European managers could see surprise over benchmarks

European money managers will be facing higher charges to benchmark their assets against indexes should pan-European rules on the use of non-EU indexes come into play in their current form.

The EU Benchmarks Regulation — adopted by the European Union on June 30, 2016, and effective next year — is an effort to counter benchmark manipulation following the LIBOR scandal, in which financial institutions were found guilty of fixing the London interbank offered rate. The aim is to regulate non-EU-originated benchmarks that are often used to calculate the performance of managed assets and set fees.

The rules will reduce the number of indexes available to investors and money managers by increasing the cost of operating such benchmarks and complying with the new rules, sources said. And less competition will mean higher fees, they said.

"We will see third-country and smaller index providers stop providing benchmarks to users in the European Union, which — combined with the investments that index providers will have to make — will bring the prices of indexes up," said Tobias Sproehnle, consultant at specialist financial services regulatory consultancy Bovill Global in London.

Another source familiar with the regulation, who asked not to be identified, added that for some non-EU index providers from South Africa or Asia that have two to three clients in Europe, the regulation will make it difficult and costly to offer indexes to them.

Rudolf Siebel, managing director at BVI, the German investment funds association in Frankfurt, said: "Assuming a stock exchange in an emerging market which offers domestic indexes chooses not to register under this regulation, those money managers which offer a specialist EM fund with exposure to this country will lose access to the benchmark and will have to look for an alternative that may not be available."

Although the regulation is unlikely to bite into the business of large index providers, ​ sources agree it will increase the cost of providing indexes. That could lead to more M&A activity in the sector, resulting in exchanges purchasing index companies, Mr. Sproehnle said. The recent sale of the World Government Bond index by Citigroup Inc. could be foreshadowing this new era, as investment banks are forced to focus on their core business.

Money managers have six months to prepare for the changes. The regulation imposes requirements for filing the benchmarks with a national regulator and engaging a third party or a separate entity to monitor methodologies of non-EU benchmarks by money managers.

This is going to be an especially significant development for money managers that have been benefiting from increased appetite for blended global equity strategies, such as benchmarking against a strategy made up 80% of the FTSE100 index, and 20% of an MSCI Inc. stock index, if MSCI were a non-EU benchmark, said the source, requesting not to be identified.

Regulators want money managers to administer their indexes in Europe or hire a third-party administrator to ensure the regulation is followed. Money managers will be required to use an EU-regulated benchmark. Users not complying could be fined 10% of the value of the annual turnover, but penalties could be much higher. "Sanctions can be either €1 million or 10% of the firm's total annual turnover, according to the last available accounts approved by the management body — whichever is the higher," said Bruno Piers de Raveschoot, chief operating officer of RIMES Technologies Regulatory Division, a financial data management specialist for money managers in London.

Mr. Siebel added the regulation is a huge issue for members of the German funds association as well as members of the European Fund and Asset Management Association because the benchmarks used by majority of European managers come from outside of the EU. "We encourage our members to engage in a dialogue with their index providers to get them to clarify their status as soon as possible," he said. Money managers have to provide information of indexes and methodologies used in funds to investors at the start of next year, Mr. Siebel added.

A source at a money manager in London, who did not wish to be named, said that "given the potentially large number of index providers seeking authorization to provide new benchmarks post the Jan. 1 deadline, efficiency of authorization is a concern. If not well executed by all parties, this could, for example, result in the inhibition of new product development as authorization is delayed."

Sources said the regulation is unlikely to harm the business of the behemoths among index firms, because it will offer passporting-type arrangements to U.S.-based providers such as MSCI and S&P Dow Jones Indices. But for smaller providers, it might not be worth it to establish themselves in Europe to serve a small number of clients.

And the U.K.'s pending exit from the European Union is complicating matters for money managers, because compliance is required by January and the result of Brexit negotiations will not be known until March 2019. For the time being, the FTSE100 is considered an EU benchmark, but that could change, depending on the final terms of the Brexit deal.

However, sources said Brexit has not stopped firms from getting on with preparing to comply. Mr. de Raveschoot added: "We know that the Financial Conduct Authority has received over 300 requests by companies to become such administrators."