November's Structured Products Washington, DC conference was dominated by one topic above all others: proprietary indexes. A regulatory panel including two officials from the Securities and Exchange Commission (SEC) and one from Financial Industry Regulatory Authority (Finra) was grilled for 40 minutes by delegates anxious to learn more about October's enforcement action against UBS – under which the Swiss bank agreed to pay $19.5 million to settle charges it had misled investors on how its in-house V10 currency index operated.
Hand after hand shot into the air as the compliance officers and legal counsels in the audience took the opportunity to quiz the regulators on what the action meant for their own custom index businesses. Did press articles on the V10, in which UBS employees waxed lyrical on the transparent and systematic nature of the index, contribute to the enforcement action?
If UBS had not marketed the product so heavily, would the V10 have ever come to the SEC's attention? Was it a whistleblower from inside UBS who revealed that the price inputs to the index were being manipulated? How connected was the enforcement action to UBS's role in the foreign exchange rigging scandal exposed earlier this year, and did the bank engage in any criminal activity in relation to the V10?
The regulators batted away most of these with a flat "no comment", stressing they had charged UBS for corporate negligence regarding its product disclosures, rather than on how the index itself operated. Not everyone was convinced. Some suggest the V10 case flowed directly from the US investigation into the forex scandal, for which UBS was penalised around $1.34 billion in total across 2014 and 2015.
Any ambiguity about the origins of a price input into a proprietary index represents a potential regulatory pitfall and could come with a hefty price tag
The enforcement action also fuelled concerns that there will be further revelations of improper activity in other banks' custom index operations to come.
These concerns are well founded. Proprietary indexes occupy a contested space between actively managed trading strategies and rules-based benchmarks, and so fall into the cracks between regulatory regimes. As dealers do not know with any certainty what standards these indexes will be held to, they tend to take an obsessive approach to their creation and ongoing governance.
The question is whether the UBS case signals a sea change in attitudes towards this product class – especially for those sold to retail investors, as the V10 was. Any ambiguity about the origins of a price input into a proprietary index, or the level of discretion a dealer has when it comes to rebalancing the index constituents, represents a potential regulatory pitfall - and could come with a hefty price tag.
As such, dealers may feel it is simply safer to retreat from exotic structures altogether or outsource the liability to third-party administrators that can take the bank's intellectual property and use it to create and govern indexes on their behalf.
Could October's enforcement action have signalled the end of the boom period for proprietary indexes? Possibly, at least for mainstream banks. At the very least, issuers will find these businesses under intense scrutiny in the years ahead.