Index Regulation and Transparency
Index Transparency—Recent Regulatory Developments
While indices have long played a crucial role in investment, index provision has not traditionally been a regulated activity. When regulators have imposed restrictions on indices that could be used by retail funds, these have been relatively high-level: wide recognition and acceptance; wide dissemination and availability of public information about composition and methodology; and sufficient diversification.1
It is only recently, against the backdrop of the rapid growth and diversification of indexing products, and in the shadow cast by integrity issues with the oil price and interbank rate benchmarks, that indices have received closer scrutiny and the question of imposing higher standards of methodological quality, governance and transparency upon indices has been discussed.
In this article, we review recent regulatory developments related to indexing with particular emphasis on the issue of transparency, which has taken on critical importance with the emergence of new forms of indices.
2001-2012: UCITS III and the rise and diversification of indexing
The “Product Directive”2, which increased the investment freedoms of European retail funds (known as Undertakings for Collective Investment in Transferable Securities, or UCITS), introduced the first reference to financial indices in UCITS regulation. The Directive relaxed risk-spreading rules to allow for the replication of (apparently poorly diversified) “well-known and recognised” indices. It also permitted outright investment in financial derivatives and, recognising financial indices as an acceptable underlying for these derivatives, created the possibility of synthetic replication. The Directive authorised replication of indices recognised by the competent authorities as being sufficiently diversified; representing adequate benchmarks for the market to which they refer; and being published in an appropriate manner.
These requirements were first clarified by the “Eligible Assets Directive”3. To be considered an adequate benchmark, an index must measure the performance of a representative group of underlyings in a relevant and appropriate way and be revised or rebalanced periodically, according to publicly available criteria, to continue to reflect the markets to which it refers. Transparency requirements with respect to publication are described as the “wide and timely” provision of “material information” on matters such as index calculation, rebalancing methodologies or index changes.
At the same time the Directive clarified that UCITS could indirectly invest in otherwise ineligible asset classes via derivatives tracking financial indices; the Committee of European Securities Regulators (CESR) subsequently issued guidelines4 detailing eligibility conditions for hedge fund indices, which notably included the requirement that these indices be systematic and that UCITS carry out appropriate due diligence on the quality of these indices.
The introduction of these broader investment freedoms facilitated the rapid development of index funds; they also allowed UCITS to pursue strategies that had previously not been possible, which created concerns about the possible retailisation of complex strategies. This prompted the successor to CESR, the European Securities and Markets Authority (ESMA), to review the UCITS regulatory regime.
The 2012 ESMA Guidelines: a benchmark for transparency
ESMA surveyed the industry and concluded that investors were not sufficiently informed about the risks of indices and that some indices appeared to have unstable objectives, rely on discretionary strategies, or maintain opacity with respect to methodology and composition.
In July 2012, following two industry consultations, ESMA established new transparency requirements for index-tracking vehicles and updated the eligibility criteria of financial indices for all UCITS. These rules5 are applicable to newly created funds since 17 February 2013; other UCITS have one year to comply. With respect to transparency, ESMA clarified that each index should have a clear, single objective and that the universe of the index components and the basis on which components are selected should be clear. ESMA went further and prohibited the use of indices that do not disclose their “full calculation methodology” or fail to publish “their constituents together with their respective weightings” at least up to the period preceding the last rebalancing. The regulator also required that this information be accessible easily and on a complimentary basis to investors and prospective investors. ESMA also prohibited investment in indices whose methodologies are not based on a set of pre-determined rules and objective criteria, or which permit the so-called “backfilling” of data.
These requirements go beyond what would be needed for a high-level understanding of the objective, methodology and historical performance of an index, which would suffice for investor orientation and a basic screening of indices. The regulator’s intention is to restrict the choice of indices to those that are systematic and for which sufficient transparency is provided for independent historical replication on a non-commercial basis, which allows one to audit the track record, gauge the exercise of discretion and conduct performance and risk analyses to assess the relevance and suitability of each index with respect to investor goals. In so doing, ESMA has taken a major step and introduced transparency in an industry which, with some exceptions, is characterised, under the pretext of protecting intellectual property, by the low level of information given to investors on index methodologies and compositions.
While such transparency is important for market indices, i.e. indices that aim to represent a given market or segment, it is all the more so for strategy indices, i.e. indices that aim to achieve a given risk/return objective. Indeed, while the latter can provide investors with improved risk/reward profiles or other benefits, they bring distinct risks of their own, notably the risk of periodic underperformance vis-à-vis market indices, which to date remain the primary benchmarks. Furthermore, while there are often several providers offering indices with comparable objectives, closer inspection reveals a wide diversity of assumptions, choices and methodologies and therefore model and parameter estimation risks. Unfortunately, these indices’ low level of transparency on detailed methodology, which is routinely justified by the use of proprietary models, makes the evaluation of risks difficult.
The ESMA rules provide the minimum level of transparency allowing investors to do their pre-investment due diligence and integrate indices into a modern risk and investment management framework; at the same time, they fully preserve the index industry's ability to charge, inter alia, for live replication data and services. To promote progress in indexing practices, we have endorsed the new ESMA framework as a global beacon of transparency and called upon regulators to ensure all interested parties enjoy non-discriminatory access to this data along with the right to analyse it and publish the results of their research so as to promote an informationally-efficient index industry.
2012-2013: A global review of indices used as benchmarks
The recently uncovered manipulations of interbank interest rate benchmarks in various jurisdictions have given regulators a fresh mandate to review the regulatory regime of indices and benchmarks. Under strong political impetus ensued a raft of regulatory consultations, quickly followed by recommendations, guidelines and draft regulation. In the autumn of 2012, the European Commission consulted on a possible framework for index provision; in January 2013, ESMA and the European Banking Authority (EBA) launched a consultation on principles for benchmark-setting designed to serve as guidance in the interim before potential European regulation. In the same month, the International Organisation of Securities Commissions (IOSCO) launched the first of two consultations on financial benchmarks. The final ESMA/EBA principles were released in June, the final IOSCO Principles in July and the draft European Regulation in September 2013.
Since these regulatory reviews were prompted by egregious cases of market abuse committed by data-contributing entities that had both the capacity to influence benchmark levels and the economic incentives to do so, they were from the start biased towards risks to index integrity heightened by conflicts of interest and the specific weaknesses of submissions-based benchmarks.
As a result, these consultations primarily approached transparency as one of several tools to address the risk of conflicts of interest rather than a prerequisite for informed investment and risk management. While all processes initially included statements in line with the promotion of a degree of transparency consistent with the needs of historical replication, they also associated transparency with the words “adequate” or “appropriate.” The European Commission and IOSCO also used vocabulary indicating that they were sympathetic to the assumption that “governance” and transparency were substitutable, i.e. that some degree of opacity was tolerable in the presence of “strong” governance mechanisms or when the extent of discretion in the methodology was limited. These premises and assumptions paved the way for a backlash against transparency and a regression relative to the high standards introduced by ESMA.
In search of the best and cheapest disinfectant
Discussions about governance typically cover various internal controls and procedures intended to minimise the likelihood that conflicts of interest will affect integrity; these include segregation of duties and information barriers, internal reviews of compliance and whistle-blowing policies. They also mention the use of external, non-market-based, mechanisms such as audits and oversight committees.
EDHEC-Risk Institute considers that the recurrence of scandals affecting highly-regulated institutions subjected to strict governance rules should lead lawmakers to question the ability of “strong” governance mechanisms to protect investors against abuse. Such scandals have not only underlined the limits of internal controls but also exposed the weakness of the external mechanisms that are expected to further mitigate the risks of abuse.
Being appointed and remunerated by the very parties whose compliance they are expected to assure, the accounting and auditing profession is inherently susceptible to conflicts of interests. This has been well documented, including by the profession’s own codes of practice and ethics, as well as richly illustrated by high-profile failures to live up to the profession’s fiduciary duties with respect to stakeholders. The unrestricted ability of professional service firms to provide non-audit services to audit clients has exacerbated the risks of abuse. In this context, one may question the wisdom of entrusting conflict of interest mitigation to parties that have proven their fallibility and remain structurally conflicted. As for “independent” oversight bodies, it is well documented that they may not be exempt from conflicts of interest themselves and are susceptible to capture by management or other powerful interests.
Altogether, non-market based compliance mechanisms, even when they impose a strong fiduciary duty on their participants, have proven incapable of preventing major scandals in the past and little should be expected from their extension or reform. As Jonathan Macey, a professor at Yale Law School, has remarked: “Indeed, one of the great ironies of the myriad new corporate governance rules passed by courts, legislatures, administrative agencies, and stock exchanges in response to the collapse of Enron is that Enron itself met or exceeded the higher standards ostensibly promulgated to prevent future “Enrons.””6
In its contributions to the aforementioned consultations7, EDHEC-Risk Institute warned that regulation focused on such an approach could be counterproductive and lead to heightened risks of abusive conduct, especially if it were implemented in a context preserving opacity. Indeed, certification effects, in particular those involving an official sanction by the regulator, increase moral hazard and adverse selection by promoting a false sense of confidence based on the idea that governance rules and regulatory oversight resolve conflicts of interest issues and guarantee integrity.
EDHEC-Risk Institute has thus expressed caution against any temptation to trade lower levels of transparency for “stronger” governance mechanisms. It considers that transparency is the most powerful mitigator of conflicts of interest as it allows for the independent and multilateral verification of track records and puts the exercise of discretion under public scrutiny. More importantly, full transparency of methodology and historical information is required for investors to conduct thorough quantitative due diligence to measure the risks, costs and potential benefits of indices and assess their suitability in the context of their risk and investment management needs and constraints.
EDHEC-Risk Institute also underlined that governance-based approaches impose significant compliance costs, which directly and indirectly reduce the welfare of investors: directly because compliance costs and the costs associated with the liabilities for non-compliance are eventually borne by investors, indirectly because these costs–which fall disproportionately on small and less established providers–create barriers to entry and lead to further consolidation of an industry which historically has been very concentrated, which does little to promote competition, lower prices and innovation. This orientation favours an oligopolistic market structure of the sort which in the past never protected against scandals but instead guaranteed that any scandal had systemic proportions.
It should also be remarked that while index integrity can be readily verified when there is full transparency and failure to provide the latter can be sanctioned by non-eligibility before any party has been harmed, detection of abuse by other governance means is eventually subject to the reliability and integrity of costly mechanisms, may involve sanctioning that takes place long after some party has been harmed, and may entail great expense for the taxpayer and/or the defendants seeking redress. In other words, governance-based approaches are not only ineffective, but also inefficient.
The 2013 IOSCO Principles for Financial Benchmarks: the low point for transparency?
The IOSCO Principles for Financial Benchmarks encompass Governance principles that notably include the need to establish a control framework and an internal oversight function; Benchmark and Methodology Quality principles that seek to promote quality, integrity and continuity; and Accountability principles that introduce complaints procedures and audits of compliance.
While these principles introduce positive advances with respect to quality of benchmark and methodology, their emphasis is on governance to protect integrity and address conflicts of interest, and on accountability to document compliance. Transparency is approached as one dimension of methodology quality and is limited to the provision of minimal disclosures, on a par with current index industry practices.
This is in stark contrast with the progress that could have been expected from IOSCO’s initial report8, which contained unambiguous language about the lack of transparency in the index provision industry as well as ambitious investor-protection targets: “Transparency should be sufficient to allow interested parties to understand how a Benchmark is derived (including the ability to replicate a published Benchmark level to assess its plausibility and detect inaccuracies or potential manipulation), what it measures and therefore understand the suitability of the Benchmark for their purposes and any limitations or risks of the Methodology.”
After its first consultation, IOSCO noted the lack of consensus amongst respondents with respect to transparency, with some expressing concerns that it would undermine index providers’ intellectual property and others supporting full transparency to allow for independent replication. In spite of this reported support for a high level of transparency, the notion of replicability disappeared from the draft IOSCO Principles9 and the transparency objective was lowered: “The Published Methodology should provide sufficient detail to allow Stakeholders to understand how the Benchmark is derived and to assess its representativeness, its relevance to particular Stakeholders, and its appropriateness as a reference for financial instruments.” The final IOSCO Principles conserved this wording but clarified that the adequate level of transparency it was requiring did not equate full disclosure of methodology or historical data and that the disclosure of “summary information and key features” would be sufficient for compliance (provided indices were produced with data sourced from regulated markets or exchanges with mandatory post-trade transparency requirements). This evolution reflects IOSCO’s acceptance of the index providers’ contentions that they have “strong market incentive to provide the best transparency to Stakeholders” and that full transparency would be detrimental to Stakeholders.
In a world in which oligopolistic firms are stalwarts of perfect competition, the erection of regulatory barriers to entry and the imposition of compliance costs that provide incentives to further consolidation, have every reason to be celebrated as victories of competition and antitrust policies.
Europe at a crossroads
In the elaboration of their principles, the ESMA and EBA rejected the ESMA Securities and Markets Stakeholder Group’s suggestion10 that the governance and transparency approaches were substitutable and that index providers should be allowed to choose with which to comply–with the expectation that less established providers would opt for transparency to avoid being priced out by the disproportionate costs of the governance-based approach. The ESMA-EBA Principles for Benchmark-Setting Processes in the European Union cover methodology, governance structure, supervision and oversight, and transparency. They promote a version of transparency that is consistent with that provided under the UCITS framework but is undermined by references to intellectual property rights as an acceptable basis for restricting access to information: “A Benchmark should be transparent and accessible to the public, with fair and open access to the rules governing its establishment and operation, calculation, and publication (…) A high degree of transparency on the process determining a Benchmark, or any modification thereof, will enhance confidence in its integrity, which would also help foster understanding of the Benchmark in the market place. Transparency may be limited in exceptional circumstances only, based on contractual provisions safeguarding confidentiality and intellectual property rights. The full Methodology along with historical records should be disclosed to the public wherever possible in order to make it fully replicable.”
The draft European Regulation on indices used as benchmarks in financial instruments and financial contracts11 makes benchmark provision a regulated activity subject to initial authorisation and substantial ongoing requirements supported by credible administrative measures and sanctions for non-compliance. Its requirements cover governance and control; data and methodology; and transparency and consumer protection. While broadly consistent with the IOSCO Principles, the proposal shows a stronger concern for the ability to assess the accuracy, reliability and suitability of benchmarks, which would justify higher transparency requirements.
Indeed, the impact study12 accompanying the proposal unambiguously recognised the importance of index replicability and endorsed full transparency as a preferred policy option: “With access to both the data and the methodology, investors and regulators would be able to replicate or back test the benchmark in order to assess its accuracy. Full transparency about what the benchmark measures, how it should be used and its shortcomings would enable regulators and the public to be fully informed about the economic reality a benchmark is intended to measure and of any shortcomings it may have in tracking this. Delayed publication or partial publication would be allowed if full and contemporaneous publication would result in serious adverse consequences for the contributors or adversely affect the reliability or integrity of the benchmark. Publication would only be permitted to be delayed to the extent it significantly diminished these consequences.”
However, EDHEC-Risk Institute is of the view that this ambition does not appear as clearly in the proposal: replicability is mentioned only in relation to the records that a provider needs to keep in the event the index were audited, and the imprecise wording13 of transparency provisions does not guarantee that a high-level of transparency on methodology will be provided to investors; furthermore, the Commission did not request the right to adopt a delegated act to further specify transparency requirements in relation to the benchmark statement, which would have provided an opportunity to make them consistent with the existing ESMA guidelines14.
That such an organisation as IOSCO could be sold on the idea that the level of transparency should be left to the discretion of index providers illustrates how much the full transparency objective identified by the European Commission will be at risk of dilution in the course of the legislative procedure. European lawmakers should thus exert the utmost caution in respect to the wording of the proposal, lest transparency and the ability to back-test benchmarks be irremediably compromised, with significant adverse impact for investor welfare.
EDHEC-Risk Institute advises lawmakers to balance the benefits of governance and control requirements with their direct and indirect costs for investors and to be wary of promoting a misplaced sense of confidence in benchmarks on the basis of governance-based regulation.
To promote fair competition and a high level of investor protection in the indexing industry without creating barriers to innovation, EDHEC-Risk Institute considers it key to focus regulation on the responsibility of professional investors and intermediaries to conduct due diligence on the integrity, quality and suitability of benchmarks and to ensure that the necessary transparency be provided for the discharge of these duties. This calls for the provision of both historical data (index levels, components and weightings) and methodology with a level of precision allowing for independent replication of the index track record.
EDHEC-Risk Institute also suggests that lawmakers ensure that all interested parties enjoy the right to use this data freely, including for the purposes of research, index evaluation and performance comparisons. This would not only allow third-party asset managers and end-investors to perform their due diligence at minimal cost, but also foster public debate on the strengths, weaknesses, benefits, costs and risks of indices, which in turn would create the conditions for a genuinely efficient index market.
Providing the public with the information required to independently replicate an index for such purposes should not be misrepresented as denying index providers the right to protect and enforce their intellectual property rights or as threatening the economic viability of the index provision industry. There are legal (for example, patents) as well as contractual tools (for example, licenses) to defend index providers against the unauthorised use of their methodologies and data15. Beyond these, there is also the strong “natural protections” afforded by the added value, for example the brand or services, that index providers provide to the lawful users of their products.
EDHEC-Risk Institute also notes that the transparency required for historical replication of indices can accommodate important time lags in the release of the underlying data, thus greatly reducing opportunities for free-riding or for front-running by parties that have not subscribed to the index feed.
Opacity typically increases the scope for conflicts of interest to play out as abuse and, worse, practically denies the public the ability to assess the relevance and suitability of indices and to manage their risks properly. Opacity should therefore not be tolerated by regulators as a blanket protection against intellectual property infringements or, in the context of indexing, presented as a way of protecting the interests of investors.
It is in the interest of investors and in the long-term interest of the passive management industry that regulators oppose rather than officially condone the engineering of opacity and the silencing of dialogue around innovations.
1 Index funds and the use of indices by the asset management industry, International Organisation of Securities Commissions, February 2004
6 Corporate Governance: Promises Kept, Promises Broken, Princeton University Press, 2010.
7 Responses to the consultations organised by the European Commission (November 2012), IOSCO (February 2013) and the European Supervisory Authorities (February 2013).
11 COM(2013) 641 final
12 SWD(2013) 337/2
13Article 7(1)e: “The administrator shall develop, operate and administer the benchmark data and methodology transparently” and Section F of Annex I detailing Article 15: “At minimum the benchmark statement shall contain: (…) the criteria and procedures used to determine the benchmark”).
14The possibility may still exist in the context of the delegated acts that could further specify requirements under Article 7.
15Having managed to grow their revenues multi-fold by moving from selling data to licensing usages, index providers have an intimate knowledge that there remain many other usages to charge historical data for.
Related Research & Consultations
Index Transparency – A Survey of European Investors’ Perceptions, Needs and Expectations
Noël Amenc, Frédéric Ducoulombier
Between August and November 2013, EDHEC-Risk Institute surveyed 109 institutional investors from across Europe, including Europe’s largest pension and reserve funds, insurance and provident institutions and their asset management subsidiaries, to document their expectations and requirements with respect to index transparency and take stock of their perceptions of, and the extent of their support for, the main directions of the ongoing regulatory debate on indexing and financial benchmarks.
EDHEC-Risk Institute comments on
Financial Benchmarks Consultation Report CR01/13
Noël Amenc, Frédéric Ducoulombier
The International Organization of Securities Commissions (IOSCO) Consultation Report titled “Financial Benchmarks” (CR01/13, January 2013) was prepared by IOSCO Task Force on Financial Market Benchmarks. The report aims to articulate “policy guidance and principles for Benchmark-related activities” to address concerns regarding the potential integrity of benchmarks and maintain confidence in the credibility of benchmarks. To inform its final Principles on Financial Benchmarks, IOSCO sought the views of stakeholders on the questions posed in this report. Having called for such work be conducted by IOSCO (in Amenc and Ducoulombier, 2012b), EDHEC-Risk Institute welcomed the opportunity to comment on IOSCO’s efforts to create “an overarching framework of principles for Benchmarks used extensively in financial markets.”
Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry
Noël Amenc, Frédéric Ducoulombier
This paper concludes three years of research on better management of non-financial risks within the European fund management industry and puts forward a series of proposals to limit these risks which emerged during the 2007-2008 crisis and undermined the quality of the UCITS label. It is our fervent hope that the three key recommendations we make, on the reinforcement of information on non-financial risks, increased responsibility of all actors within the fund management industry, and the creation of a new label of “Restricted UCITS,” be adopted by the industry so as to restore the reputation of the UCITS brand to its previously hard-earned and rightful place.
This research is drawn from the former CACEIS research chair on “Risk and Regulation in the European Fund Management Industry” at EDHEC-Risk Institute.
Comments from EDHEC-Risk Institute on the IOSCO Consultation Report CR05/12 concerning the principles for the regulation of Exchange Traded Funds
Noël Amenc, Frédéric Ducoulombier
The International Organization of Securities Commissions (IOSCO) Consultation Report titled “Principles for the Regulation of Exchange Traded Funds” (CR05/12, March 2012) was prepared by IOSCO Technical Committee Standing Committee on Investment Management (TCSC5). The report presents what it describes as “proposed common investor-protection principles or guidelines on Exchange Traded Funds (ETFs)” and “touches on certain market structure and financial stability issues.” TCSC5 requests comments on these principles and guidelines, as well as comments on a number of specific concerns. EDHEC-Risk Institute commented on this work whose stated ambition is to serve as a benchmark against which “both the industry and regulators can assess the quality of regulation and industry practices concerning ETFs.”
EDHEC-Risk Institute comments on ESMA Consultation Paper, ESMA/2012/44
Noël Amenc, Frédéric Ducoulombier
EDHEC-Risk Institute welcomed the opportunity to comment on the ESMA Consultation Paper titled “ESMA’s guidelines on ETFs and other UCITS issues” (ESMA/2012/44, January 2012). We welcomed the broadened focus of this new consultation which goes a long way towards approaching important issues in a horizontal way across all UCITS rather than in a vertical way limited to UCITS ETFs. As emphasised in our supporting contribution, we believe that the narrow focus of the previous ESMA consultation was running contrary to the promotion of a horizontal approach to regulation calling for a coherent treatment of economically equivalent products. Continued adherence to a silo approach centred on UCITS ETFs would have increased the risks of adverse selection by investors and regulatory arbitrage by issuers within the UCITS space.
What are the Risks of European ETFs?
Noël Amenc, Frédéric Ducoulombier, Felix Goltz, Lin Tang
This paper outlines EDHEC-Risk Institute's positions on the major concerns of counterparty risk, liquidity risk, confusion between ETFs and other ETPs, risks associated with special types of ETFs, and potential impact of ETFs on the underlying markets and systemic risks. The focus is solely on European ETFs, the bulk of which are regulated by UCITS Directives. Prior to looking at the potential risks of ETFs, the paper presents ETFs and sizes-up the European ETF landscape.