The draft EU Regulation on indices used as benchmarks in financial instruments and financial contracts (the Benchmark Regulation) is in the final stages of the legislative process. This draft regulation contains new outsourcing requirements which expand the regulatory framework for outsourced services to include the outsourcing of benchmark indices.
In this specialist context, a benchmark is a financial instrument that provides a point of reference for evaluating a fund’s performance, and is defined in the Benchmark Regulation as ‘an index, by reference to which the amount payable under a financial instrument or financial contract, or the value of a financial instrument is determined or an index that is used to measure the performance of an investment fund with the purposes to track the return of such index or to define the asset allocation of a portfolio or to compute the performance fees’.
Since the implementation of the Markets and Financial Instruments Directive (MiFID) in November 2007, under which regulated entities must ensure that their outsourcing arrangements comply with a number of regulatory requirements (enshrined in the UK in the Financial Conduct Authority Senior Manager Arrangements, Systems and Controls Handbook, known as the ‘SYSC Rules’), financial institutions have increased their focus on the terms they agree for outsourcing transactions. The Benchmark Regulation will increase this focus for both financial institutions and other stakeholders, as the Benchmark Regulation will apply to a wider group of entities than the SYSC Rules and will extend to all benchmarks.
Those familiar with the UK outsourcing rules will know that the outsourcing of a material function by an FCA regulated firm will be considered to be a critical outsourcing under the SYSC Rules. However, many benchmark providers have not yet been subject to these rules as they are not FCA regulated firms. The Benchmark Regulation aims to deal with this regulatory gap and Article 6 of the Benchmark Regulation provides a set of rules in relation to outsourcing which will apply to benchmark providers, as defined by their use and management of benchmarks rather than whether they are specifically regulated by a relevant competent authority in any specific EU Member State.
Why introduce new regulation?
Benchmarks are often critical to the pricing and valuation of financial products and instruments and, in particular, are used widely in pricing cross-border transactions and for assessing the performance of funds or portfolios. As a result, the value or price that is set for a benchmark may have a significant impact on financial markets. A particular concern for legislators is that a loss of confidence or failure in the accuracy and integrity of benchmarks can result in reduced market confidence, leading to losses for both consumers and investors and the possibility of distortion of the economy. The significant impact that benchmarks can have on the market is an issue because many providers operate and manage their benchmarks in an environment that may lead to conflicts of interest. In particular, the administration of benchmarks requires the exercise of discretion which, when the benchmark provider is both the person that has control over the provision of a benchmark, the ‘benchmark administrator’, and uses the benchmark for trading purposes, leads to conflicts of interest and opportunities for manipulation.
Differences between SYSC 8 and the Benchmark Regime
As with the SYSC Rules, Article 6 of the Benchmark Regulation does not provide a prescriptive format for the structure and terms of an outsourcing arrangement. The provisions act as high level guidelines designed to shape the behaviours of both the benchmark administrator and the service provider and provide a framework for monitoring these behaviours. When compared against the SYSC rules, the Article 6 provisions are higher level and provide less specific guidance yet there are general principles that can be identified and compared against the SYSC Rules.
An important difference to note between the UK outsourcing regime and the Benchmark Regulation outsourcing regime is their contrasting framework and application. Whereas the SYSC Rules apply to FCA regulated common platform firms, the Benchmark Regulation applies to any entity that is providing benchmarks, contributing the input data to a benchmark or using a benchmark in the EU. Specifically, Article 6 will apply to administrators of benchmarks who are outsourcing some or all of the functions in the provision of benchmarks.
While the SYSC Rules apply specifically to ‘Material Outsourcings’ there is no materiality concept in the outsourcing terms of the Benchmark Regulation and no specific definition of what will constitute an outsourcing under the regime. From our reading of the text, it would appear that any outsourcing of the administrator’s functions that are relevant to the benchmark services and activities (interpreted in the general meaning of the word as an arrangement between an entity and a service provider by which that service provider performs a process, service or activity which would otherwise have been undertaken by the entity itself) must be in compliance with Article 6.
There are, however, also general similarities between the SYSC 8 Rules and the Benchmark Article 6 regime, including that Article 6 requires that the administrator should not outsource its functions in a way that could materially impair its control of the benchmark or the relevant competent authorities’ ability to supervise the benchmark. The Article 6 rules also require that the entity carrying out the outsourcing remains fully responsible for discharging its regulatory obligations, reflecting the SYSC Rules position. In the context of these similar overarching principles, it seems likely that from a contractual and negotiating perspective the outsourcing of benchmarks can be dealt with in similar way to the way in which regulated outsourcings are dealt with currently in the UK.
With this in mind, it is arguable that many of the terms that we would expect to be included in a contract for a regulated outsourcing in the UK, in particular the inclusion of wide-ranging audit rights (to the benefit of the outsourcing entity and the relevant competent authority), would still be required under Article 6. This is particularly the case as many of the Article 6 rules directly reflect the wording used in the SYSC Rules. For example both SYSC 8.1.8(5) and Article 6(e) state that the administrator, or common platform firm under the SYSC Rules, must ‘retain the necessary expertise to supervise the outsourced functions effectively and to manage risks associated with the outsourcing’. However, the Article 6 rules do not always track the SYSC Rules exactly and there are certain aspects of what we might now consider to be a market standard regulated outsourcing contract in the UK that might not be considered necessary from an Article 6 perspective. An example would be terms including obligations to measure performance. Although any entity outsourcing a function will understandably want to be able to measure performance, the requirements of the SYSC Rules provide an outsourcing entity with a stronger position to negotiate for the inclusion of performance measurement and management terms, such as service levels and service credits. However, whereas the SYSC Rules specify that ‘the firm must establish methods for assessing the standard of performance of the service provider’, Article 6 does not make reference to measurement of performance at all. It is likely that this is not so much an omission as an operation of the fact that the Article 6 rules are higher level than the SYSC Rules and include significantly less detail. There is a risk, however, that this lack of detail may result in a disruption of the negotiating positions that we have come to expect in regulated outsourcings, as the outsourcing entity will not have the same regulatory backing to its request for performance measurement and management tools, such as service credits.
FCA Response
As an EU Regulation, the Benchmark Regulation has direct effect in all EU Member States. In terms of incorporating the Benchmark Regulation into the FCA Handbook, the FCA could expand SYSC 8 to cover the requirements, include the requirements in the new ‘BENCH’ general guidance on benchmark submission and administration that is expected to be issued, or rely on the Regulation directly.
Timing
As mentioned above, the draft Benchmark Regulation is in the final stages of the legislative process, with political agreement on the provisions having been reached in November 2015. However, we understand that some technical changes to the text may be pending. The European Parliament is expected to formally adopt the Regulation in Q1 2016 and publication of the final text in the Official Journal is anticipated by mid-2016, the day after which the Regulation will enter into force.
The Benchmark Regulation is expected to apply 18 months after entry into force – ie end-2017. However, the European Parliament has submitted a late request for the Regulation to apply 24 months after entry into force – ie mid-2018.
Hinal Patel is a Partner in the ICT department at Simmons & Simmons LLP: hinal.patel@simmons-simmons.com.
Sophie Sheldon is an Associate in the ICT department at Simmons & Simmons LLP: sophie.sheldon@simmons-simmons.com.
