Iosco softens index approach on final benchmark principles

The structured products industry has welcomed Iosco's publication of benchmark principles that promote softer treatment for equity indexes

Frederic Ducoulombier, Edhec

The International Organisation of Securities Commissions' (Iosco) final version of the Principles for Financial Benchmarks, published on July 17, comes after market participants submitted comments on the principles' draft, published in April. By then, the organisation had already set out two sets of principles: general ones that could be applied to all types of benchmarks; and a more specific set that would affect the interbank benchmarks, such as Libor or Euribor.

The paper has not won universal acclaim, especially in relation to the release of proprietary information as well as consumer protection. "Iosco's view of transparency is regressive to what we have seen in Europe with the requirements imposed on Undertakings for the Collective Investment of Transferable Securities (Ucits) by Esma (the European Securities and Markets Authority) for the use of financial indexes," says Frédéric Ducoulombier, director of the Edhec Risk Institute for Asia. "There was an opportunity with these Iosco discussions to promote the extension of the investor protections introduced by Esma to other jurisdictions and other index users, but this opportunity has been lost."

"For example, in its January 2013 consultation report, Iosco had included ‘the ability to replicate a published benchmark level' in its discussion of transparency," says Ducoulombier. "The index industry opposed the idea and this language disappeared from the draft principles. Iosco has gone to great lengths in its final release to clarify that the adequate level of transparency it is requiring does not equate full disclosure of methodology or historical data."

Ducoulombier is referring to the wording Iosco came up with in the final document, which says principles 4, 5 and 12 have been amended to make clear that transparency to stakeholders "does not mean full disclosure of proprietary information".

Index providers were forthright in the consultation set up by Iosco to say equity indexes should not be included in the scope of the organisation's principles, given that the room for manipulation was almost non-existent. Although the official version of the principles softens the approach, a source close to Iosco says he still does not share the view that equity indexes are completely free of risk of manipulation.

"Equity indexes can be manipulated in some ways. For instance, there can be government issues as well as conflicts of interest because of the index provider's ownership structure [principle 5 on ‘Internal Oversight' addresses that point]," says the source. "Therefore, we cannot say that all these principles are not relevant for them and many of the guidelines can also be applied to equity indexes."

Alex Matturri, chief executive of S&P Dow Jones Indices, picks up on the conflict of interest concern to call for independent committees within the index providers. "The potential conflicts of interest have to be addressed and, again, having an independent committee that oversees indexes that are not involved in either commercial or any other invested interest is not too different from the way we have always operated," says Matturri.

Edhec's Ducoulombier also stresses that conflicts of interest can exist. He says the right to intellectual property from index distributors should not stop transparency. "Index providers are subject to conflicts of interests, and discretion and opacity in methodology increase the risks of abuse," he notes. "Providing the public with the information required to independently replicate an index for evaluation or research purposes should not be misrepresented as denying index providers the right to protect and enforce their intellectual property rights. There are legal as well as contractual tools, for example, licences, to defend index providers against unauthorised uses of their methodologies and data."

The source close to Iosco says equity indexes, by their very nature, are less vulnerable to manipulation than a benchmark based on submissions because it is basically a mathematical calculation. "However, we cannot say we are not concerned about them. Nevertheless, we have tried to have a more proportional approach," says the source.

Index providers have shown their satisfaction with the final version of the principles, as it has taken into consideration their comments. "The final version seems to be driving the index business to a way of management with committee-based structures, which is similar to what we do. Many index providers don't work that way, and we have always felt that's a good way to bring transparency to the market," says S&P Dow Jones Indices' Matturri. 

Rick Redding, executive director of the Index Industry Association (IIA), also welcomes the final version of the principles. Coinciding with the publication of Iosco's paper, the IIA has released its Best Practices to set up standards for its members, and hopes other non-member companies will also follow them.

Some of the standards set out by the IIA refer to transparency – by establishing "adequate internal controls" to ensure the data utilised is robust – as well as to conflicts of interest. The association says an index provider should secure that "personal interest or business connections do not compromise" its performance, as well as "establishing a segregation of reporting lines" within the index provider.

The conflict of interest issue remains the main concern regarding equity indexes. "We need to make sure that benchmark administrators are, if possible, free of conflicts of interest and that these are reputable institutions. But before then, it is critical to concentrate efforts on those benchmarks whose methodologies make them most vulnerable to manipulation, which are those reflecting less liquid markets and those not based on actual transactions. Iosco has in general terms agreed with this view," says Rosa Abrantes-Metz, associate professor at the Stern School of Business, New York University, and a member of the panel that prepared the final document. 

"No index is completely immune to manipulation and the same holds true for equity indexes, but it is all a matter of degree. I've worked in many cases where actual prices are manipulated, and therefore if such transactions were to be part of a benchmark, this would also have been manipulated as a consequence of the manipulation of its inputs," says Abrantes-Metz. "However, it is much harder to manipulate an actual price, and even harder to manipulate a benchmark based on large volumes of actual prices such as most equity indexes. Therefore, as advised by Iosco, efforts to enhance robustness of benchmarks need to place a larger focus on those based on quotes, and also those reflective of less liquid markets even if based on actual transactions. This is not typically the case for equity indexes."

Other market participants are concerned about how the principles will potentially conflict with national rules. "We fear that often we will have overlaps/contradictions between the proposed principles and the existing national civil contract law that already applies to proprietary indexes in the relationship between provider/asset manager and investor," says Thomas Wulf, secretary-general of the European Structured Investment Products Association.