Benchmark Regulation

• Author: Gina-Gail S. Fletcher
• Position: Associate Professor of Law, Indiana University Maurer School of Law. J.D., Cornell Law School
• Pages: 1929-1982

Benchmark Regulation Gina-Gail S. Fletcher * ABSTRACT: Benchmarks are metrics that are deeply embedded in the financial markets. They are essential to the efficient functioning of the markets and are used in a wide variety of ways—from pricing oil to setting interest rates for consumer lending to valuing complex financial instruments. In recent years, benchmarks have also been at the epicenter of numerous, multi-year market manipulation scandals. Oil traders, for example, deliberately execute trades to drive benchmarks lower artificially, allowing the traders to capitalize on the manipulated benchmarks. This ensures that later trades relying on the benchmarks will be more profitable than they otherwise would have been. Such manipulative practices have far-reaching and, in some instances, destabilizing effects on the financial markets. In responding to these benchmark manipulation scandals, regulators have relied on the existing anti-manipulation framework, which is based solely on ex post prosecution of wrongdoers. The current framework treats benchmark manipulation as just another form of market manipulation. But, as more benchmark manipulation schemes come to light, they cast doubt on the effectiveness of this traditional approach to curbing a modern-day form of manipulation. This Article provides the first in-depth analysis of the differences between benchmark manipulation and traditional forms of market manipulation. This analysis demonstrates that regulators cannot adequately address benchmark manipulation through ex post enforcement actions alone. In failing to recognize how benchmark manipulation differs from traditional manipulation, regulators miss a prime opportunity to oversee a key facet of the financial markets and safeguard market integrity. By focusing on the unique attributes of benchmarks that make them susceptible to manipulation, * Associate Professor of Law, Indiana University Maurer School of Law. J.D., Cornell Law School. For their helpful comments on this project, many thanks to William Bratton, Brian Broughman, Guy-Uriel Charles, John C. Coates, James D. Cox, Christopher Drahozal, Joan Hemingway, Timothy Holbrook, Kristen Johnson, Patricia M. McCoy, Ajay Mehrotra, Donna Nagy, Aviva Orenstein, Veronica Root, and Hilary Sale. I am also grateful to the participants at the 2015 Duke University School of Law Culp Colloquium, SEALS 2015 Annual Meeting, National Business Law Scholars 2015 Annual Meeting, and the Midwestern Law and Economics 2015 Annual Meeting. Finally, I am grateful to Lauren Fletcher, Erin Buerger, and Antoni’A White for their invaluable research assistance. All errors and omissions are my own. 1930 IOWA LAW REVIEW [Vol. 102:1929 this Article puts forward a comprehensive prescriptive regulatory framework aimed at detecting and minimizing benchmark manipulation, rather than merely punishing wrongdoers after the fact. I. INTRODUCTION ........................................................................... 1930 II. MARKET MANIPULATION AND EX POST REGULATION ................ 1936 A. E X P OST R EGULATION OF M ARKET M ANIPULATION ................ 1937 B. T HE L IMITS OF “T RADITIONAL ” M ARKET M ANIPULATION ...... 1940 C. B ENCHMARKS IN THE F INANCIAL M ARKETS ............................ 1943 1. Uses of Benchmarks .................................................... 1943 2. Benchmark Industry ................................................... 1945 III. BENCHMARK MANIPULATION ...................................................... 1947 A. I NTEREST R ATE ..................................................................... 1948 B. F OREIGN E XCHANGE .............................................................. 1953 C. C RUDE O IL ............................................................................ 1956 IV. BENCHMARK REGULATION .......................................................... 1962 A. I N F AVOR OF E X A NTE R EGULATION ....................................... 1963 B. T HE B ENEFITS OF S ELF -R EGULATION ...................................... 1967 C. T HE P ROPOSED F RAMEWORK ................................................. 1969 1. Regulated Entities ....................................................... 1970 i. Benchmark Administrators ....................................... 1971 ii. Data Contributors .................................................... 1972 2. Detecting Benchmark Manipulation ......................... 1973 3. Conflicts of Interest ..................................................... 1973 4. Enforcement Mechanisms .......................................... 1975 5 . Government Oversight ............................................... 1978 V. OBJECTIONS AND RESPONSES ...................................................... 1979 VI. CONCLUSION .............................................................................. 1981 I. INTRODUCTION Benchmarks have quietly become a ubiquitous feature of the financial markets. 1 A benchmark aggregates market information into a single metric that is used as the basis for pricing or valuing financial contracts or obligations. More specifically, a benchmark is a price, rate, or index that 1. DAVID HOU & DAVID SKEIE, LIBOR: ORIGINS, ECONOMICS, CRISIS, SCANDAL, AND REFORM 2–3 (2014), https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr667. pdf (discussing the use of LIBOR as a common benchmark for the health of financial markets). 2017] BENCHMARK REGULATION 1931 measures one or more underlying assets, prices, or other data based on a formula, value assessment, or market survey. 2 Benchmarks are embedded into a wide variety of financial contracts—from consumer loans to long-term commodity contracts to complex financial derivatives. 3 For example, derivatives based on the leading interest rate benchmark—the London Interbank Offered Rate (“LIBOR”)—have an estimated outstanding notional value of $220 trillion. 4 Yet many outside the financial markets were unaware of benchmarks until the revelation of the LIBOR scandal in 2012. When a company or consumer is interested in obtaining a loan, LIBOR is one of the primary benchmarks banks and other lenders utilize to set interest rates. 5 Although it began as a way to estimate borrowing costs among banks, non-banks and other market actors have adopted LIBOR extensively throughout the financial markets. 6 LIBOR is widely referenced in pricing derivatives and numerous complex financial instruments, and it impacts interest rates applicable to everyday consumer loans—such as student loans, auto loans, and mortgages. 7 Given that LIBOR undergirds trillions of dollars of financial obligations, the presumption is that a central bank or other type of governmental agency oversees this benchmark, but this is not the case for LIBOR nor most other benchmarks. 8 LIBOR is calculated from the submissions of leading banks estimating the rate at which they could borrow funds from other banks. 9 But, dating back to (at least) 2007, banks such as JPMorgan, Barclays, and UBS—known as panel banks—began to exploit their role as input providers to profit from derivatives that referenced the benchmark. 10 To manipulate the benchmark, 2. ONNIG H. DOMBALAGIAN, CHASING THE TAPE: INFORMATION LAW AND POLICY IN CAPITAL MARKETS 89 (2015); INT’L ORG. OF SEC. COMM’NS, FINANCIAL BENCHMARKS: CONSULTATION REPORT 48 (2013), https://www.iosco.org/library/pubdocs/pdf/IOSCOPD399.pdf. While the term “benchmark” covers a broad range of metrics, it is important to specify the scope of this Article. First, the benchmarks analyzed herein exclude those created for public policy purposes such as consumer-price indices or inflation indices. Second, benchmarks that reflect the value of an investment portfolio, such as the Standard & Poor’s (“S&P”) 500, are also outside this Article’s scope. 3 . See FIN. STABILITY BD., REFORMING MAJOR INTEREST RATE BENCHMARKS 6 (2014), http://www.financialstabilityboard.org/wp-content/uploads/r_140722.pdf; HOU & SKEIE, supra note 1, at 2–3. 4. FIN. STABILITY BD., supra note 3, at 6. 5 . Behind the Libor Scandal , N.Y. TIMES: DEALBOOK (July 10, 2012), http://www.nytimes.com/ interactive/2012/07/10/business/dealbook/behind-the-libor-scandal.html. 6 . See Michael J. De La Merced, Q. and A.: Understanding Libor , N.Y. TIMES: DEALBOOK (July 10, 2012, 10:38 PM), https://dealbook.nytimes.com/2012/07/10/q-and-a-understanding-libor. 7 . Id. 8 . See infra Part II.C. 9. De La Merced, supra note 6. 10 . See Understanding the Rate-Fixing Inquiry: The Banks: Global Financial Firms Reach Settlements , N.Y. TIMES: DEALBOOK (July 28, 2014), http://www.nytimes.com/interactive/2012/07/16/business/ dealbook/20120716-libor-interactive.html?_r=0#/#banks. 1932 IOWA LAW REVIEW [Vol. 102:1929 panel banks did not report the interest rate at which they could borrow to the British Bankers’ Association (“BBA”), the trade association that administered LIBOR, as expected; rather, they reported rates based on whether they wanted LIBOR to rise or fall, so that their derivatives positions would become more profitable. 11 The extensive integration of LIBOR into the markets, coupled with a dearth of oversight, meant that panel banks were able to earn illicit profits from their misdeeds, and the markets and regulators were none the wiser until years later. 12 Upon uncovering the LIBOR manipulation scheme, regulators worldwide fined all participating banks approximately $14 billion in total 13 — a pittance compared to the illicit profits earned throughout the life of the manipulation scheme. 14 The LIBOR manipulation scandal was expansive, impacting trillions of dollars of financial contracts—but, frighteningly, it typifies benchmark manipulation. Although the transfer of wealth to LIBOR’s manipulators from the markets was significant, the scheme itself was not unique. Indeed, scarcely had the dust settled when regulators uncovered a similar manipulation plot. The benchmark at the center of this scheme...