— Paul Amery's Blog

There are no bullet-proof benchmarks

Manipulating interest rate, currency and commodity benchmarks will soon be a criminal offence in the UK, carrying the threat of a seven-year jail sentence, according to press reports.

Meanwhile, evidence mounts of an epidemic of benchmark-rigging.

The 2012 LIBOR scandal has been followed by other alleged cases of price-fixing, involving gold and foreign exchange.

Traders have gone on the record to describe traders’ attempts to skew survey-based energy benchmarks by submitting unrealistic prices that suited their trading positions—just as occurred with LIBOR.

Other types of market manipulation appear to have taken place in the financial instruments used by indices underlying tracker products.

In 2009 I published an article describing how investors in oil ETFs were being hit by apparent front-running in the futures contracts being used by the trackers as reference prices.

Unsurprisingly, the business of producing indices and benchmarks is now under intensive regulatory scrutiny.

Those compiling benchmarks have to comply with IOSCO’s 2013 principles for financial benchmarks, which set new governance and transparency requirements, by next month. The European Commission has its own draft benchmark regulation on the table.

Some of the firms involved in benchmark-setting are deciding it’s not worth the hassle—or the increasing potential legal liability—to continue. Deutsche Bank recently resigned from the daily London gold and silver fixes, having failed to find a buyer for its seat on the fixing panel.

Requiring greater transparency in benchmark-setting, introducing new sanctions and bringing about a greater separation between those calculating benchmarks and those involved in trading should help to counter the worst abuses.

But none of these things will make benchmarks immune from attempted manipulation.

Even share indices, which, unlike oil, FX and interest rate benchmarks, are calculated using prices from relatively transparent public markets, are not fool-proof.

All indices undergo periodic rebalancing. When index providers announce details of the stocks due to enter and exit their benchmarks some traders seek to profit from the information during the period between the announcement and the date of the index change itself.

Index firms can change the benchmark rules to try and counter attempted front-running, for example by randomising the dates on which the rebalancing occurs within that time-frame. This may deter manipulators, but it also detracts from the index’s transparency. A benchmark using opaque construction rules wouldn’t work as a benchmark at all.

There’s no perfect solution here. The most popular benchmarks are used in financial products because they have gained widespread acceptance and met a market need. $350 trillion of derivative products were reportedly linked to LIBOR, which was originally seen as a superior, market-based alternative to official central bank interest rates. But such volumes of traffic attract those seeking to influence prices or flows.

The more accepted an index or benchmark becomes, the greater the inefficiencies it may generate.

Heavier fines and jail sentences may deter the worst cases of benchmark-fixing. But some attempts at market manipulation are an inevitable result of the use of indices and benchmarks as reference prices in financial products.