Benchmarks have quietly become a ubiquitous feature of the financial markets. Prior to the revelation that the London Interbank Offered Rate (LIBOR) had been systematically manipulated for several years, few outside the world of finance had heard of this or any other benchmark. This is in spite of the fact that benchmarks are deeply embedded in the financial market and “real” economy—affecting the price of oil, consumer interest rates, and valuation of trillions of dollars of derivatives. In recent years, however, benchmarks have been at the epicenter of numerous, sustained, multi-year manipulation schemes. Benchmarks present a new frontier in market manipulation but, in the U.S., their distortion is treated in the same manner as “traditional” market manipulation. As I argue in this Article, Benchmark Regulation, this shortcoming poses a significant source of risk to the global markets.
A benchmark is a price, rate, or index that measures one or more underlying assets, prices, or other data based on a formula, value assessment, or market survey. In short, a benchmark aggregates market information into a single metric that is used as the basis for pricing or valuing financial contracts or obligations. As an aggregation of data, benchmarks provide information on the underlying asset that is both deeper and richer than the data to which any single market actor has access. These metrics enhance market efficiency through the reduction of information and transaction costs, as market actors are able to rely on the benchmark rather than compiling their own data. For these reasons, many benchmarks now represent the accepted price of an underlying asset or the de facto rate that the market uses.
In recent years, benchmarks have been at the epicenter of numerous, multi-year market manipulation scandals. Between 2012 and 2015, there was a spate of market manipulation schemes involving the distortion of benchmarks linked to oil, gold, natural gas, precious metals, and even milk. With each new scandal, U.S. financial regulators have responded with investigations, fines, and sanctions; yet, their reactions seem to be too little, too late. In the U.S., benchmark manipulation is addressed exclusively through after-the-fact prosecution of wrongdoers, when and if discovered. The reliance on ex post prosecution of wrongdoers stems from the view of benchmark manipulation as another form of or akin to “traditional” market manipulation. But, as I argue in this Article, benchmark manipulation is meaningfully distinct from traditional market manipulation—in implementation, scope, and market impact—and, as such requires a different regulatory response.
Using the manipulation of three benchmarks as case studies, this Article analyzes the fundamental characteristics of benchmarks that justify an ex ante regulatory approach in order to minimize and respond to instances of benchmark manipulation. As shown in these case studies, benchmark manipulation is possible and profitable because of the innately conflicted process that underpins the production of a benchmark. All benchmarks are compiled using data contributed by entities that are the primary consumers of the benchmark. The dual and conflicting role these entities play in the creation of a benchmark exposes the metric to possible manipulative practices. Additionally, how benchmarks are used in the market further exacerbates the potential for manipulation. Namely, the widespread integration of benchmarks in the financial market amplifies the reach of benchmark manipulation schemes; and the importance market actors place on benchmark liquidity negates any possibility of market discipline in the face of manipulation. The combination of these features renders an enforcement-only regulatory approach ineffective at curbing benchmark manipulation. Therefore, U.S. regulators ought to implement an ex ante regulatory framework to oversee benchmarks.
As I argue in Benchmark Regulation, ex post enforcement actions are an inefficient way to deter benchmark manipulation. The lack of government oversight of benchmarks exposes the financial markets to an avoidable and significant source of manipulation. In order to minimize the impact and likelihood of benchmark manipulation, the benchmark industry should be subject to ex ante regulations. This Article puts forward a comprehensive, prescriptive regulatory framework for U.S.-based benchmarks. The proposed regulatory regime would address the underlying motivations of benchmark manipulation, but also grant the benchmarking industry much-needed flexibility in self-governance.
The Article lays out a two-tiered self-regulatory format, mirrored on the governance approach to stock exchanges and futures markets. The benchmark industry would form a self-regulatory organization (SRO) responsible for adopting, implementing, and enforcing prescriptive rules for the industry. But, importantly, the SRO would be subject to the oversight of a relevant financial regulator, such as the Securities Exchange Commission, the Commodities Futures Trading Commission, or the Financial Stability Oversight Council. The proposed framework involves the industry in its own regulation, allowing for tailored rules that do not stifle innovation or hamper efficiency, but also engages government oversight of this crucial aspect of the financial markets.
Gina-Gail S. Fletcher is Associate Professor of Law at the Indiana University Maurer School of Law.