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Implications of new European benchmark legislation for asset managers, indexing companies, and institutional investors

By Dr Hartmut Graf

Stoxx Author pic Hartmut Graf CEOSummary:The European Commission has proposed legislation that aims to further reinforce the integrity of benchmarks in Europe and abroad. If passed in its current form, however, this legislationcould have an adverse effect on a so far well-functioning global market andlead to regulatory arbitrage. In addition, rather than addressing the real critical issue, i.e. the potentiallyinherent conflicts of interests where they might exist, the regulatory approach focuses on over-simplistic criteria.

The correct regulatory response?

In the wake of the Libor and Euribor rate-rigging scandals, the European Commission was concerned that the same unethical practices could occur with other indices. To counter this, it has proposed legislation that will compel benchmark administrators to comply with a range of provisions regarding the source of their data. Failure to meet these provisions could result in administrative measures, including financial penalties.

The proposed regulations will cover indices that are used as benchmarks for tradable financial instruments or investment funds. However, within the so-called “regulated data benchmarks” there is a class of indices, which is not at all likely to be exposed to manipulation: Equity indices such as the EURO STOXX 50 and DAX, are already based on regulated data from exchanges. Together with their transparent methodology,those indices not only have no leeway for manipulation, but the fact that they are used and checked by many market participants ensures the highest level of protection to the markets. Unfortunately, the proposed regulation concentrates more on “size” than “conflicts of interest”. Potentially, this would result inreduced oversight for the many (smaller) indices with inherent conflicts of interest (e.g. especially, as the user of those indices is often also the index administrator),while tightening regulation for larger “regulated data benchmarks”.

At STOXX, we are committed to transparency and welcome all initiatives that benefit the end-investor. We are currently not fully convinced, however, that the proposed EU legislation will achieve that. Moreover, we believe that the regulatoryprinciples adopted by all major index providers are already delivering the legislation’s desired effect on a global basis, without impacting their ability to remain competitive.

The IOSCO principles: high standards already in force

As benchmark providers with an overriding commitment to transparency, we believe that thestandardscurrently enforced by the International Organization of Securities Commissions (IOSCO) are valid and fully sufficient measures. All major benchmark providers – including STOXX, MSCI, FTSE Russell and S&P – are currently fully compliant with IOSCO’s Principles for Financial Benchmarks.

This is no hollow exercise. The process of compliance involves independent auditing and, where necessary, changes to practices. In STOXX’s case, we began the process of compliance with the IOSCO principles in late 2013 with a deadline of July 2014– which required us to make some small adjustments to our controls and governance. Overall, most of our processes were already in line with what the principles require. This was followed by a full audit conducted by PWC at the end of 2014. In other words, compliance with the IOSCO principles sets rigorous standards that are fully enforced through the compliance process.

The timeline

The new EU legislation is expected to be published in the Official Journal later this year and the majority of the rules will then come into force in 2016. The European Commission issued the proposed regulations in 2013, and The Council of Member States and the European Parliament have both drafted amended versions. In the summer of 2015, the proposed legislation entered the “trilogue” stage – the process in which all three parties meet to create a version that they can all accept. This process may provide an opportunity for external organisations – including index providers – to influence the final shape of the legislation.

Hopes for compromise to ensure feasibility

Index providers and asset managers have been in discussions to influence the decision-makers to ensure that this legislation will be workable and proportionate. There are some signs that their voices have been heard, as proportionality is now considered in a more granular way.

First, indices will be divided into three tiers: critical, significant and standard. However, as argued already above, the regulated data benchmarks should be exempted from this categorization;otherwise they would be labelled as “critical”or “significant”with stringent oversight as a result. This is because the classificationwould be based on the amount of financial instruments priced against them, with “critical” benchmarks defined as those with over €500bn of assets. There is, however, uncertainty on how this calculation should be made. To reiterate, this would mean that newly-launched indices with smaller size but higher conflict of interests would be regulated less stringently compared to established indices with lower conflicts of interest.

Global repercussions for asset managers and index providers

Whileit is encouraging that elements of proportionality are being considered, other parts of the proposed regulations pose other serious concerns. One of these discussionsconcerns the EU-market access of index providers domiciled outside the European Union (EU). Given that there will be only very few countries globally where a similar legislation would be implemented, it is rather unlikely that there would be a harmonized regulatory landscape across the board. As this applies in particular also to the market participants in the United States, we are worried about a global disadvantage for EU providers.

In the same vein, the third-country authorization also restricts fund managers’ use of indices produced outside the EU to countriesdeemed equivalent by the European Securities and Markets Authority.This could bea major problem for asset managers. Under the proposed regulation, it wouldbe difficult for a European-based asset manager to use an index produced in Hong Kong that references a Chinese market, for example.
Thiswill pose particular difficulties for asset managers that provide index-tracking products such as index funds or exchange-traded funds. It will also have a long-term negative impact for the EU, as these modern, cost-efficient instruments that gained attractiveness in the past years will be less available in this market. This wouldput the European investors with long-term saving plans, a topicof high importance in the rapidly-aging societies,at a disadvantage.

The by far better solution would be to grant global index providers access to the European market for their regulated data benchmarks based on audited IOSCO compliance.

Industry uncertainty

Once the regulations are passed, a period of uncertainty would be inevitable. Asset managers will be forced to review all the benchmark indices that they use and consider whetherthey can continue using those indices. Meanwhile, index providers will strive to get their indices approved as benchmarks. This will take time, without any predictability about the eventual outcomes.

If asset managers change their benchmarks too soon, they could then find that the index provider has managed to get the benchmark approved. But if they delay, they could be left without an approved benchmark. Changing benchmarks is an onerous process; therefore many asset managers could face an unenviable dilemma.

A cautious outlook

STOXX’s view is clear. We welcomeregulation that promotes transparency and protects investors. We have declared compliance with the IOSCO principles and have been independently audited. In our view, the IOSCO principles provide a level playing field in benchmark regulation at a global level, and national as well as regional initiatives such as the European Commission’s should be based on these. In particular, regulated data benchmarks should be exempted from strictest regulation. We are wary of both the uncertainty that the proposedlegislation could bring and potential negative implications for competitiveness and innovation –which could ultimately be to the detriment of end-investors.

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