‘(7) In reviewing critical benchmarks in accordance with Article A20 of the Benchmarks regulation as amended by this Act the FCA must have regard to—
(a) ensuring a benchmark is based on actual trades or contracts;
(b) preventing a benchmark from manipulation for the benefit of anyone submitting information to that benchmark; and
(c) robust sanctions up to and including custodial sentences for anyone found to be engaged in manipulation or attempted manipulation of a benchmark.’
This amendment would require the FCA to have regard to ensuring a benchmark is based on actual trades or contracts, that it is not open to manipulation and that robust sanctions are in place for those who manipulate, or attempt to manipulate, a benchmark.
Thank you for your chairmanship today, Mr Davies. Perhaps with your indulgence I may, as I did the other day, explain how I shall try to approach this morning’s sitting. I believe that within a sometimes impenetrable Bill the clauses we are to debate this morning may be the most impenetrable. That is often the case when clauses change provisions elsewhere, as in this instance. I shall, as I go through my remarks on the provisions, ask the Minister some questions. The real meat will come at about clauses 13 to 16, and I will speak for a bit longer. I just want to give the Committee the shape of my approach.
To return to the amendment, it begins, I guess, with LIBOR. I want by way of illustration to ask the Committee to think about the price of bread. If we were all asked what the benchmark price of a loaf is, it would be easy to establish it. We would go to a supermarket, look on the shelf, and see the price of a loaf. If we were keen shoppers with a good eye for a bargain, we might go to two or three supermarkets and compare the price of a loaf. I could pop-quiz the Committee, but I shall not put anyone through that.
The price of a standard loaf in one of our supermarkets is roughly £1.10, give or take; people who want to go for one of those sourdough loaves can pay a bit more if they want, but for what I would call a normal brown loaf it is about £1.10. That is the benchmark price of a loaf, dictated by the supply and demand of a competitive supermarket environment.
Now I want Members to imagine a different way of setting prices, where we were setting the price of a loaf and could all submit our opinion on what the price of the loaf might be—and we owned bakeries, and were selling loaves. We would have a debate every day to set the price of bread. Perhaps the Minister and I would converge on about £1.10, but someone else might say, “Look, could we just edge that price up? Could you do me a favour and make today’s price £1.11 or £1.12? It would be a really good favour and, by the way, if you do it I might send you a case of champagne at Christmas.”
The trader might be saying those things in the knowledge that they had a lot of loaves to sell that afternoon—maybe millions. The penny difference in price could make a great difference to the profit. Alternatively, a benchmark price of £1.09 instead of £1.10 could mean that they would lose a lot of money on the bread they had to sell. That is basically what was happening with LIBOR. That is the problem that was unveiled.
The problem is exacerbated where there is not a liquid market for bread and where the benchmark relies more and more on what our oral witnesses last week called “expert judgment”. That is one phrase for it, but we could also call it opinion, and if we did not have supermarkets selling millions of loaves every day and the price of bread was down to the opinion of only the bakers, we can see there would be the potential for price manipulation.
That is what was happening with LIBOR and what was uncovered as traders around the world shaved tiny proportions off the daily rates. The volume of money being traded meant that even a tiny proportion—0.01% or something like that—could make a huge difference to their own trading account over the course of the year. That is the problem that this set of clauses is trying to deal with.
How do we deal with the problem? We focus a lot on what the Bill calls the representativeness of the benchmark, because there is not really a problem when millions of loaves are being sold and there is a competitive environment; if I do not like the price at Tesco, I can go to another supermarket and try my luck elsewhere. But when wholesale markets were not very liquid and relied more and more on expert opinions, there was the potential for—indeed, the reality of—manipulation. That is what happened.
That matters because this benchmark underpins trillions of pounds’-worth of trades, yet was found to be vulnerable to the kind of manipulation I have just tried to illustrate. I have tried to show that even the tiniest movement in the daily benchmark could make a big difference to traders because of the volumes of money that they were trading. The benchmark’s flaws were exposed a number of years ago, yet its use to underpin trading has persisted because of the volume of contracts linked to it.
One of the problems in the complexity of this set of clauses is that it takes us into the area of contract law, which is both complex and, in this case, international. Huge volumes, contract law and international jurisdictions are involved, so—to be fair to the regulators and the Treasury—it is not easy to get this right. Our amendment does not try to get into the contract issue, which we will come to later when we debate a few clauses further on, but rather tries to set out some ground rules for the regulator in establishing and sanctioning successor benchmarks to LIBOR.
The criteria that we have set out ought to be uncontroversial. The first is that the benchmark should be based on actual trades in the market for which real prices were paid. I confess I have been away from the issue for a while, although I served on parliamentary inquiries into it some years ago, but we learned last week that those so-called expert judgments are still being used to set LIBOR prices. That is someone’s opinion of what a trade might cost, not necessarily what it does cost in a real marketplace. That use of expert judgments has created the potential—and, as we have seen, more than the potential—for manipulation.
We also learned that SONIA, the sterling overnight index average and the favoured successor to LIBOR in the UK, is based on much more liquid markets. That is a good thing, but there is also a potential problem. LIBOR is an internationally used benchmark. While we are debating this legislation, the United States is also legislating, the European Union has parallel legislation and the Swiss have parallel legislation—and they have all gone for slightly different successors. That raises the problem, which the Minister and I will get into discussing: how to take contracts based on an internationally used benchmark and try to ensure fairness to those who signed up to contracts under it when the countries legislating for successors to it are all choosing slightly different overnight rates for those successors.
The amendment, therefore, goes with the grain of how trades are moving. We all agree that a benchmark based on large liquid markets will be more accurate than one based on opinion. The second and third elements of the amendment give the regulator a duty to prevent manipulation by those submitting information to the benchmark and to have robust sanctions, including custodial sentences, when that occurs.
We will get back to debating that elsewhere in the Bill. When the LIBOR scandal unfolded some seven or eight years ago, I remember that both the Treasury Committee and the Parliamentary Commission on Banking Standards heard evidence from chief executives of the major banks. Often, their defence was, “I had no idea what my traders were doing. I did not know that they were doing this.” There was a constructive ignorance built into the system. Although that did not make the chief executive look good, it was far better than the chief executive admitting that they knew what the trader was doing but they looked the other way because it was making more profit for the bank and the trader. The sanctions and the responsibility up through the institution are very important.
All that is hugely important for trust in the system. The average constituent probably does not know much about LIBOR or what it does, but the truth is that the financial products they buy are often related to this benchmark, so it does have an impact in the real world. No matter how esoteric the financial products are—they have become too esoteric—in the end there is a customer, and the customer should only pay a fair price. The imbalance of information should not result in the customer being fleeced or the trader being unfairly enriched, and it is the job of the regulator and the financial institution for which that trader works to ensure that is the case. That is the intention behind our amendment: to set that as a clear goal for the regulators before we get into the meat in the clauses of how we will transition from LIBOR to other kinds of benchmarks.
It is a pleasure to serve under your chairmanship again, Mr Davies. I appreciate the opening remarks of the right hon. Member for Wolverhampton South East and his compelling attempt to contextualise the complexity of the scrutiny of the clauses that we will undertake this morning. In that spirit, it might be helpful if I contextualise for the Committee what benchmarks are, what the LIBOR benchmark is and where we are with the EU benchmarks regulation before I respond to the Opposition amendment.
A benchmark is a standard against which the performance of a fund can be measured or by reference to which payments can be calculated. They are most commonly found in financial instruments, but are used to compare a variety of products, from commodities—oil, gold and diamonds—to the weather. The most widely used benchmarks are interest rate benchmarks, such as LIBOR, the Euro Interbank Offered Rate and SONIA. They reflect interest rates for inter-bank lending and borrowing. They are regularly calculated and made publicly available. As was mentioned, they are used in a wide array of financial instruments used in global financial markets. They also have a use in trade, finance, valuation, accounting and taxation.
The LIBOR methodology is designed to produce an average rate that is representative of the rates at which large international banks could fund themselves in the wholesale and secured funding market. It is produced by ICE Benchmark Administration. It is calculated based on submissions made to the administrator each day by a number of major global banks known as the panel banks. They use a methodology that requires, to the greatest extent possible, submissions based on or derived from actual transactions. LIBOR is internationally used and systemically important. It is available in five currencies and published over seven time periods, known as tenors, ranging from overnight, up to one.
“to ensure the accuracy, robustness and integrity of financial benchmarks” providing participants in the market with confidence in their use. The benchmarks regulation places requirements on administrators, supervised entities and supervised contributors relating to governance, transparency and methodology requirements.
The right hon. Gentleman mentioned his involvement in the Parliamentary Commission on Banking Standards, set up following the LIBOR scandal. The commission’s focus on LIBOR was around the scandal itself and the inadequate governance and scrutiny that the financial sector was under. The right hon. Gentleman referenced that and the inadequacies of the defence of the executives whom he encountered during that work. The commission’s report highlighted the fines levied to the perpetrators of the scandal. That is an encouraging example of a more appropriate penalty, highlighting that fines had not previously provided a sufficient deterrent.
It is worth mentioning the importance of this issue and why we are legislating today. The panel banks that contribute to LIBOR had previously colluded with each other to manipulate the rate, which came to light in the 2012 LIBOR scandal. In light of the LIBOR scandal and subsequent investigations, significant improvements have been made to the administration and governance of LIBOR, particularly around the quality of the governance and controls around submission, and the administration of the rates—that pricing of bread process.
However, the scandal also brought to light an inherent weakness in LIBOR: the underlying market that LIBOR seeks to measure and the unsecured wholesale term-lending markets that are no longer very active. This means that LIBOR has increasingly been based on expert judgments rather than actual transactions. Given that LIBOR is referenced in $400 trillion globally of financial contracts, it is a serious risk to financial stability for those not to be grounded in real transactions. On that basis, in 2014 the Financial Stability Board recommended the identification of alternative rates that could be used in place of interbank offered rates, or IBORs, and that market participant transactions should move from IBORs to these rates.
That is the context for what we are doing today. We are here to ensure that we have a mechanism for the FCA to manage the process of moving away from LIBOR going forward. The Government are committed to operating a fair and effective market and ensuring consumers are protected from all forms of market abuse, including manipulation of a benchmark. The amendment proposed by the right hon. Member for Wolverhampton South East—although provided, as ever, with the best of intentions—does not advance these goals.
First and foremost, the review process in article 20 of the benchmarks regulation, which requires the FCA to review critical benchmarks, concerns whether or not a benchmark meets relevant criteria to qualify as a critical benchmark and is subject to more stringent oversight. It is not an assessment of the benchmark’s input data, or of the legislative framework that applies to the benchmark.
Adding additional considerations to this process could, in fact, weaken our regulatory regime, potentially preventing certain benchmarks that are, legitimately, not wholly based on transaction data, from being classified as critical, therefore greatly reducing the oversight powers that the FCA has over them. Even if we did consider these suggestions appropriate for all critical benchmarks, it is not clear how requiring the FCA to have regard to them would factor into the clear criteria outlined in the benchmarks regulation. That would damage the clarity of the review and designation process.
Furthermore, such requirements are unnecessary. The UK benchmarks regulation already contains this requirement:
“the input data shall be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure.”
It also says:
“The input data shall be transaction data, if available and appropriate.”
It is therefore important that there be some flexibility for an administrator in choosing appropriate input data. For example, where a benchmark measures an illiquid market, such as the value of large infrastructure projects, it may be inappropriate to have a benchmark methodology that is solely reliant on transactions. The use of expert judgment enables the continued calculation and publication of such benchmarks.
I listened carefully to what the right hon. Member for Wolverhampton South East said. The risk of inappropriate use of estimations that was inherent to the previous scandal is a live concern. That is why the calibration of those inputs in all circumstances needs to be carefully governed.
Separately, I note that there is already clear legislation that covers manipulation or attempted manipulation of a benchmark and provides sanctions for such activities. Under the Financial Services Act 2012, it is a criminal offence to make misleading statements in relation to benchmarks. In fact, in the Bill, as the right hon. Gentleman also rightly mentioned, there are measures that increase the maximum sentence for such a crime to 10 years.
It is wonderful to serve under your chairmanship, as ever, Mr Davies. The Minister is explaining that there is a process for enforcement. We all know that this issue is very specialist. If he thinks the current regulations and sanctions are appropriate, could he set out how they are being enacted and monitored? Frankly, it requires someone with a specialist understanding of how these rates can be manipulated to enact them in the way he outlines. If he does not want to add the amendment, could he explain how these issues can be investigated, and what resources there are to do that?
I thank the hon. Lady for her point. These matters are administered by the FCA. I have set out the framework under which it operates. Its resourcing is a matter for it, and I speak on a six-weekly basis to the chief executive about that. The sanctions available to the FCA vary considerably according the nature of the breaches. Some will be small, modest technical breaches.
At this point I cannot give her chapter and verse on the exact attribution of resources to this measure, but I can look into that and come back to her.
It is a pleasure to serve under your chairmanship, Mr Davies. I will be brief. The Minister has made a compelling case, but perhaps not as compelling as that made by the right hon. Member for Wolverhampton South East, who made illuminating remarks on the potential price of bread, although I encourage him to go to Aldi, where he will get it for a lot cheaper than £1.10.
What is proposed here is a common-sense approach that would give the wider public confidence that the Government are taking this matter seriously, notwith- standing the Minister’s remarks thus far. In general terms, I do not think there is a huge difference between the two positions, but looking at both sides, I think the common-sense approach would be to tighten this process and make it more robust; that would provide the public with the confidence they feel they need on these matters, particularly given the scale of past scandals.
I listened carefully to what the Minister said. I do not think anyone looking at the issue would conclude that the responsibility for these actions had been fairly allocated, so there is an issue. I am not saying we want to go around looking to put people’s heads on spikes—we do not want that sort of politics—but it does rankle with our constituents when certain types of crime that are, candidly, easier to understand are met with heavy punishments while somebody who does a very complex crime that is more difficult to understand can somehow get away with it.
Having said that, I accept that legislation for criminal offences, and particularly for custodial sentences, needs to be very carefully drafted in exactly the right way, and I cannot say that I am 100% certain that my amendment is, so I beg to ask leave to withdraw the amendment.
Clause 8 is the first of 14 clauses that amend the benchmarks regulation in order to provide the FCA with the powers it needs to oversee the orderly wind-down of critical benchmarks such as LIBOR. Critical benchmarks are benchmarks that meet certain criteria—for instance, they are used in a significant volume of transactions, or the benchmark is based on submissions by contributors, the majority of whom are located in the UK. A number of powers in the benchmarks regulation are limited to the oversight supervision of critical benchmarks or the administrators of such benchmarks.
Clause 8 adds new criteria for what may be designated as a critical benchmark. As a result, a benchmark will be considered critical if its cessation would cause significant and adverse impacts on market integrity in the UK, even where the benchmark has market-led substitutes, provided one or more users of the benchmark cannot move on to a substitute. The new test means that, as a critical benchmark winds down, the value of contracts that use the benchmark diminishes. The powers available to the FCA to manage the wind-down of critical benchmarks will remain available, provided that the benchmark meets the relevant tests to remain designated as a critical benchmark.
In addition, one of the existing tests for what may be designated as a critical benchmark has been changed. The test originally stated that a benchmark would be designated as critical where it met either both a qualitative and quantitative threshold of use in more than €400 billion-worth of products, or the qualitative threshold only. The quantitative threshold has now been removed, as it has become redundant. This measure has been welcomed by industry as an important development in managing LIBOR transition, and will ensure that the FCA has the powers it needs to manage the orderly wind-down of this critical benchmark.
I am aware, as a result of my engagement with industry—indeed, the Committee heard evidence of this last week—that there is support among market participants for additional safe harbour provisions to complement the provisions in this Bill. I can assure the Committee that we are committed to looking into that further issue and providing industry with the reassurance it needs. That conversation is ongoing and, I think, is to the satisfaction of the industry; we are working to a conclusion with it. However, given what I think the Committee will concede is the complexity of the matters involved, I cannot commit to an outcome, and I think the industry recognises that.
I want to go back to what happens if moving to another benchmark is “not reasonably practicable”. I note that the Minister is looking into that and seeking reassurance. One thing that we are particularly concerned about in this clause is the question of whether “one or more users”, if it is reasonable and practicable, can switch to a market-led substitute benchmark. How do the Government define what is reasonably practicable in this case? Will he explain that to me, please?
I am grateful to the hon. Lady for her question. In terms of the benchmark’s being classed as critical and the appropriateness of substitutes, certain contracts face barriers to moving off a benchmark. While some contracts are bilateral and that renegotiation may be possible, many contracts are multilateral and involve the consent of multiple parties before a change can be made. Therefore, in some cases, achieving consensus on the changes is likely to be difficult or impossible, due to the absolute number of parties that will be involved, or due to the threshold at which consent would be achieved. In those situations the existence of an appropriate substitute is not relevant, as users will not be able to move on to it. The complexity of what they are on means that there is not anything substitutable.
If there are still enough contracts using a benchmark for it to mean that the benchmark’s cessation would have an adverse effect on market integrity in the UK, and parties are unable to move away from that benchmark, it is appropriate that the benchmark should be recognised as critical.
In truth, this is a complex judgment made by the regulators in the context of what is happening in the market, the readiness of the alternatives, and what I have just described. The Government will make a direct evaluation of that, but here we are setting out the context in which that power will be used by the FCA.
On the point about the Government making a direct evaluation, if the benchmark user argues that it would not be reasonably practical to move to a market-led substitute, but the Treasury disagrees with that, what recourse does the user have to challenge this decision?
These matters will be governed by protocols with the industry. The industry would have a dialogue with the FCA, through which these matters would be resolved. There would be a dispute, I would imagine, about the number of contracts, the number of people involved in those contracts, and the readiness of an available alternative. Usually, these matters would be resolved through dialogue and consultation.
That is really helpful, in terms of the dialogue with the FCA. Will a process be followed to ensure a fair system is applied with regard to substitutes that disagree with the Treasury process, or will how it is done be judged at that time?
The complexity of these contracts and their reference to these benchmarks necessitates ongoing dialogue. There is a significant team in the FCA that deals with this work. The industry has been very concerned about this. This is a live, ongoing conversation. Given the context, and the history that the right hon. Member for Wolverhampton South East and I set out, and how appalling this situation was previously, there is wide consensus that this should be done in an open and collaborative way. This regulation will be used in that spirit.
Paul Richards from the International Capital Market Association, who gave evidence last week, said there were around 520 legacy bond contracts to be moved over, and only 20 had been converted in the market so far, because it is a difficult and time-consuming process. Is there more the Government could be doing to reassure and help? Does the Minister envisage bringing forward any amendments to make this any easier? It sounds like this process will cost the markets money.
I thank the hon. Lady for her question. The evidence from the ICMA last week underscored the ongoing complexity and challenges of this. It may be that legislation will be required in a future Session, but that would be subject to a resolution. There is no point of crystallisation from the industry; it is not compelling us to bring something forward. There is no resistance on the part of the Treasury to doing that; it is a question of working out what would be appropriate for the market. That dialogue will continue, and the Government will respond in the appropriate way in due course. I think the gentleman who gave evidence last week was appropriately making the Committee aware of that ongoing additional dialogue regarding that safe harbour provision. But there is no point of conflict between the Treasury and the industry on this matter.
The questions asked by my hon. Friend the Member for Erith and Thamesmead expose the potential for litigation if the Government and regulators are moving contracts from one basis to another; some of the people involved will have deep pockets and expensive lawyers. The Minister tells us that it will all be sorted out—thrashed out—and I hope he is right; but I am not sure that we can guarantee that.
I have a couple of questions about the clause and those clauses that follow. First, is it all about LIBOR, even though it talks about critical benchmarks, or is it more general? For example, might the provisions be used on a benchmark related to the price of a particular metal, or something like that? For our understanding of the matter, should we, wherever the provisions refer to a critical benchmark, just be thinking about LIBOR—because that is what we really mean; and is there some parliamentary drafting reason why the Bill does not say that?
Secondly, the clause deals with a review of which benchmarks are critical benchmarks. The Minister said, and the clause says, that that seems to be a benchmark for which a market-led substitute exists, although for some reason it is not practical to transfer activity to such a market-led substitute. That is what is confusing about the clauses. We are told that the policy decision, and the regulatory decision, is to move away from LIBOR and to cease using it by the end of 2021. That is my understanding. Yet it seems that the clauses both facilitate that and facilitate the continued use of such benchmarks.
My reading of the clause and the one that follows is that the FCA will retain the power to compel organisations to submit information to a critical benchmark, even though the policy decision has been made to move away from that benchmark. The question then is why the regulator would want to do that, and what the power means for the 2021 LIBOR end date. Does the power mean that the FCA could compel submitters to keep submitting information to LIBOR, and is that because so many contracts depend on it? Is that really why the power to continue submitting information to critical benchmarks is engaged in this? What I am really asking is whether the clause is putting the brakes on LIBOR or, in some ways, continuing a facilitation of LIBOR after the end of 2021, for some things.
In the UK, LIBOR is the only critical benchmark. However, for reasons that the right hon. Gentleman has alluded to, we do not want the provision to be on just the LIBOR benchmark. For reasons to do with the type of legislation that that would mean—private legislation referring to something specific—a different process would be created. We have to use benchmark legislation—benchmark regulations; but LIBOR is what it pertains to. That is the only critical benchmark in the UK.
A mechanism to compel panel banks to continue to submit data beyond the end of 2021 does not exist. We have to be able to wind down in an orderly way and make provision for continuity, which is needed for the tough contracts that continue to exist and will need some reference point. We need to do that in a way that satisfies the market and maintains stability. It is in that context that we are giving the FCA the powers.