Why benchmarks are turning a corner

21 February 2018

Regulated benchmarks appear more accurate and markets are benefitting. To understand why, look no further than your nearest used-car showroom.

In 2013, following the LIBOR scandal, regulators started an important period of reforms in financial benchmarks. This period culminated at the start of this year with the new EU Benchmarks Regulation.

The financial industry uses benchmarks to settle contracts, monitor trade executions and signal prices. FCA regulations – together with standards set by IOSCO – improved systems and controls requirements to reduce the chances of manipulating benchmarks.

Previous analysis, has shown that regulation has improved the accuracy of the Intercontinental Exchange (ICE) Swap rate benchmark, as well as the liquidity of the underlying market. But why? What explains this improvement in liquidity?

A new economic model, published by the FCA, suggests the key is improved accuracy. More precise benchmarks mean dealers can profit less from their informational advantage. By way of analogy, imagine buying a second hand car from a dealer. You want to pay a reasonable price. But you face a couple of problems.

More precise benchmarks mean dealers can profit less from their informational advantage.

First, dealers know how much they paid for that car, but you do not. Second, you have to contact each dealer directly, leaving you with only a glimpse of how the market values the car. Dealers know far more about car prices than you do, allowing them to sell you the car for a higher price.

Now, imagine you can look up a reference price in a car magazine. This helps you challenge dealers and steer away from unreasonable prices. But the accuracy of the reference price matters.

If the reference price (the benchmark) is based on self-reports from dealers, it will not be very precise. Suppose instead the magazine introduces a committee monitoring the benchmark and, instead of asking each dealer to submit a report, bases the benchmark on real prices paid for that model of the car. Both moves improve the reference price, giving you a more precise way of judging an offer from a dealer. Dealers, in turn, face a reduced advantage.

Many financial markets had a similar problem: benchmarks were not accurate enough and dealers could profit from them. Regulations improved the accuracy of the benchmarks leaving traders better off.

The new FCA analysis helps us understand why. It also suggests that the regulation of benchmarks complements enforcement action. Regulatory fines improve market outcomes, but are unable on their own to fully restore market efficiency.

This article is based on a full economic analysis that is available on the FCA research pages.

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