Eighteen days before Halloween, US structured product providers suffered a nasty fright. After years of general warnings to tighten up disclosures for products linked to proprietary indexes, the Securities and Exchange Commission (SEC) finally took action, accusing UBS of making false and misleading disclosures about the performance of one of its indexes.
The Swiss bank paid $19.5 million to settle the charges without admitting or denying them. But while the size of the settlement is a drop in the ocean compared with those for foreign exchange and Libor rigging, it has led to concerns that the regulator has only just begun investigating what has been a lucrative product line for dealers in recent years.
"There may well be additional enforcement actions – not only in the area of disclosure, but also in other areas concerning prop indexes," says a derivatives partner at a law firm in Washington, DC.
Proprietary index products are often structured as a bond with a performance element linked to a rules-based index or strategy created by a bank or third-party provider. Some replicate hedge fund-type strategies, for instance, while others might provide exposure to interest rate curve strategies. The products have been a huge success – JP Morgan's Efficiente index family alone had more than $3 billion in assets under management as of April 2015.
Anything that might threaten the reputation of these products is therefore taken very seriously, which is why the UBS sanction has caused such a stir. But while rivals were adamant that UBS's alleged actions – which included inserting mark-ups on internal hedges and trading in advance of client hedging transactions – were not symptomatic of the sector as a whole, the case has led many to check for weak points in their own disclosures. The process was given extra impetus after SEC commissioner Reid Muoio (pictured) told the Structured Products Washington, DC conference on November 5 that he had another "case or two" similar to the UBS action in motion.
"This is something that has been at the forefront of our minds for the past couple of months," says Laurence Black, head of equity and fund structured client strategy and solutions at Barclays in New York.
Structures that involve non-public price inputs, such as the internal pricing for hedges seen in the UBS case, have been a particular focus. Since 2013, the SEC has required issuers to publish the offering price and the issuer's valuation of the structured note to enable investors to understand the difference between the prices – in other words, how much profit banks are making on a structure.
The regulator does not specify exactly what pricing inputs to include, so some banks have erred on the side of caution and are not using internal prices. Governance procedures have been ramped up for those sticking with non-public inputs, while some dealers have also looked to use third-party calculation agents to ensure the indexes are priced independently.
"What [the UBS enforcement case] does is put a ton more pressure on the question of whether the pricing inputs and your pricing experience is actually objective or whether it is in fact influenced by someone who potentially has a conflict [of interest]," says one senior executive at a US-based investment firm specialising in exchange-traded products.
Published on October 13, the SEC's investigation into UBS did not make easy reading for the proprietary index industry. It concerned the bank's V10 currency index, which offered retail investors exposure to a custom short-term currency trading strategy designed by UBS that they would otherwise have no means of accessing.
The trading strategy hypothetically went long the three highest-yielding Group of 10 nations' currencies and short the three lowest-yielding G10 currencies using six-month over-the-counter forward contracts in a low-volatility environment, while in periods of higher volatility the strategy was reversed. Moving between the strategies was known as a switch day.
The Swiss bank's marketing literature for the product said the V10 index was "transparent" and "systematic", and used "market prices" as inputs. But while UBS stated in the risk factors section of the product's prospectus supplements that it would use forward contract prices based on market observations at 3pm London time, the SEC claimed the actual prices were, at times, manipulated, and that UBS's ability to affect these prices through its own trading was not explained in the disclosures.
While UBS normally used mid-market prices when calculating the index, on switch days it used prices on its hedge transactions, which it obtained from its own forex trading desk via an intermediary. In 2010, the intermediary started to add mark-ups to hedge transactions on switch days, leading to inputs being used "that were not consistent with market prices", according to the SEC order – bringing down the performance of the index by 1%. "Given the intermediary's largely administrative function, there was little, if any, legitimate business justification for the amount of these mark-ups," said the SEC order.
In 2011, UBS's forex desk allegedly added undisclosed spreads on switch days, "largely at the discretion of the forex spot desk", affecting the performance of the index by around 4%. Around the same time, the SEC order said the forex spot desk entered two dozen trades in its management trading book shortly before executing potentially market-moving internal V10 hedging transactions "which were directionally consistent with those hedging transactions".
None of these actions were disclosed to investors prior to them purchasing the structured note, nor was any reference made to the impact it could have on the value of the index. The cumulative impact of these practices was to depress the performance of the V10 by around 5%, costing investors approximately $5.5 million according to the SEC.
Structured product lawyers say the case highlights the dangers of relying on non-public information – such as the switch-day hedging prices – as an input when calculating proprietary index values.
"The banks recognise that not using a market input, but rather prices that were available to them alone, creates risk," says the Washington, DC-based derivatives lawyer.
That doesn't mean banks will necessarily shy away from using these inputs. "Some banks might continue to use internal prices if a certain product has been successful for them or there is a particular demand from the marketplace, because they simply can't get them from more traditional market sources, especially in cases where there is no established trading market or an illiquid market for the underlying asset," says the lawyer.
One executive overseeing the risk premia business at a US bank says that while it still uses internal prices when no public proxy is available, the firm employs a rigorous sign-off process involving two separate governance functions when doing so. "[UBS] had the twin issues of charging mark-ups and not disclosing. We fully disclose transaction costs on all our strategies and have procedures in place to track them. If we have a trading book that we have seen is capturing the bid-offer on a particular strategy, we compare it with what we have told clients," says the executive.
Barclays' Black says the bank employs third-party calculation agents to quantify the inputs for many of its indexes, which ensures independence of pricing. But the bank's most heavily customised products are calculated by its own index research group, which is completely separate from the investment bank to avoid any potential conflicts of interest.
Barclays avoids using non-public prices in its index suite as they would compromise the ability of its third-party calculation agents to validate the inputs, says Black (pictured). Nevertheless, recent events have caused the bank to re-examine its indexes to make sure there are no weak spots. "There are three areas we're working on: one, the independence of the index calculation agent for each product; two, checking the public availability of all the data sources we use for our indexes; and three, making sure each product is suitable for the end-client," he says.
Some US issuers have also brought in consultants to probe for weaknesses in their index governance frameworks. "We have agreed to hire an external consultant into our internal governance group. He will spend hours with all of us understanding exactly our perspective and will come back with recommendations on anything we can do better and anything we are missing. It is super helpful for us to get this outside view," says the US bank executive.
Others suggest dealers may look to outsource the calculation of this business entirely, with third-party administrators taking on pricing and structuring roles: "The development of relationships with administrators that are responsible for more than just calculation is happening. It is a big transition," says a New York-based financial regulation lawyer.
"These indexes used to be all in-house, so the index creation unit would work co-operatively with the structuring unit and other relevant businesses within the organisation. Now there is a separating out of those functions, where issuers will need to clearly define roles and responsibilities between themselves and these administrators," the lawyer adds.
In the meantime, some banks have revisited their documentation to ensure it matches up with how the proprietary indexes are actually priced. The executive at the US bank says its lawyers demanded a rewrite of documentation describing one index to include a statement on the time of day it rolled the three-month US Treasury futures that served as one of the inputs. Depending on the timing, the issuer could hold a 91-day or an 89-day exposure, and the lawyer said the bank would have to explain in its disclosures why it preferred one to the other.
Our advice to clients has been that they are at risk if they are not using objective, verifiable inputs in their index
The executive says the SEC's scrutiny will make disclosures "gigantic" and could discourage all but the most sophisticated investors from investing in proprietary indexes. This may not be a bad thing, though. "Yes, it puts people off. But it puts off the right people. If you have an index document that has 1,000 pages, you are not equipped to buy something like that if you only have two people managing the whole portfolio."
Despite launching a case based on failures in pricing disclosure, the SEC has not specified exactly which prices should be used for the index inputs (See box: Regulation on the way). But one thing is clear, say lawyers: the regulator will not tolerate ambiguity in a product disclosure's description of where the price inputs come from.
"Prop indexes are difficult in that you've got to look at the instruments underlying the index. If it's your own index, you are charged with a higher duty because you know what the underlyings are [and] a misstatement or an omission is going to be scrutinised more heavily," says one New York-based structured products lawyer.
Interestingly, the SEC only accused UBS of failing to disclose that the V10's price inputs were subject to discretion – not that they were manipulated in the first place. So does this mean UBS would have been cleared of any wrongdoing had it openly stated that the index performance could be arbitrarily distorted?
"The SEC's beat is disclosure. It didn't have jurisdiction over the actions that made the related disclosures false and misleading. That said, our advice to clients has been that they are at risk if they are not using objective, verifiable inputs in their index," says the New York-based financial regulation lawyer.
At the Washington, DC conference, the SEC's Muoio explained that the commission's enforcement action was for corporate negligence, not criminal activity. But issuers are not convinced that simply disclosing dubious pricing methodologies will automatically absolve them of all responsibilities.
"I sat and listened and, as someone in the market, I'm not going to raise my hands and say that can't possibly be right. If you can disclose that and people still want to buy the product, that's fine. [But] think of yourself as an investor – how happy would you be with that explanation?" says the senior executive at the US-based investment firm.
Regulation on the way
While structured products businesses are rushing to tighten up their governance procedures around proprietary indexes, the global and national-level regulatory framework overseeing the products is at an embryonic stage.
On November 25, the European Union reached a preliminary agreement on proposed regulation for financial benchmarks. While the draft regulation is focused on preventing a repeat of the Libor and forex-rigging scandals of recent years, the text clearly captures all indexes used as a reference price for a financial contract – including proprietary indexes linked to structured products.
The final text is not expected until 2016. However, it is expected to mandate a set of minimum standards aligned with those published by the International Organization of Securities Commissions (Iosco) in July 2013. Many issuers have already brought their proprietary index governance processes in line with the principles, hoping compliance will render them immune to the kind of enforcement action suffered by UBS.
For example, Iosco principle nine states that an index administrator should publish a concise explanation in simple language that describes, among other things, the size and liquidity of the underlying market, indicative percentages of each type of market data that has been considered, and an explanation "of the extent to which and the basis upon which expert judgment [discretion], if any, was used in establishing a benchmark determination".
There is currently no US equivalent to the EU benchmark regulation and none is in the works. One Washington, DC-based derivatives lawyer says the only guidance on the issue comes from the Securities and Exchange Commission's industry letters, public statements and enforcement actions. This guidance creates a climate of concern without giving a clear indication of where the commission might go next, the lawyer says.
However, speaking at the Structured Products Washington, DC conference in November, Sean Davy, a managing director at the Securities Industry and Financial Markets Association, said the UBS case "starts to get a little more into the weeds" of benchmark regulation. Regulators will start to ask issuers more penetrating questions about how they manage their benchmarks, he added.
The week on Risk.net, July 7-13, 2018Receive this by email