On 8th of September 2022, FCA published a Dear CEO Letter to benchmark administrators, outlining their supervisory priorities for benchmark administrators under the UK Benchmark Regulation (BMR) and applicable FCA Principles and Rules, including the Senior Managers Regime and Conduct Rules. In this blog, we explore the key messages in their supervision strategy, along with the key actions that benchmark administrators should consider in the context of this letter and an increase in regulatory interest in the sector across the globe.
Customer Duty and the role of benchmark administrators in disclosure
Interestingly, the FCA open their letter with reference to their final guidance for a new Consumer Duty. Whilst there is an acceptance that the activities of benchmark administrators are not in scope of the Duty, there is none the less a clear expectation from the FCA that administrators should “support users of their benchmarks in meeting their obligations under the Duty”, in the spirit of the objective that Firms should put their customers’ needs first.
The FCA emphasised the importance of the ability of users to understand how a benchmark is derived and assessed for its representativeness, relevance and appropriateness for its intended use. This is primarily through the publication of benchmark methodologies and statements.
Administrators should consider how they disclose the methodologies and benchmark statements, particularly when they group them together within benchmark families, to help ensure they still appropriately disclose the economic reality of the markets the benchmark intends to measure. As benchmark users are likely to be in scope of the new Consumer Duty rules, administrators should look to ensure that methodologies and benchmark statements are clear and provide the relevant information they may need.
The letter emphasised the concern that due to the subjective nature of ESG factors, and how ESG ratings and data are incorporated into benchmark methodologies, that this gives rise to an increased risk of poor disclosures in ESG benchmark statements. As a developing market with significant growth the regulator has called on administrators to ensure that methodologies and benchmark statements are clear in how ESG factors are incorporated in the benchmark methodology, especially given their subjective nature.
In particular, administrators should ensure they clearly disclose when they use ESG data and ratings, for example as part of the process to determine the constituent elements of the benchmark and that the methodology explains the underlying methodology for the data and ratings used, especially when third parties are used. In our previous blog (click here), we explored the increasing regulatory interest in ESG data and ratings. Given the extent of benchmark development, oversight, and control that was needed historically to support the effective supervision of other benchmark asset classes (e.g. interest rate and FX), we expect that the efforts needed to apply this consistently to ESG benchmarks, will not be an insignificant ask for benchmark administrators.
It’s important to recognise also, that the disclosure around ESG benchmarks has been an area of focus from the European Commission, with the discussion around whether an EU ESG Benchmark Label would be useful to users currently being considered in their recent targeted consultation.
Credit Sensitive Rates (CSRs)
As the market enters the final stages of the transition away from LIBOR to risk-free rates, the FCA reiterated their views around the limited use of credit sensitive rates as some of the same risks around LIBOR are prevalent in CSRs. Administrators wishing to offer CSRs in the UK are expected to engage with the FCA early. Firms should ensure they understand their use of CSRs are ensure they are consistent in its application to regulatory expectations. Whilst this message has been made clear by the FCA in previous statements, its inclusion here marks an underlining of its supervisory expectations, in a public forum.
Data Quality and Operational Resilience
The FCA noted that they have observed, through their data gathering exercises, evidence of poor data quality and controls, and instances where there have been late publication, non-publication or calculated errors.
Firms should look to review and understand whether their current control frameworks are fit for purpose and that their pre and post publication controls can identify errors in a timely manner. Firms should also look to the final rules and guidance for operational resilience (noting the connectivity and overlap of regulatory requirements between these rules, and the requirements of BMR), and ensure they meet the BMR requirements around the management of operational risk, business continuity, disaster recovery plans and contingency planning.
Where firms rely on third parties, for example a calculation agent or providing input data, enhanced due diligence should be performed to ensure the administrator is able to monitor, review and challenge the service and data received as well as be able to adequately supervise these functions where services are outsourced.
The FCA also called out a particular risk around cryptoasset benchmark administration, especially due to unregulated and fragmented nature of the underlying markets. Firms looking to offer such benchmarks are encouraged to engage with the FCA early.
Governance and Oversight
The FCA reiterated their expectations in the assessment of potential and actual conflicts of interest, along with the expectations that the oversight function remains effective in overseeing the administrator’s activities and compliance with the BMR. Conflicts of interest continues to be a significant areas of regulatory interest, from the SEC in their recent request for comment on index providers as we discussed in our previous blog. SMR and Conduct Rules apply to administrators and as such, there is an expectation that these requirements will be implemented effectively. There should be a clear audit trail behind key decisions such a methodology and policy and procedure changes.
The FCA has called on administrators to engage with the Wholesale Data market study, which is expected to launch in November 2022. The study is looking to understand the market for benchmark and indices and whether it is working well for users, especially around cost competition and ensuring improved service quality.
The timing of the letter from the FCA, given the pace of development of ESG and crypto benchmarks, the final push on LIBOR transition, and the development of new regulation (e.g. Consumer Duty) is key, and emphasises the FCA’s view of the importance of the role that benchmark administrators play in financial markets. It is clear that the FCA expects more by way of effective control and oversight by administrators, and as such, the message by the FCA on what firms should do with the letter is very clear and therefore should not be under-estimated.
Firms should undertake an exercise to consider how they have ensured that the concerns raised by the regulator have been addressed (if they apply), and how the regulator’s supervisory strategy is aligned to the oversight of the benchmarks they administer.