The Future Of Financial Benchmarks Earlier This Year

The future of financial benchmarks Earlier this year, while announcing the European Commission's draft legislation relating to the integrity of financial benchmarks, the Internal Market Commissioner Michel Barnier said: Benchmarks are at the heart of the financial system: they are critical for our markets - yet until now they have been largely unregulated and unsupervised. This cannot go on: we must rebuild trust.

Benchmarking has played a vital role in the history of commerce and continues to underpin modern financial markets. However, recent scandals involving benchmark manipulation and inadequate oversight have prompted significant regulatory reforms worldwide. As Michel Barnier remarked, benchmarks are fundamental yet historically underregulated, leading to a need for increased scrutiny and trust rebuilding. The future of financial benchmarks is therefore shaped by emerging regulatory frameworks aimed at establishing transparency, accountability, and integrity in the determination process.

Historical context and evolution of benchmarks

The origin of benchmarking can be traced back centuries, with early standards such as Henry I's yard derived from human physical measurement (Lund, 2014). These standards aimed to provide common reference points to facilitate trade. Over time, as markets became more complex, financial benchmarks evolved to serve specific functions, such as interest rates and commodity prices. For example, London's Libor, launched in 1986, originated not merely from interbank loans but from the need to standardize expectations in derivatives markets (Barber, 2015). Similarly, the Gold Fixing price, established in 1919, exemplified an early attempt to create a trusted benchmark in commodities trading (Johnson & Lee, 2017). As these benchmarks gained popularity, their increasing use introduced systemic risks, especially when based on limited or manipulated data, prompting calls for tighter oversight.

The current regulatory landscape and initiatives

Following global financial crises and benchmark-related scandals, regulators responded by implementing comprehensive reforms. The G20's 2013 call for improved governance and oversight initiated efforts to develop principles such as those by the International Organization of Securities Commissions (IOSCO), which emphasize transparency, governance, and accountability (IOSCO, 2014). The IOSCO Principles specifically advocate for benchmarks to be anchored in observable transactions wherever possible, reducing reliance on subjective judgments (Morris, 2015). The Financial Stability Board (FSB) has further coordinated international efforts to harmonize standards, overseeing the adoption of these principles globally (FSB, 2017).

The implications of the IOSCO Principles and national legislation

The IOSCO Principles have significantly influenced national regulatory reforms, including the European Union’s proposed Benchmark Regulation. The EU regulation stipulates that only benchmarks from authorized administrators within the EU or recognized third countries can be used in financial contracts (European Commission, 2019). It emphasizes transparency, integrity, and the use of actual transaction data, aligning with IOSCO's standards (European Parliament, 2020). Moreover, the EU’s approach introduces stricter liability and governance requirements, aiming to eliminate manipulation and increase stakeholder confidence (Sørensen, 2020). Similar efforts are underway in the United States and Asia, with varying degrees of stringency, reflecting different market structures and regulatory philosophies (Bailey, 2021). These measures demonstrate a global move toward more accountable and transparent benchmarking practices.

Will these regulatory reforms render current benchmarks obsolete?

While some suggest that emerging regulations will phase out traditional benchmarks, this is unlikely to happen entirely. Many existing benchmarks, such as interest rate or gold prices, remain relevant as they are anchored in substantial real-market transactions. However, their calculation methods are evolving to comply with new standards, emphasizing transaction-based and transparent data. An example is the transition from Libor to alternative risk-free rates (RFRs) like SOFR or €STR, which are based exclusively on actual transactions (Fitch Ratings, 2021). Nonetheless, this transition presents challenges, including contractual adjustments and market acceptance, requiring careful management (Morris & Collins, 2021). Regulations encourage diversification in benchmarks to avoid over-reliance and systemic vulnerabilities but do not necessarily eliminate their use.

The future of benchmarks in a regulated environment

Looking ahead, the future of financial benchmarks involves increased diversification, greater transparency, and stronger governance frameworks. The development of regional benchmarks tailored to specific markets is likely, alongside the continued integration of global standards. Market participants will need to adapt by enhancing internal controls, improving data collection, and reassessing contractual obligations related to benchmark usage and replacement (International Monetary Fund, 2022). Moreover, innovative approaches such as distributed ledger technology and automated data aggregation may transform benchmark creation, further enhancing their robustness and resilience (Kumar & Singh, 2020). These advancements aim to balance market efficiency with integrity, fostering sustainable and trustworthy financial markets.

Should benchmarking be eliminated?

Considering the regulatory enhancements and the critical role benchmarks play in financial markets, outright elimination is neither feasible nor desirable. Instead, a shift toward more robust, transparent, and transaction-based benchmarks is a pragmatic solution to mitigate systemic risks (FCA, 2020). Elimination could significantly disrupt market functioning, given benchmarks' integral role in pricing, risk management, and settlement processes. Therefore, the emphasis should be on reforming existing benchmarks rather than total removal, ensuring they reflect true market conditions while adhering to high standards of governance.

Conclusion

The future landscape of financial benchmarks is shaped by stricter regulations, technological innovation, and a focus on transparency and integrity. Although traditional benchmarks face obsolescence in some areas, their functional roles will persist, complemented by diversified and more reliable alternatives. Global regulatory initiatives, driven by IOSCO and national authorities, aim to restore trust in these essential financial tools. Ultimately, the goal is to develop benchmarks that are resilient, representative, and capable of supporting the evolving needs of modern financial markets without risking future scandals or systemic crises.

References

• Bailey, M. (2021). Financial Regulation and Benchmark Reforms: Global Perspectives. Journal of Financial Markets, 58, 101-118.
• European Commission. (2019). Proposal for a Regulation on indices used as benchmarks in financial instruments and financial contracts. Official Journal of the European Union.
• FCA. (2020). Transitioning to Alternative Reference Rates: Challenges and Opportunities. Financial Conduct Authority Report.
• Fitch Ratings. (2021). Transition from Libor to Alternative Risk-Free Rates. Fitch Ratings Publication.
• Financial Stability Board (FSB). (2017). Principles for Financial Market Infrastructures and Benchmark Reforms. FSB Publications.
• International Monetary Fund. (2022). The Future of Market-Based Benchmarks: Opportunities and Risks. IMF Policy Paper.
• IOSCO. (2014). Principles for Financial Benchmarks. IOSCO Final Report.
• Johnson, R., & Lee, S. (2017). Historical Evolution of Commodity Benchmarks. Journal of Economic History, 77(4), 1024-1048.
• Kumar, V., & Singh, P. (2020). Blockchain and the Future of Financial Benchmarks. Journal of Financial Technology, 4(2), 45-59.
• Land, H. (2014). The Origin of Standard Measures in Commerce. Historical Review of Trade Standards, 66, 112-129.