ESMA's discussion paper (DP) outlining its preliminary policy orientation and proposals for level 2 measures of EU Benchmark Regulation has encouraged industry participants to review best practice ahead of the landmark rules due to be implemented.

The scope of the EU Benchmark Regulation goes much further than anything we have seen before and will affect all firms that administer, use and contribute to financial benchmarks, including any global firm with an EU client. The regulation's wide scope, which includes activities where calculations are used to produce indices that measure fund performance, is likely to mean firms that do not consider themselves to be in the Benchmarks business end up being captured. Given this scenario, it's no wonder that industry participants are increasingly engaging with regulators and seeking advice from index providers to ensure that their index administration practices are compliant.

The impending EU Benchmark Regulation is intended to help mitigate potential risks around conflicts of interest at benchmark providers and contributors. We have recommended in our comment letter to ESMA that independent oversight or administration can mitigate inherent conflicts of interest in the provision and use of benchmarks and the final rules should clearly recognise this as a best practice approach to combating this.

The FCA has already been outspoken in its view that it expects all benchmark administrators to immediately mitigate risks, even highlighting in its Thematic Review the importance of independence in governance and that appointing an independent administrator can help mitigate conflicts of interest.

The inherent conflicts of interest for benchmark administrators are primarily focused on those who deal in products which reference their own benchmarks but also include those who reference benchmarks for attributing performance and risk. For example, perceived conflicts may exist where there is an ability to change the methodology. IOSCO (International Organisation of Securities Commissions), who have devised principles for financial benchmarks, suggests it is good practice to separate the administrator function by relinquishing control of the index methodology to a control function. Typically this role might fall to an internal compliance team which typically lacks the expertise required to be effective and may encumber the pace of product innovation. However, by opting to transfer index administration to an independent provider with the proper expertise, the intellectual property can remain with the index owner while the administrator independently manages the methodology change process. This mitigates conflicts and transfers the burden of regulatory compliance, while effectively supporting the benchmark evolution process and the creation of new benchmarks.

In the DP, ESMA mentions independent benchmark administrators by referring to entities that are "dedicated to providing benchmarks alone." The intent seems clear but such phrasing could imply that only those firms which solely provide indices are best placed to provide index administration. It should be recognised that an administrator can be "independent" even if it performs other activities beyond benchmark administration, as almost all firms will, as long as it does not take positions in financial instruments that reference the benchmarks it administers. What matters is that benchmark administrators are free of conflicts of interests in controlling the methodology and have the expertise needed to ensure high quality outputs. For example, at Markit we have a number of products unrelated to indices, but we have deep subject matter knowledge across a range of asset classes. As a benchmark and liquid index provider with roots in OTC credit derivatives, we also have extensive expertise in the tradable products and benchmarks which support them.

It's important to remember that independent benchmark administrators have no commercial interest in a benchmark other than its quality and its representativeness. There should be no confusion about whether independent third party administrators should be recognised and accepted as a valid service to manage identified conflicts of interest and satisfy regulatory best practice.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.