Can a Leopard change its spots?

As the dust begins to settle on the benchmark manipulation scandals that have rocked the financial services sector in recent years, Nicola Tavendale asks what has changed?

The administration and calculation of certain financial benchmarks were once so deeply flawed it made them vulnerable to manipulation for years. It took the most serious financial scandals of modern times to act as a catalyst for change.

In July 2016 it will be a full four years since the full extent of the London Interbank Offered Rate (Libor) scandal became public knowledge.

Then there were additional investigations into the manipulation of other global benchmarks such as the WM/Reuters London FX rate (the Fix) and LMBA Gold.

They sparked an unprecedented process of reform in the setting and governance of these rates.

Following the findings of the Wheatley Review, the UK created the world’s first benchmark regulation for eight critically important rates. This summer will also see the release of an updated FX Global Code of Conduct by the Bank for International Settlements (BIS), the Financial Stability Board (FSB) will report on the progress of reforms to Libor, Euribor and Tibor (the Ibors), while the Bank of England continues to develop an alternative near risk-free interest rate benchmark.

Far-reaching change

According to David Clark, chairman of the Wholesale Markets Brokers’ Association, the success of benchmark reform in the UK since 2012 can be measured by the “significant changes that have been made in benchmark governance and the introduction of extended Market Abuse Regulation.

“The changes in governance, especially the introduction of comprehensive independent Oversight Committees, are the most significant and have clearly given market users of benchmarks confidence in their integrity.”

The governance and oversight arrangements also focus strongly on the surveillance of benchmark submission and calculation, Clark adds, claiming that this has dramatically reduced the opportunities for manipulation.

Arguably the most extensive of reforms implemented to date are the changes, both planned and already implemented, by the new administrator of Libor, the ICE Benchmark Administration (IBA).

The new surveillance IBA is completely bespoke and represents a significant investment for the group.

Finbarr Hutcheson, president of the IBA, says: “Nothing was available at the time so we built it ourselves, which I think was far more successful – specific to Libor – and we have since been able to adapt that for the other benchmarks we produce for swaps and gold.

“If I distil the Wheatley report to a single message it is this: there was a significant conflict of interest amongst the banks and the British Bankers’ Association (BBA),” Hutcheson adds.

Understandably the BBA, Libor’s former administrator, was run as an industry organisation rather than as a professional benchmark business, he explains.

While this made sense in the past, at some point the benchmark grew too big and the inherent conflict of interest needed to be addressed.

“We have learnt that lesson with a vengeance,” Hutcheson adds. In addition to Libor, the IBA has also taken over the governance of LBMA Gold, ISDAFIX (now the ICE Swap) and will be launching a further product in the summer summer called ISDA SIMM (Standard Initial Margin Model), which is part of the calculation for collateralising uncleared derivatives.

“We continue to fulfil the function of an independent, conflict free administrator that can bring together and provide value to the market where they need an independent organisation to produce data or information,” Hutcheson adds.

Additional change

In April, the governance of a further critically important benchmark, the WM/Reuters FX rate, also notably changed after Thomson Reuters acquired the business from State Street Corporation.

Thomson Reuters has been working with the regulators, central banks and supranational organisations such as the FSB and Iosco on financial benchmark reform from the very beginning, according to Tobias Sproehnle, head of benchmark services at Thomson Reuters. “Benchmark reform has helped to build confidence in the industry where it had fallen away,” he adds. “It has ensured that the benchmarks meeting the emerging global standards are more reliable and more accurate than ever before.

“We are still in the early stages of a long process – only one market so far has fully regulated benchmarks, there is more work to be done – but pioneering work by Iosco and the FCA is leading the way.”

Prior to this change of governance, the calculation of the Fix had already been changed to extend its benchmark window from one minute to five, which does appear to have been effective in reducing volatility around the Fix, claims Jim Foster, deputy head of eFX at State Street.

“At the same time, the proportion of benchmark flow which is executed electronically has dramatically increased,” he adds. “This brings increased internalisation of risk by the e-trading desks and more even execution throughout the window, which has helped to reduce volatility further.”

Regulatory vs. market reform

Yet while there has been good progress made in implementing reforms to benchmarks, in particular to the Fix, there is definitely scope for further improvements on other fixings, argues Bujar Bivolaku, head of regulation, Barracuda FX.

“I think the market in general has reacted positively to the reforms and it feels like confidence is being slowly restored in the FX market,” he explains. “This is only a start of financial benchmarks reforms but it’s a good start.”

He adds that prior to the FSB reform recommendations, many banks used manual processes to dealing with benchmark orders, which lacked the necessary controls and were more prone to errors.

“What we have in place now is more automated electronic management, specifically designed for managing benchmark orders,” Bivolaku adds.

While radical reform to the benchmarks was necessary at a governance level, the intervention of regulators in the reform process also needs to be carefully balanced against the potential for too much oversight which may actually harm the market, warns Dr Rosa Abrantes-Metz, managing director for antitrust, securities and financial regulation practices, Global Economics Group, and Adjunct Professor, Stern School of Business, New York University. “But everything has costs and benefits and ultimately the benefits from enhanced regulatory oversight of benchmarks to date have out-weighed the costs to a large extent,” she adds. “Namely, the elimination of conflicts of interest by administrators, higher transparency and changes in calculations that make manipulation harder.”

Instead of governmental bodies taking control of benchmarks, she argues instead for private benchmark administrators to take a key role.

Private benchmark administrators free of conflicts of interest will have a reputational and business stake in the success of their benchmarks, she explains, and therefore have the incentive to ensure they are credible and robust. “But it is critical that conflicts of interest are not present,” she adds.

Libor reforms

Benchmark regulation ultimately benefited from the global acceptance of the 19 Iosco principles for financial benchmarks which has become the template for governance and a framework for their management and use going forward, explains Clark.

He believes that the evolution of Libor, which is still a work in progress, is founded on compliance with these new regulations and the spirit of the Iosco principles.

He adds: “It has also been widely consulted on with the industry and will emerge as an evolved benchmark curve with wide stakeholder support.”

In March, the IBA released its plans for the further reform of Libor. Following the first six months of putting surveillance in place, testing and ensuring it could “cover business as usual”, Hutcheson says that the last 18 months “have been spent looking at how to evolve it strategically for the long term.”

This has included developing resilient and robust technology alongside very secure data integrity, he adds. “It has frankly moved the banks from having ten or 15 minutes to check their submission to 40 minutes, which means there is less risk of making an error and being accused of wrongdoing,” says Hutcheson. “That’s reassuring and helpful to them.”

Looking ahead, the IBA has designed a so-called waterfall of submission methodologies to ensure that Libor panel banks use funding transactions where available in a bid to anchor the rate to true transactions, as well as reflecting significant changes in banks’ funding models. The first phase of this implementation will be introduced during the summer and is due to complete by the end of 2016, with banks continuing to send IBA their data every day but how they determine these submissions is now uniformly prescribed by IBA. In addition, IBA is conducting a feasibility study to determine if it can move to using an internal algorithm instead. This would effectively entail that the banks’ responsibility is purely to report their transactions to IBA, significantly reducing the cost and risk for submitting banks.

Buy-side appetite

The demand for benchmarks may remain undiminished, particularly from the buy-side, but the reasons behind this demand can also be called into question. The motivation to move or manipulate the benchmarks is too large, according to Abrantes-Metz, but benchmarks are important for pricing and therefore need to be believable.

“But in my view, they may not be necessary for all the functions in which they are currently used,” she adds. Buy-side demand for the FX Fix is particularly note-worthy. Traditionally, buy-side institutions used the Fix to manage currency exposure of their multi-asset portfolios (usually equity and bond portfolios) according to Bivolaku.

It was a way to ensure they were obtaining comparable FX pricing and execution from their bank and the standard market benchmark fix provided transparency around the pricing, he explains. “But with the latest structural changes in the FX market, asset managers are becoming more sophisticated with their FX execution and no longer rely solely on trading at the benchmark fix,” Bivolaku says.

“Asset managers these days are embracing multiple trading strategies, for example algo trading giving them tighter pricing and the advent of transaction cost analysis (TCA) gives them further tools to drill down into the quality of their FX execution.”

Regulators are also steadily moving towards putting in place a global regime, argues Sproehnle.

“This means that participants in every market can be assured that their local benchmarks are operated and governed to the highest standards in a manner consistent around the world,” he adds. Foster agrees that the reforms “appear to have worked as intended, producing a market which is both fair and efficient”.

This ensures clients have access to benchmark-based execution services in a competitive marketplace at a clear price, he adds, which ultimately attracts both users and providers of these services.

Risk of repetition

But Abrantes-Metz argues that there are many areas where work may still need to be done to prevent the potential for manipulation of key benchmarks. “Many leading commodity futures contracts – which include traditional commodities such as gold, silver, as well as treasuries and FX – are still settled in very narrow windows of time (of 30 seconds or one minute),” she says.

The reality is that it is much easier to manipulate prices that are set in 30 seconds or one minute than prices that are set over a five- or ten-minute interval, Abrantes Metz argues, adding that she is “surprised that to date that no reforms have taken place in these futures settlement processes in order to implement wider calculation windows.”

In addition, she also does not favour the continued calculation of the gold and silver fixings through auctions rather than by all market trades in a wider time window.

“These processes have been reformed and are now more transparent, and the benchmark administrators are no longer the banks themselves but independent parties,” she explains. “These are liquid enough markets to allow such benchmark settings.”

However, IBA counters that the auction to determine the LBMA Gold Price concentrates liquidity at that moment in time, each morning and each afternoon.

It adds: “All liquidity transacted in the auction results in bona fide trades, meaning that the benchmark is based on a significant volume of traded spot gold.” Hutcheson adds that the bank CEO’s are very wary of the potential for manipulation and the impact on their reputation. “The fact that we have trebled the participation in [the gold rate], which in fact has the biggest retail participation, is a demonstration of their greater confidence,” he says.

Learning lessons

Indeed, the fact that Libor continues to be “the most widely used benchmark on the planet”, according to a senior market source, is perhaps an indication that it was not the calculation of the rates that was the main concern but rather the potential for manipulation and subsequent reputational damage.

The work of global bodies such as ISDA or the FSB have also already proved useful and effective, according to Foster, especially in setting out expectations of behaviour and pushing for netting initiatives.

“There should now be a much lower variation of behaviour across banks, which creates a more level playing field for those participants, as well as encouraging higher standards in general,” he argues. But the market cannot be complacent, warns Abrantes-Metz, and it needs to learn the lessons from benchmarks and proactively reform other market structures to pre-empt and prevent potential further abuse.

“It was clear that some of these structures were highly defective with large gains from potential manipulation, very low probability of detection, and hence, highly susceptive for abuse: means, the motive and the opportunity,” she explains.

Yet, abuse went on for many years with very little awareness by authorities of the likelihood of such conduct. Abrantes-Metz adds that perhaps the market should not be waiting for the next scandal to be uncovered, but should instead “roll up its sleeves and reform deficient structures now.”