What's Next for Benchmark Users in the UK?

This blog is aimed at the Asset Management sector.

With Benchmark Regulation now entering its seventh year, regulatory focus on this area remains sharp. There is much both in the benchmark world itself as well as in the wider regulatory environment which is likely to affect the benchmarks used by asset managers. This is the first of two articles which intends to update you on recent developments and suggest a number of activities that the FCA may expect to be taken as a result.

In this article we will focus on regulatory developments both in the UK and the EU. In the second article, we will focus on the ongoing work of EU and IOSCO in this space as well as the potential impacts on the benchmark world of the incoming Sustainability Disclosure Requirements and regulation of ESG rating agencies and data providers. We will also provide more detail about what a good benchmark fallback plan could look like.

In short, key actions for asset managers include:

• Keeping closely abreast of the regulatory developments and regulatory expectations which affect benchmark administrators as these will be key to asset managers meeting their own regulatory requirements. With continued scrutiny of the chosen benchmark by the FCA at the fund authorisation gateway, the FCA will expect asset managers to engage with their benchmark administrators for specific pieces of information where these are not already clear in the benchmark administrators publicly available information.
• Updating benchmark fallback plans as soon as practicable to avoid any market disruption and impact on consumers if any of the benchmarks you currently use are negatively impacted as a result of these changes. This could be as a result of initiatives either here or in the EU for example, changes to the third-country benchmark regime in the EU, or just more intrusive supervision of existing requirements for transparency and robustness especially in relation to ESG benchmarks. We recommend that asset managers undertake an inventory of all their benchmarks without delay, assessing the risk of cessation or material change to them as a result of the developments discussed in this blog.

EU Focus

In the EU, an important decision is pending from the Commission regarding the future of the third country regime for non-EU benchmarks. Currently, the end of 2023 marks the end of the transition arrangements for third country benchmark providers operating in the EU, meaning that EU benchmark users will no longer be able to use a benchmark operating under those arrangements unless the benchmark administrator has received or applied for authorisation in the EU by the end of this year. With only a very small percentage of third country benchmark administrators seemingly having sought authorisation in the EU, the consultation (which closed last year but for which a report from the EU Commission to the European Parliament is due by 15 June this year), seeks a solution to this problem. One option being explored is the creation of a new category of benchmark, a strategic benchmark, which would be subject to Benchmark Regulation requirements, whilst other non-strategic benchmarks could be used as desired. However, how this could be applied creates a number of practical issues, not least how it interacts with current benchmark categorisations and how this can be applied without un-levelling the playing field for those benchmarks required to operate under the full requirements.

The UK Benchmark Regulation’s own transition arrangements continue until the end of 2025, and therefore those asset managers using third-country benchmarks in the UK will not be affected by the above at this stage. That said, these developments should be followed closely by asset managers in the UK for if or when the UK decides to follow the EU’s suit, and also by those asset managers with EU funds referencing a third country benchmark in case the benchmark availability is negatively impacted.

A further initiative in the EU which requires monitoring, is the feasibility study by the EU Commission on a minimum standard for an EU ESG benchmark which would bring standardisation to ESG benchmarks and thereby aims to address concerns about greenwashing practices. The results of this study were issued in December 2022 suggesting stakeholders are supportive of having such a standard defined at EU level. However, the report itself does not provide a recommendation for a proposed way forward, rather sets out further considerations for each of the proposed mandatory or voluntary minimum ESG standards and alignment to other aspects of the Sustainable Finance Action Plan. The Commission’s next steps on this are now awaited and should be followed closely for their potential impact on existing EU ESG benchmarks and over time, whether the UK chooses to follow suit.

Current UK Regulatory Focus

Meanwhile, regulatory scrutiny here in the UK appears to focus on operational performance related issues for example, late or non-publications and calculation errors and improvements in disclosure and transparency, especially ESG and crypto-asset benchmarks. However, it also encompasses wider issues such as complex licensing arrangements and other potential barriers to switching between different benchmarks which could also have wide-reaching change on benchmark users. Furthermore, there could also be headwinds for benchmarks from closely linked pieces of regulation such as the incoming Sustainability Disclosure Requirements.

The FCA’s 2022 supervisory strategy letter to benchmark administrators gives good insight into its current views of the risks of harm posed by this population of firms and its expectations on how firms should address these. High on its list are calls for benchmark administrators to provide benchmark users with adequate and accurate information in their benchmark statements and benchmark methodologies which should allow benchmark users to both assess the economic reality or market that the benchmark is intending to measure and the extent to which the benchmark is actually representative of that reality. The FCA reiterates these concerns specifically in relation to ESG benchmarks in its 20 March 2023 letter to UK authorised benchmark administrators. The letter outlines its findings of a preliminary review on ESG benchmarks and expresses concerns regarding the adequacy of disclosures and robustness and quality of ESG benchmarks.

Of particular relevance to benchmark users in the supervisory strategy letter is the Wholesale Data Market Study which includes benchmarks and looks at whether competition is working effectively in these markets and the potential impact of this on prices.

It is of course too early to know how this work will conclude especially in light of the FCA’s new secondary objective to improve competition of UK markets. However, if the FCA determines that potentially rule changes are required as a result, this may add further pressure for benchmark users to provide increased justification (for example of non-price factors such as brand recognition or the proven operational resilience of the benchmark administrator) in their Assessment of Value or under their new Consumer Duty obligations for the continued use of an existing more expensive benchmark rather than taking advantage of an increased ability to switch to a potentially cheaper or better-quality supplier.

With more scrutiny of benchmarks at the FCA’s fund authorisations gateway and as part of supervisory engagement especially on areas such ESG, demonstrating that the benchmark administrator’s benchmark statement and benchmark methodology documents have been accessed and reviewed, would be a good way for asset managers to demonstrate that an informed decision has been made about the appropriateness of any particular benchmark for their own investment strategy. Where there are gaps in the information provided by a benchmark administrator, asset managers should consider if such a gap could impinge on their ability to meet their own regulatory requirements. The FCA has expressed concerns in its recent letter to benchmark administrators about a lack of disclosure in relation to information they are required to complete in their Level Two templates under the Low Carbon Benchmark Amendments. We believe that the FCA will expect you to have reviewed these Level Two templates as part of your ESG benchmark selection process and for you to have requested information directly from the benchmark administrator if there are omissions so that you can explain the cause of the these in your own disclosures.

For funds that reference an ESG benchmark, asset managers should also consider how the fund’s fees are justified in comparison with the fees for funds with similar characteristics in the non-ESG range; this is of particular importance given the FCA’s focus on value and good customer outcomes.

Conclusion

For asset managers who are benchmark users there is a clear regulatory expectation that new requirements in the form of Consumer Duty, incoming SDR and the existing requirements in terms of value for money coalesce with messages to benchmark administrators particularly in relation to ESG. The FCA may also expect asset managers to make reference to the documents benchmark administrators are required to produce either at the fund authorisation gateway or as part of regular Supervisory engagement in order to demonstrate how the chosen benchmark will be the one which provides the best outcome for consumers.

The above also provides an opportunity to review benchmark fallback plans as per the requirement set out in Article 28 in the Benchmark Regulation. Undertaking such a review at the current time would be a clear way of demonstrating to the FCA an understanding of the ways that the initiatives set out in this blog could affect the benchmarks they use. Article 28 requires benchmark users to maintain robust written plans setting out the actions they would take in the event a benchmark materially changes or ceases to be provided, nominating alternative benchmarks and indicating why such alternatives would be suitable. In relation to ESG, this exercise may prove of particular importance considering the small number of sustainable benchmarks in the market and the current regulatory focus on whether the use of a bespoke benchmark might blur lines between an active or passive strategy – an area we will cover in more detail in the second of these articles.

For detailed support on implications of regulatory landscape on Asset Managers, as benchmark users and what types of early action might be useful, please contact either Carolyn Hodder at chodder@deloitte.co.uk and Lira Akhmetov at lakhmetov@deloitte.co.uk