transitional provisions and other key terms

On 10 November 2016, ESMA published its much-anticipated final report on the technical advice (Technical Advice) requested by the European Commission under the EU regulation on indices used as benchmarks in financial instruments and financial contracts (Benchmark Regulation). The Technical Advice follows ESMA's February 2016 discussion paper (DP) and its May 2016 consultation paper (CP), which included a draft version of ESMA's proposed advice (see our briefing).

Published or made available to the public

Under the Benchmark Regulation, a "benchmark" must be an "index" and an "index", in turn, is (amongst other things) "any figure (i) that is published or made available to the public…". In its earlier CP, ESMA proposed taking an extremely broad view of the meaning of this phrase, citing, by way of justification, Recital 8 of the Benchmark Regulation that "the scope of [the Benchmark Regulation] should be as broad as necessary to create a preventative regulatory framework". In particular, ESMA had proposed in its CP that, for an index to be considered to be "made available to the public", it must be "accessible by a large or potentially indeterminate number of recipients" (or accessible via its use by a supervised entity).

In its final Technical Advice, ESMA has proposed that the meaning of the phrase be broader still, in that it has removed the requirement for the index to be made available to a "large" number of people, retaining only the "indeterminate number" requirement.

Therefore, even a figure made available to a very limited number of people only will be "made available to the public" so long as the figure is accessible to an open group of recipients (though presumably the converse is also true). Thus, for example, ESMA rejected a request to specifically carve out indices that are made available only to investors in a specific financial instrument, given its view that "investors typically trade their financial instrument and the group of holders will change over time" and therefore is "indeterminate".

Another controversial view ESMA took in its earlier CP was that the incorporation of an index value into published coupons, strike prices, differentials, and values of financial instruments and investment funds referencing it had the effect of making the index value available to the public on the basis that investors could derive the index value from such published information. Following pushback from several respondents to the CP, ESMA acknowledged that it will not always be possible to derive an index value in such manner. This acknowledgement from ESMA is helpful since it clarifies that, for example, the provision of bid/offer prices should not be caught, as it is unlikely that an investor could isolate the index value from such price. However, ESMA has made it clear that, where it is possible to derive the index value from coupons, strike prices, differentials, and values of financial instruments and investment funds referencing it, this will constitute the value being "made available to the public". To clarify its view slightly, ESMA has amended the original advice to refer to the accessibility of an index value - as a figure - through its use as a benchmark being a factor that determines its being "made available to the public".

In keeping with its expansive approach in the name of investor protection, ESMA further confirmed its views that:

• a figure can be made available to the public when (i) it is used as a reference index by a regulated firm and (ii) it can be extrapolated from another (public) figure related thereto;
• whether or not a fee is payable by the person(s) receiving the information is irrelevant; and
• similarly, the administrator's awareness (or otherwise) of the accessibility of the figure is irrelevant - "availability" of the figure is independent of the administrator's knowledge and administrators are advised to rely, where necessary, on the defence contained in Article 2(2)(h) of the Benchmark Regulation, which exempts from compliance any index provider which is not aware and which could not reasonably have been aware that one of its indices was within scope as a result of its onward use (absent any relevant non-disclosure agreement or similar).

However, ESMA has agreed that figures which are only accessible by a group of employees or contractors of the firm, which have been calculated by that firm, and which are not used as a reference index in a traded financial instrument, will not be caught.

Administering the arrangements for determining a benchmark

Given the variety of models employed in the provision of benchmarks, ESMA has been mandated to provide advice on what constitutes "administering the arrangements for determining a benchmark", one of three elements that constitute the "provision of a benchmark". An administrator - a natural or legal person that has control over the provision of a benchmark - may outsource aspects of the provision of the benchmark, although such outsourcing often does not reduce their responsibilities. The key element is whether or not the administrator has control over the whole provision process. In its earlier CP, ESMA proposed that "administering the benchmark" refers to the ongoing management of infrastructure and personnel and setting and maintaining a specific methodology. This is in line with the IOSCO Principles on the provision of benchmarks.

Outsourcing any of the three elements of the process of providing a benchmark to third parties is permitted, and this would not impact the identity of the administrator in ESMA's view.

ESMA has not been mandated to advise on whether or not there can be more than one administrator, but it does make the comment in its Technical Advice that there will only be one natural or legal person that can exercise control over the whole provision process in most cases.

ESMA further underlines that it is the maintenance of the methodology, and not (or not only) the initial setting of the methodology which is the essential element. However, having ongoing control over the maintenance of the methodology does not equate to having control over the provision of the benchmark more generally, which ESMA believes requires control of a higher level. ESMA believes that "administering the arrangements" includes setting the methodology and adapting this to ensure it is fit for purpose on a continuous basis, as well as its ongoing maintenance where such adaptation is not required.

Issuance of a financial instrument

ESMA had been asked to specify what is meant by "issuance of a financial instrument which references an index or combination of indices", one of the five modalities set out in the definition of "use of a benchmark". ESMA has concluded that OTC derivatives do not fall within the scope of "issuance of a financial instrument". However, ESMA re-affirmed its view that OTC derivatives are caught under a different modality - the "determination of the amount payable under a financial instrument or contract by referencing an index or combination of indices". ESMA's final advice states that the issuance of a financial instrument means the creation of transferable securities, money market instruments or units in collective investment undertakings, to be sold to potential investors by way of a public offer or placement or by way of admission to trading on a regulated market, MTF, OTF or a systematic internaliser.

ESMA helpfully makes it clear that, as article 29(1) of the Benchmark Regulation refers to use of benchmarks in the EU, issuing a financial instrument on a third country venue would be outside the scope of the restriction.

Critical benchmark measurement

The Benchmark Regulation differentiates between different types of benchmarks - one category being "critical" benchmarks. Under Article 20 of the Benchmark Regulation, there are quantitative thresholds provided in order to ascertain whether a benchmark is deemed "critical". ESMA was mandated to advise on measurement of the nominal amount of financial instruments, derivatives and funds for the purpose of determining whether the applicable threshold has been reached.

The advice in this area is fairly technical. To highlight a few significant changes from its earlier CP:

• structured finance products other than derivatives are now included in the measurement of the nominal amount of financial instruments other than derivatives. ESMA acknowledges that this is a consequence of the discussions on the nature of structured finance products that are currently ongoing; and
• in relation to derivatives, ESMA is considering widening the regime for publicly available trade repositories data under EMIR - this may be proposed in a future consultation on second level measures for EMIR. ESMA also acknowledges that, for derivatives, the settlement price may be unknown, and ESMA has therefore amended its advice so that the end of day price of the underlying at the effective date of the contract may be used instead.

In addition to satisfying certain quantitative criteria, for a benchmark to be considered critical it should have no or very few appropriate market-led substitutes. Another factor is whether it would have a significant or adverse effect on market integrity, financial stability, consumers, the real economy or the financing of households and corporations in one or more Member States if the input data of the benchmark was unreliable or not fully representative of the intended market or economy. ESMA has broadly maintained its position from its earlier CP on this requirement - including the use of "significant share of" terminology - without further elaboration. ESMA refers to this as the "relevant impact approach". ESMA stresses that the criteria must apply to a diverse range of economies in different Member States and that national authorities must have some flexibility in assessing whether a benchmark is critical.

Endorsement

Under the Benchmark Regulation's endorsement regime, an EU administrator may apply to the relevant national authority for permission to endorse a benchmark or a family of benchmarks provided in a third (i.e. non-EU) country for use in the EU, provided that several conditions are met. One condition is that "there is an objective reason to provide the benchmark or family of benchmarks in a third country and for said benchmark or family of benchmarks to be endorsed for their use in the Union."

In considering measures to determine the conditions under which national authorities may assess whether there is an objective reason for endorsement, ESMA sets out a list of non-exhaustive criteria which the authority should take into account. Broadly, these criteria are not very different from that proposed in its earlier CP. However, acknowledging that new third country benchmarks would otherwise struggle to obtain endorsement, ESMA has introduced an additional indicator for a reason for use of a third country benchmark in the EU: that the benchmark is likely to be used to a material extent in the EU, or there are no market-led substitutes in the EU.

However, it remains difficult to see how the endorsement regime will attract much interest given its legal and practical issues (see our briefing), and market participants will continue to have concerns around the effectiveness of this (and other) treatment of third country provisions in the Benchmark Regulation.

Transitional provisions

Interpretation of "existing" benchmarks

A controversial element of ESMA's earlier CP was its proposed interpretation of the phrase "existing benchmarks" in the transitional provisions of the Benchmark Regulation. ESMA had proposed that "existing benchmarks" be interpreted to refer to benchmarks in existence as at the date of entry into force of the Benchmark Regulation (i.e. 30 June 2016). This meant that certain transitional provisions, namely a compliance grace period and a "force majeure" type exemption for EU benchmarks, were only available for EU benchmarks existing as at 30 June 2016 – with no provision made for those launched between 30 June 2016 and 1 January 2018 – the date of application of the Benchmark Regulation ¹.

Following industry responses alarmed at this 18 month gap in the transitional provisions, ESMA has re-interpreted "existing benchmarks" to in fact refer to benchmarks referenced in financial contracts or instruments or used to measure the performance of investment funds on 1 January 2018. ESMA notes, however, that this is more properly a matter for the European Court of Justice, and its Technical Advice no longer refers to the point.

Relying on ESMA's revised interpretation of "existing benchmark", the transitional provisions provided for in Article 51 of the Benchmark Regulation will apply to all benchmarks which are in existence on the application date of 1 January 2018. Therefore, in relation to a benchmark which exists on 1 January 2018, users may continue to use such benchmark (i) until 1 January 2020 or, where the index provider submits an application for authorisation or registration, unless and until such authorisation or registration is refused, or (ii) where the relevant national authority has agreed that ceasing or changing the benchmark to fulfil the requirements of the Benchmark Regulation would result in a force majeure event, frustrate or otherwise breach the terms of any financial contract or financial instrument or the rules of any investment fund which references that benchmark, until such time as is agreed by that authority (see "Force majeure determination" below).

However, ESMA refrained from extending the definition of "existing benchmark" to any benchmark of an administrator with a pending authorisation or registration application. This means that no new benchmarks can be created after 1 January 2018 by an administrator until it has been authorised or registered.

Force majeure determination

The Benchmark Regulation allows national regulators to permit continued use of an existing (see Interpretation of "existing" benchmarks above) non-compliant benchmark if ceasing or changing the benchmark to conform with the Benchmark Regulation would result in a force majeure event, frustrate or otherwise breach the terms of the financial contract or instrument referencing it. ESMA was asked to provide advice on the conditions that national regulators should take into account in making such determination.

ESMA's Technical Advice sets out a non-exhaustive list of criteria to be considered, being:

• whether the changes to input data or methodology of a non-compliant benchmark required to make it compliant would lead to a substantially different value, which in turn would lead to a higher risk of breach or frustration of the terms of the contract or instrument. ESMA suggests that the non-compliant benchmark data could be compared to the value from compliant data over a period of time;
• whether changes to the input data or methodology would undermine the "index representativeness of the underlying market or economic reality";
• the availability of a substitute benchmark measuring the same market and economic reality;
• whether the non-compliant benchmark already includes a reference to a possible substitute benchmark; and
• whether transitioning to another administrator would substantially change the benchmark.

It remains to be seen how these criteria will be applied by competent authorities in relation to financial instruments issued under structured product programmes that include provisions adapted from ISDA definitions relating to index modification, index cancellation and change in law.
Helpfully, ESMA has deleted its original proposal that any such grandfathering order by a national authority be subject to a cut-off date. ESMA was swayed by the arguments that the text of the Benchmark Regulation does not specify a time period and the transitional provisions could therefore potentially apply until such time as no financial contract or instrument is linked to that benchmark.

In the comments to the Technical Advice, ESMA rejected a proposal that it should be a force majeure event where (in the absence of an equivalence decision or endorsement by an EU-based entity) a non-EU administrator does not apply for recognition, citing the specific non-EU transitional provisions that may be relied upon as the reason for its decision.

Finally, ESMA has introduced a provision to the effect that national regulators should publish their decisions relating to non-compliant benchmarks so that users can rely on this key information when selecting a benchmark for use in compliance with the Benchmark Regulation. However, ESMA warns that the publication of a list of non-compliant benchmarks by regulators carries the risk of being incomplete and might lead to legal uncertainty, since only known non-compliant benchmarks will be included.

^{1 Save for "critical" benchmarks (solely EURIBOR as at the publication date of this briefing), in respect of which the Benchmark Regulation applies from the date of its entry into force - 30 June 2016.}