By Wietske Jarvis-Blees, Thomson Reuters

Regulators have highlighted the challenges of regulating benchmarks in the wake of the interest rate rigging scandal and, more recently, manipulation of foreign exchange and precious metals benchmarks. 

Greg Medcraft, chairman of the Australian Securities and Investments Commission (ASIC) and of the International Organisation of Securities Commissions (IOSCO), said manipulation of benchmarks was a very serious concern. Medcraft was speaking at a seminar in Sydney hosted by the Centre for Law, Markets and Regulation at UNSW. 

"Clearly, financial benchmarks are integral pillars to our financial markets. We have trillions of dollars of financial transactions involving millions of investors, market participants and borrowers who reference these benchmarks, and our concern was to ensure that those who use benchmarks could do so with confidence in their integrity and their reliability," Medcraft said.

Medcraft said that, to limit the opportunities for manipulation, in 2012 IOSCO had formed a task force on financial market benchmarks that considered how policy makers, regulators and administrators could work towards giving markets confidence in the integrity of these benchmarks. 

In July last year, the task force delivered a report that set out 19 principles intended to provide an overarching framework for the administration. Broadly, they covered four areas: governance, including conflicts of interest management; the quality and particularly the design of benchmarks, including data sufficiency; the methodologies used by administrators, including controls over the data collection; and finally, accountability mechanisms which require administrators to establish complaint processes to undertake audit reviews and to cooperate with regulatory authorities.

Benchmark administrators will also be required to disclose publicly the extent of their compliance year-on-year on an "if not, why not" basis, a factor that Medcraft said was critical. "It is no use having standards if they are not implemented in a consistent fashion," he said.

Medcraft said the principles had been well-received by both securities regulators industry and policy makers. "They were endorsed by the G20 and by the Financial Stability Board last year and I understand that they are reflected in the proposed regulation being developed in Europe," he said.

Medcraft declined to comment on current investigations by ASIC into the manipulation of FX currency market benchmarks by a number of global banks including Barclays, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley, BNP Paribas, Royal Bank of Scotland, Standard Chartered and UBS, although he did tell delegates: " … I would probably remind all those banks that it is probably a good idea to kick the tyres before we get there." 

The Wheatley Review

Meanwhile, Martin Wheatley, chief executive of the UK Financial Conduct Authority (FCA), offered insights into the challenges of reforming the UK system in the aftermath of years of manipulation of the London Interbank Offered Rate (Libor). Wheatley said that in many respects, UK regulators had responded quickly to the Libor manipulation problem, which had become evident when, in June 2012, a number of criminal settlements by Barclays Bank revealed significant fraud and collusion by member banks. A review was initiated, now commonly referred to as the Wheatley Review, which considered in detail the underlying problems within Libor and came up with a 10-point plan to fix the benchmark. 

That 10-point plan, Wheatley said, involved "basic, simple things", such as ensuring that banks made clear use of transaction data and that there was an audit trail covering their submissions. 

"One of the things we have said to industry is, 'This isn't hard stuff, it is not rocket science. If you have got a bunch of traders who are conflicted who have large P&Ls [profit and loss statements] connected to a value that they can set unmonitored and use chat rooms without any monitoring or oversight from the bank, don't you think that is something that you should be looking at?... So we are encouraging everybody to go and kick the tyres not just of Libor but of the other areas," Wheatley said.

Libor administration

The FCA had also brought Libor administration and submission activities within its regulatory remit, Wheatley said. "Libor was one of those scandals that erupted outside of the regulatory perimeter. So when we started to look at Libor it wasn't a case of saying, 'Oh well, this is clearly market misconduct', because the definition of market misconduct did not extend to Libor; it did not extend to the submission of interest rates cost of borrowing. So we had a problem, and every other regulator had a problem, as to how do we tackle what is obviously abuse but which legally, within our structure, is probably outside our jurisdiction?" Wheatley said.

He said this was a problem that persisted in many jurisdictions today, whereby submission of data to benchmarks was not captured by regulation. Depending on the ethical model of the jurisdiction in question, that could lead to a situation where manipulation was technically not illegal. 

"If the model that you adopt is an ethic of obedience, there is no rule you are breaking by manipulating Libor. Clearly we can all say now that it was wrong, and it is easy to say that it was wrong, but if you adopted a strict read of the situation you would have said, 'Well, there is no law that I am breaking, that was the first point'," Wheatley said.

Wheatley said there had also been a normalisation of manipulation at play that had developed over a period of years. "We have seen time and time again many of the scandals which do take a long time to come into the market is when something becomes endemic and it is normal within the players in the industry nobody sort of questions it and the knowledge of what was going on wasn't questioned, even within the senior management of those firms," he said. 

Wheatley pointed to one firm where senior management had denied all knowledge of any of their traders' Libor-related activities while at the same time paying a very high retainer to one of their traders who had special Libor connections. 

"I don't know what 'special Libor connections' means, but there was clearly an acceptance that this was quite a profitable activity," Wheatley said.

Psychology of conduct

Deen Sanders, CEO of the Professional Standards Authority Australia, said cases such as these drove a need for further research into regulation from a psychological point of view. 

"There is a lot more to be learnt about how we solve these problems in the future from a psychology of conduct rather than from a legality of conduct [point of view]. If we then understand the problem was in fact a collusionary one, but not necessarily with evil intent, well the question is how did that arise? How did that level of ignorance and or group collusion arise in the absence of any external normalisation of those behaviours, how is it even internally normalised? There is a great deal to be learnt about our thinking about regulation from the issue of psychology, as much as there is from new frames of law, and that is certainly our interest and I know it is also a growing interest across regulatory conversation," Sanders said.

High-level principles

In the UK, Wheatley said, regulators had resolved the problem by referring instead to the FCA's 11 Principles for Businesses, one of which referred to the need to have adequate systems and controls in place.

"For us, even though we didn't have regulatory jurisdiction over the activity of Libor-submitting and Libor activity, we could say to the bank, 'But actually what we have found suggests that you do not have adequate systems and controls'. And so very often for us we use our very high-level principles rather than the very prescriptive rules when we need to take action," Wheatley said.

Wheatley said the UK's tool kit for regulating Libor was nearly finished, and included an audit trail, compliance controls and conflicts of interest management, although a few persistent challenges remained. 

"One of the big changes for us in the UK was to develop a tool kit that would allow us to actually work with the industry and create a structure that allowed us to regulate Libor. We are nine-tenths of the way through that: it is now a regulated activity, firms do have audit trails, they do have oversight, they do manage the conflicts, and we now have regulated submitters in firms or a regulated submitter in the administrator," he said. 

Wheatley said, however, that the regulator continued to struggle with the use of transaction data to support submissions. "The most use you can make of transactions, the better because that creates much more of an audit trail; it is much clearer to the regulator that you genuinely were basing the submission that you made on the transactions that you have done, and so that is broadly what we have decided in the UK," he said.

One problem, Wheatley said, was that since the crisis, banks had drastically reduced their levels of borrowing, resulting in a paucity of data from which to derive Libor figures.

"We have reformed a whole set of elements of the market so we have an audit trail, we have compliance controls, we have conflicts of interests management, but we are still looking at a market where you are being asked to represent at what price could you borrow, and to inform that decision ideally you will have done some borrowing," Wheatley said.

"One of the concerns that we had [was] that actually, even with all of the reforms having been made, people weren't lending to each other. The market had changed, so banks lending to each other on an unsecured basis had largely moved out of favour since 2007. It has come back a bit in the last two years, but frankly not enough for us to be comfortable across the full range of tenures and currencies. [So] even though you have solved everything else, there is still the problem that lending to other banks on an unsecured basis for anything longer than a week or sometimes three months is a part of the market that, if [if it has] not totally disappeared, is still a challenge," he said.

This article first appeared in Thomson Reuters Compliance Complete on 27 March 2014.