Neutral index providers are an asset for financial markets
Indices are probably among the most well-known ‘financial instruments’ – and they also have a quite impressive history to look back on: The Dow Jones Industrial Average, the world’s most prominent stock market index, was already created in 1896.
But it was not the world’s first market index. That distinction belongs to an 1884 predecessor of what is today called the Dow Jones Transportation Average. Even 130 years ago, the Dow Jones Transportation Average was not only a gauge of the market but a yardstick of the broader economy. Nowadays, an index is an aggregation of market data of financial instruments – stocks, bonds commodities – used either as a basis to create financial products or as a benchmark to evaluate the performance of financial investments.
The indexing industry, in terms of products and players, has grown immensely in the past century. Index providers such as MSCI, S&P Dow Jones, FTSE, STOXX, Russell and others play a vital role by providing reliable, transparent indices that allow for efficient and global capital allocation. Reliable, objective indices created by the providers named above are constructed based on a rules-based methodology, and in general from traded prices of liquid instruments from a regulated trading venue. These indices hold the possibility of full replication and are fully available to professional investors and product providers. The sell side of the market – issuers of financial products, such as ETFs – and the buy side – asset owners and managers – use such market indices.
The rigging of LIBOR prompted regulators to scrutinise benchmarks used by the financial industry, particularly those benchmarks based on surveys, OTC market data and indicative quotes. The European Commission, the International Organisation of Securities Commissions, the European Banking Authority and the European Securities and Markets Authority – all motivated by the LIBOR scandal – are mulling initiatives that are likely to change the landscape for the indexing business, with calls for more oversight and the suggestion that index providers offer their data free of cost. In the midst of this regulatory blitz, regulators need to draw clear distinctions between a benchmark such as LIBOR (which is a reference rate and is based on a panel’s subjective decision) and indices, which may be used as benchmarks but are based on objective data and clear methodologies.
One of the biggest concerns regulators have about benchmarks is the potential conflict of interest of parties providing data used for the calculation of indices, and simultaneously using these indices for the construction of financial instruments. However, the current regulatory attempts do not draw a hard line between those activities, but try to handle this potential conflict of interest by stricter governance requirements. The above mentioned indices which are calculated by neutral index providers however were never subject to those conflicts of interest. The further enlargement of the regulation will potentially burden the index industry in general, where most of the neutral index providers have already installed a wide range of safeguards in the past – in their own interest, as they are living in a fully competitive environment where clients demand transparency, clarity, unambiguity and neutrality.
“We would caution against a one size fits all approach in the potential application of lessons learned from a review of LIBOR/EURIBOR setting.” wrote Rick Redding, executive director of the Index Industry Association, in a recent public response to the European Parliament’s consultation on the abuse of market benchmarks. Redding added that for index providers “there simply does not exist the same opportunity for manipulation, or incentives to manipulate on the part of the index provider which potentially exists with respect to the setting of LIBOR and EURIBOR rates.”
Neutral index providers already publish extensive rulebooks, which detail the methodology of their indices. In addition, their indices are fully replicable. The methodology and calculation of objective indices is free from conflicts of interest as index providers, which generate their income from licensing fees, do not benefit from the performance of the indices they construct. Hence, it is in their interest to remain committed to working with the highest quality and integrity and to serve all market participants equally. At the same time, however, regulators need to be vigilant about index administrators and their relationship to issuers of financial products. For example, a conflict of interest may rise in the case of an ETF provider that acts as its own index administrator.
Safeguards are needed in the marketplace to protect investors from manipulation. However, drafting rules that place neutral index providers in the same category as the providers of panel-based indices is not ideal. Restricting neutral index providers will likely lead to a decrease in innovation in the sector. Neutral index providers serve a broad investor base and are best equipped and suited to offer unbiased indices to any investor group.