The EU Benchmarks Regulation (“BMR”) went live on 1 January 2018, forming part of the EU’s response to concerns over the reliability and integrity of financial benchmarks. BMR provides a harmonised framework to ensure clients investing in these regulated products are protected from the risk of benchmark manipulation. The majority of focus to date has been on the administrators of benchmarks largely because of the steps required to evidence compliance. The UK is leading the way in registration and authorisation as shown by ESMAs published register.The impact on asset managers has received less attention, most likely due to MiFID II taking the front seat for 2018 implementation. The scope of BMR clearly captures a significant portion of the EU’s asset management industry as described further below. Swiss Asset managers managing financial products that reference indices and are registered for distribution with the EEA may be considered benchmark users too. Managers and their regulated fund products, such as AIFs and UCITS, regularly use benchmarks, and to a lesser extent may also be the administrators of and/or contributors to benchmarks. Further, we have seen global asset managers utilising the third country administrator route allowable within the regime as the set-up for their benchmarking business. Here, we examine what constitutes a benchmark, how to determine if you are a user and the associated key considerations. Although far less common within the asset management industry, we have also touched on the requirements for firms that contribute to and/or administer benchmarks based in and outside of the EU.
Who and what is in scope of BMR?
BMR applies to supervised entities that are either administrators, contributors or users of financial benchmarks.
Regulated managers and fund products using benchmarks within the scope of BMR are ‘supervised entities’, which is defined in Article 3(1)(17) as MiFID II investment firms, AIFMs, UCITS and UCITS Management Companies amongst other industries.
A definition of a benchmark within scope of BMR differs from that set out by IOSCO and is broadly defined as any index that is used in financial instruments, financial contracts or used to measure the performance of an investment fund.
From these definitions it is clear the vast majority of the asset management industry will be impacted by BMR, the extent of which should be assessed on a case by case basis.
Are you a User?
An index, as defined by Article 3(1)(1), becomes a benchmark under BMR when, amongst other uses, it is used to measure the performance of an investment fund for the purpose of:
- computing the performance fees;
- tracking the return; or
- defining the asset allocation of a portfolio.
It is commonplace for investment funds1 to use well known indices for the purpose of computing performance fees, for example outperformance of LIBOR plus a defined spread. Interpreting further uses that fall within scope of BMR has been challenging for asset management firms, however ESMA have provided some further guidance as discussed below.
Tracking the return
An example guided by ESMA, is an index tracker fund, where an investment fund has a strategy to replicate or track the performance of an existing index or indices. This could be through synthetic or physical replication of the target indices.
Firms that have investment funds that provide investors with pay-offs that are linked to the performance of indices are also captured by BMR.
Defining the asset allocation of a portfolio
Where an index is used to measure the performance of an investment fund with the purpose of asset allocation within a specified portfolio, this is considered to be a benchmark and consequently the investment fund is defined as a user falling in to scope of BMR. Practically, this should be clearly set out in the investment policy of the investment fund and should “define constraints on asset allocation of the portfolio in relation to an index.” 2 These investment funds may also be actively managed where the manager has discretion over the allocation of assets within.
Note, where the associated investment documentation simply refers to an index for the sole purpose of comparison to performance with no bearing on asset allocation, ESMA have confirmed they do not consider this to be a benchmark within BMR.
Key BMR requirements for users
As of 1 January 2018, BMR has directly impacted how and which benchmarks are used by supervised entities. The three key requirements being:
- Choice of benchmark– Supervised entities are only able to use benchmarks provided by a BMR registered and/or authorised benchmark administrator. Benchmarks which are provided from outside of the EU are also captured by BMR and must be registered, ESMA currently maintain registers of these. There are transitional provisions for registration/authorisation up until 1 January 2020.
- “Robust written plans” - Supervised entities that use a benchmark need to produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided. These will nominate and provide rationales for suitable alternative benchmarks where feasible and appropriate. Not only must the plans be reflected in contractual relationships with clients, these can also be requested by the FCA, or the relevant EU National Competent Authority.
- Fund literature– Where benchmarks are used, UCITS prospectuses need to include clear and prominent information stating whether the benchmark is provided by an administrator on the register. Prospectuses approved prior to 1 January 2018 need to include this information within the next prospectus update or by 1 January 2019, whichever is sooner. ESMA has recently provided further clarity that where a benchmark administrator is not yet on the register, this fact should be referenced within. Subsequently, once the administrator is registered, the prospectus should be updated to reflect this.
Administrators & Contributors
Whilst we understand that the majority of the asset management industry will be impacted by the requirements set out for users of benchmarks, there will also be a subset of the industry that falls within the scope of benchmarking administrators and/or contributors. Administrators have control over the provision of a benchmark as defined in Article 3(1)(5) and involve the use of input data. Firms providing any input data that is required for the determination of a benchmark that is not readily available to an administrator, or to another person for the purposes of passing on to an administrator is defined as a contributor. Administrators and contributors must implement a number of governance and oversight requirements, depending on the type and criticality of the benchmark under BMR, a significant project to undertake both internally and with other firms providing or using the information. It is important to note that benchmarks dependent on investment fund NAVs input data are considered ‘regulated-data benchmarks’. BMR places less onerous requirements on asset management contributors of this regulated input data.
Third country administrators
A benchmark administrator that is based outside of the EU that provides benchmarks or indices used within the EU by a supervised entity3 will be subject to the third country regime requirements of EU BMR and accordingly will be defined as a third country administrator. For such benchmarks to continue to be used in the EU after 1 January 2020, the third country administrator must comply with the requirements of EU BMR, subject to the transitional requirements detailed in a previous .
Once firms have deliberated whether they wish to continue to provide third party benchmarks within the EU, they must then consider the most appropriate route to full compliance. There are three options available to third party administrator; Equivalence, Recognition and Endorsement. Firms must choose the most suitable option based on factors such as the number of benchmarks in scope and their complexity.
With the transitional period underway and running until 2020, the registers are gradually being populated and transition plans should be in place. Asset managers should have already performed or be in the process of the following:
- A thorough review of benchmark usage to understand current use;
- Create an inventory of benchmarks and put in place appropriate controls to ensure its ongoing accuracy and completeness;
- Engaging with benchmark administrators to understand their plans and whether they will be in compliance with the regulation by 2020; and
- Write robust written plans on the policy and procedures when there is a material change or cessation of a benchmark used. These policies should include alternative benchmarks where possible.
Whilst the majority of asset managers will be users, all participants should have processes in place to identify the contribution and the administration of input data. The FCA can request evidence of compliance and under Article 42 of BMR can impose administrative sanctions and enforce fines.
This blog was first written by the UK Deloitte Benchmarks team.
1Defined as an AIF or a UCITS as per Article 3(1)(19)
2A5.4 within ESMA Q&A
3Supervised entity as defined under the EU BMR, Article 3 (17)