Regulators respond to LIBOR rigging
The LIBOR manipulation scandal, and concerns over its European equivalent EURIBOR, has called into question the construction and governance of benchmarks generally. LIBOR clearly needs to be reformed. Currently individual institutions (with multiple conflicts of interest and strong incentives to manipulate submissions to protect the image of their own creditworthiness or improve their trading positions) “exercise judgement” in estimating the price at which they might have borrowed money in the opaque and illiquid inter-bank lending market. For a benchmark to be robust and credible it should be based on actual data collected from diverse sources based on transactions executed in a well-regulated and transparent market, supported by appropriate governance and compliance procedures and monitoring--so there is much work to be done.
In the UK the Chancellor of the Exchequer commissioned Martin Wheatley, Managing Director of the FSA and CEO designate of the Financial Conduct Authority, to undertake a review of the framework for fixing LIBOR. On 10 August, HM Treasury published an initial discussion paper containing a number of proposals to address the current failings of the regime. Wheatley’s task is mission critical-- London’s future credibility as a global financial centre depends on getting the new LIBOR regulatory framework right.
Wheatley believes that the existing structure and governance of LIBOR is “no longer fit for purpose”, given the scale of identified weaknesses and the loss of credibility it has suffered. However, he believes a wholesale replacement of the LIBOR regime would be too disruptive. Instead the LIBOR setting and governance regime has to be significantly strengthened to take account of these weaknesses. In parallel, alternative benchmarks need to be identified and evaluated, with a view to other benchmarks taking on some or all of the roles that LIBOR currently performs in the market.
The paper outlines various options for overhauling LIBOR. However, there is no easy fix. One option would be to replace the benchmark with a borrowing rate based on actual trades overseen by a new independent body. However, Wheatley believes it may not work when transaction volumes are low. A better solution may be to use a mixture of actual transaction data and predicted rates even though this still gives banks the ability to rig the rate to some degree.
What’s more certain is that the rate setting process will be subjected to more formal regulation in the future. This may mean that individual data submitters require special FSA clearance, according to the paper. The paper also raised the question as to whether or not banks should be forced to partake in the currently voluntary process of setting LIBOR--a move that would enlarge the current pool of submitters.
The discussion period closes until 7 September. The Wheatley review will report by the end of September 2012 to enable the UK Government to consider its recommendations when finalising the new Financial Services Bill.
The EC has also reacted quickly by adopting two amended proposals
on market manipulation on 25 July 2012 to prohibit benchmark manipulation, making these criminal offences.
These proposals would widen the scope of the Market Abuse Directive (MAD) and Regulation (MAR), respectively, to include benchmarks. Specifically, the proposals would amend the definition of the offence of market manipulation to capture benchmark manipulation and amend the criminal offence of “inciting, aiding and abetting and attempt” to include it.
The EC is not proposing minimum types and levels of criminal sanctions at this stage, but wants Member State to provide for criminal sanctions in their national laws to cover the manipulation and attempted benchmark manipulation.
The European Banking Authority (EBA) announced on 31 July that implementation of FINREP (the standardised EU-wide framework for reporting financial accounting data) will be postponed until 1 January 2014, because it is unable to finalise Implementing Technical Standards (ITS) on supervisory reporting requirements under the Capital Requirements Regulation (CRR) until final political agreement is reached on the package of reforms under the Capital Requirements Directive IV (CRD IV) and CRR.
EU legislators failed to agree on Level 1 text of CRD IV/CRR before the European Parliament’s (EP) summer recess. The EP and the Cypriot Presidency of the Council (facilitated by the European Commission (EC)) will start negotiations up again quickly when the EP returns in early September but the delay has had a knock-on impact on the overall process, with the EP’s plenary vote on CRD IV also being pushed back to later in the autumn.
Despite the delay, CRR is still likely to come into force on 1 January 2013, with national supervisors being required to check firms’ compliance at that date. With the final Level 1 measures not yet adopted and the ITS still to be finalised, this leaves institutions facing a somewhat messy picture. They still have to comply with CRR at 1 January 2013, but certain aspects covered under the ITS will be phased-in because the EBA recognises that firms face technological and other challenges in complying with the CRR, FINREP and the related common regulatory reporting regime (COREP).
Therefore, firms will probably be required to comply with the full ITS requirements on FINREP from 1 January 2014. Also, the EBA may take decisions regarding phasing in other data requirements, particularly those not directly used to assess compliance with specific CRR requirements, after CRR has been finalised.
RRPs for financial market infrastructure providers
The Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) believe financial market infrastructures (FMIs) such as central counterparties, clearing, settlement and payment systems and trade repositories should prepare recovery and resolution plans (RRPs) to reduce systemic disruptions in the financial system if they become distressed or fail.
The CPSS and IOSCO published a consultative report on the “Recovery and Resolution of Financial Market Infrastructures
” on 31 July 2012, covering a substantive summary of the key recovery or orderly wind-down strategies for FMIs, the identification of FMIs’ critical operations and services, and a description of the measures needed to implement the key strategies. The report builds on the principles previously laid down in two key documents: the CPSS-IOSCO “Principles for Financial Markets Infrastructures
” (April 2012), and FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions
” (October 2011).
The report outlines the issues that should be considered when designing an effective recovery and resolution regime, such as:
- the relationship and continuity between the key attributes and the principles
- recovery and resolution approaches for different types of FMIs
- important interpretations of the key-attributes when applied to FMIs
- co-operation and co-ordination among relevant authorities.
On 1 August, the UK HM Treasury also published a consultation paper, “Financial sector resolutions: broadening the regime
”, setting out proposals to enhance the mechanisms available for dealing with the failure of FMIs and other systemically important non-banks. HM Treasury is committed to a more aggressive timetable than that for related EU measures, because it wants to quickly eliminate the risk of taxpayers having to fund more bail-outs.
But why the sudden interest in FMIs? FMIs form an important backstop in the new regulatory system by recording, collecting and disclosing information and mutualising risks, with supervisors relying on these entities to promote financial stability and market confidence. Global regulatory believe that this coupled with FMIs’ growth in recent years provides clear justification for strengthened principles in this area. If not properly managed, FMIs’ systemic nature can pose significant risks to the financial system and be a potential source of contagion, particularly in periods of market stress. Designing adequate RRPs for FMIs is considered vital to managing the systemic risk they pose and clearly FMIs have potential vulnerabilities. FMIs and their participants do not necessarily bear all the risks and costs associated with their payment, clearing, settlement, and recording activities. Moreover, there may not always be strong incentives or mechanisms for safe and efficient design and operation, fair and open access, or the protection of participant and customer assets. In addition, participants may not consider the full impact of their actions on other participants, such as the potential costs of delaying payments or settlements.
Given the heterogeneous population of FMIs (trade repositories, clearing houses, etc.), FMIs need to consider both consultations carefully to determine how they fit with their specific objectives and activities.
The CPSS-IOSCO consultation closes on 28 September 2012, and the HM Treasury consultation closes on 24 September 2012.
ESAs strengthening cross border supervision of payment institutions
The European Supervisory Authorities (ESAs) believe a common structure for cooperation and coordination between home and host supervisors is necessary to mitigate against money laundering risks posed by payment institutions. Currently, cross border AML supervisory practices for payment institutions vary--supervisors adopt different practices, exchange different information and use different notification templates.
On 2 August, the ESAs published a “Protocol for Supervisory Cooperation” for payment institutions under the Third Anti-Money Laundering (AMLD3) [2005/60/EC]. The Protocol aims to facilitate the exchange of information between home and host supervisors. It also outlines provisions in relation to passport notification and registration processes to facilitate effective AML supervision of agents and branches of payment institutions operating cross-border in the EU.
The ESAs believe that the cross-border activities of payment institutions and their agents pose risks of both terrorist financing and money laundering. Under the Payment Services Directive [2007/64/EC] (PSD) the authorisation of a payment institution is the responsibility of the home supervisor who must work closely with host country authorities. So the regimes’ success depends on effective communication between the two supervisors.
The Protocol also tries to provide some clarity on how branches and agents of payment institutions are treated under the AMLD3, in line with European Commission’s (EC) guidance published in October 2011. Firstly, under AMLD3 branches qualify as ‘financial institutions’ and therefore are fully subject to host country rules. Agents of payment institutions are not considered separate financial institutions nor do they explicitly fall within any of the categories of entities under AMLD3. However, according to the PSD, payment institutions remain fully liable for the activities they have outsourced to agents. The territorial nature of the AMLD3 implies that agents themselves, acting on behalf of the payment institution, have to comply with AMLD3 requirements of the host country. However, the payment institution has to enter into a contract with the agent to ensure it complies with the AMLD3 requirements.
The Protocol is based on High Level Principals governing how supervisory colleges function, which were adopted by the Committee of European Banking Supervisors (CEBS) and the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) (forerunners to the EBA and European Insurance and Occupational Pensions Authority respectively) in January 2009. It also builds on EC guidance on the payment institutions supervision. The Protocol does not replace or derogate national laws, which may give supervisors powers and responsibilities that go beyond those in the Protocol.