February 11, 2013
Mr. Alp Eroglu
International Organization of Securities Commissioners
Calle Oquendo 12
Re: Public Comment on Financial Benchmarks Consultation Report (CR01/13)
On behalf of the Index Industry Association (“IIA”), we are pleased to respond to the International Organization of Securities Commissioners (“IOSCO”) Consultation Report on Financial Benchmarks (the “Consultation Report”). The IOSCO Task Force on Financial Market Benchmarks (the “Task Force”) Consultation Report is an important milestone in the global response to recent investigations and enforcement actions against attempted manipulation of certain benchmarks.
Founded in 2012, IIA is an independent, not-for-profit organization representing the global index industry. The purpose of IIA is to represent the global index industry by working with market participants, regulators, and other representative bodies to promote sound practices in the index industry that strengthen markets and serve the needs of investors. Several of the leading index providers in the world are members of IIA, including Barclays, FTSE Group, Markit, MSCI Inc., NASDAQ OMX, Russell Investments, and S&P/Dow Jones Indices, LLC. Our members have calculated indices since 1896 and, in the aggregate, the members of IIA calculate over one million indices for their clients, covering a number of different asset classes, including equities, fixed income, and commodities.
IIA shares the Task Force’s commitment to the development of benchmarks with high levels of transparency and integrity. In fact, a key motivation behind forming IIA was the desire by our members to agree upon and develop a best-practices framework for the calculation and dissemination of indices. Since its formation in 2012, IIA members have continued to dialogue and collaborate on the contents of such a best-practices framework.
We therefore agree with the Consultation Report’s finding that benchmarks should, to the extent possible, be tied to public and observable market transactions entered into at arm’s length between buyers and sellers. However, the reality is that many asset classes are not exchange-traded and, as a result, market transaction data does not exist. IIA members agree that if such information were publicly available, indices would be tied to such data. Given this marketplace reality, however, IIA members aim to provide high-quality, understandable, and reliable indices to index users that meet their investment needs.
With this in mind, IIA is a natural supporter of appropriate and proportionate index industry standards. There are, however, many different types of indices that capture and provide information for a number of different uses from various sources of information. Some benchmarks rely entirely on estimates or surveys, such as LIBOR or EURIBOR, while others are tied to observable market data. Moreover, for certain indices, observable market transaction data may not exist. Some indices also serve as benchmarks in financial instruments and commercial and non-commercial contracts, while others are used to provide an investor with a representation of a particular market segment.
Given these substantial differences, we agree with IOSCO that a one-size-fits-all approach is not appropriate when developing global principles for financial benchmarks. Other regulators also agree that developing a single regulatory framework for all benchmarks poses serious implementation issues. For example, the Wheatley Review points out that developing an overarching framework for key international benchmarks may be challenging because of the fundamental differences among benchmarks using various types of indices.
Accordingly, a regulatory framework seeking to address transparency or governance concerns relating to financial benchmarks should only include benchmarks that are based on estimates and surveys and subject to manipulation. It should not include indices based on observable market transactions or indices relying on non-exchange traded data that do not pose the same risk of manipulation as benchmarks based on panel or survey based estimates. This distinction in regulatory treatment recognizes that many indices do not pose a risk of manipulation or conflicts of interest concerns, are representative of their underlying market, and are constructed in a credible manner. Moreover, inappropriately regulating these types of indices could potentially reduce investment and innovation in new types of indices to the detriment of investors and the capital markets with no appreciable benefits.
We have endeavored to provide the Task Force with our unique insights on how to develop a workable and informed regulatory structure for financial benchmarks. That framework should focus on the transparency, accountability, and integrity of financial benchmarks while avoiding unnecessary or duplicative measures that would hurt investors and the global markets.
We provide our response below with brief remarks about the role and importance of indices, followed by responses to the chapters of the Consultation Report.
The Critical Importance of Indices
As modern investing and portfolio management theories have evolved, it is important to note that investing on the basis of indices has dramatically grown in popularity. This is because of the overall perception of the relative poor performance of actively managed funds and because of the growing awareness of academic work such as the efficient market hypothesis, the random-walk theory and the capital asset pricing model. As an example of the growing popularity of index investing, according to the Investment Company Institute the amount invested in index mutual funds grew from $27.46 billion at the end of 1993 to $1.09 trillion by the end of 2011. In fact, it is estimated that indexed assets—linked to U.S. and international stock and bond indices—now exceed $4 trillion.
An index fund investment product in whatever form (e.g., mutual funds, exchange traded funds, UCITS funds, etc.) often consists of a portfolio designed to reflect the composition of some market index by holding securities or other instruments in the same proportion as the index itself. This type of investing is sometimes referred to as passive management and typically results in administrative costs for securities analysts, portfolio managers and others that are considerably lower than for actively managed funds. Index funds also derive their low-cost structure from their low turnover, or costs associated with the buying and selling of securities, such as commissions and bid-ask spreads. With a low turnover rate, index funds are able to reduce their trading costs and maximize total returns realized by investors in a fund.
Indeed, the growing popularity of index funds has played a role in the overall decline in average fund expense ratios paid by investors. In fact, as of 2011 the average expense ratio for index funds is 13 basis points, compared to an average expense ratio of 93 basis points for actively managed equity funds and 66 basis points for actively managed bond funds. Moreover, from 1997 to 2011 the average expense ratio of index equity funds fell by 13 basis points, compared with a decline of 11 basis points for actively managed funds.
Institutional investors are also attracted to index investment strategies because they are low-cost investment alternatives that often outperform actively managed funds. A 2012 mid-year survey conducted by S&P/Dow Jones Indices found that, for the period between 2007 and 2012, 65.44 percent of actively managed large-cap funds were outperformed by the S&P 500, 81.57 percent of mid-cap funds were outperformed by the S&P MidCap 400, and 77.73 percent of the small-cap funds were outperformed by the S&P SmallCap 600. Index investment strategies thus have a track record of providing investors with a low-cost method of obtaining greater returns than actively managed fund alternatives.
In short, index funds permit investors to pursue diversification and asset allocation strategies on a cost effective basis. Such products have become so popular among institutional investors and investment advisors that they now form the “core” of many investment portfolios and they have thereby contributed greatly to the capital formation process, retirement security and many other worthwhile public policy objectives. However, it is important to emphasize that any issues raised by index investing are separate and distinct from the questions of accuracy, integrity, governance and transparency with respect to the indices themselves that are raised by the Consultation Report.
We strongly support the Task Force’s commitment to transparent and high-quality benchmarks. However, in developing a possible framework to govern financial benchmarks, we believe that the Task Force should consider whether the concerns the Task Force has regarding benchmarks that rely on surveys, estimates, or other subjective methodologies apply to indices produced by IIA members.
Several recommendations in the Consultation Report could be modified based on this distinction. These include the required level of oversight of a Benchmark Administrator, the role of data integrity, verification of information underlying an index, and suitability requirements for the provision of indices.
Going forward, the importance of indices to investors and the markets should be carefully considered when developing a financial benchmark framework. Index-based products play a fundamental role in investment diversification by providing a low-cost means for individual investors, asset managers, banks, hedge funds, and pension funds to diversify their holdings in a simple and cost-effective manner. Market participants benefit from transparent, straightforward, and reliable indices to serve their investment needs. Duplicative, unnecessary, or costly regulation would reduce or perhaps even eliminate these benefits, particularly in today’s low-yield environment.
Consequently, any regulatory framework developed to govern the production and use of benchmarks should be tailored to specifically benefit investors and capital markets, or geared towards those benchmarks that would be improved by new or additional regulation.
Chapter 1 – Introduction
At the outset, we wish to recognize the substantial work the Task Force has undertaken to develop a possible oversight framework for financial benchmarks. The Consultation Report is a thorough assessment of the potential methodology, transparency, governance and accountability issues associated with financial benchmarks. It also closely examines the role and responsibilities of financial benchmark information suppliers, administrators, and users in any future regulatory framework.
However, we note that certain fundamental issues arise when the Consultation Report’s definition of a benchmark is applied IIA member indices, particularly when one considers the type of regulation that would apply to such benchmarks. As stated in the Consultation Report, benchmarks are broadly defined as prices, rates, indices or figures that are (1) made available to users; (2) calculated periodically; and (3) used for reference for one of several distinct purposes, such as determining the interest payable under an agreement, determining the price at which a financial instrument may be bought or sold, or measuring the performance of a financial instrument.
The Consultation Report’s proposed definition is problematic because it considers several, highly differentiated indices, rates, and other figures to be “benchmarks” subject to the same standards of regulation. However, IIA member indices differ considerably from interest rate benchmarks and other survey and estimate based figures with respect to the amount of transparency, oversight, and accountability. Such differences make certain of the recommendations, discussed below, inapplicable or harmful to index providers without providing any regulatory benefits to investors or the economy. They also risk damaging a critical investment tool upon which investors heavily rely.
Accordingly, we recommend that the definition of benchmark only apply to certain interbank lending benchmarks, such as LIBOR and EURIBOR, which are currently based on nonpublic surveys or estimates of underlying data that is typically not verifiable. To that end, we believe that the definition of benchmark should specifically exclude indices that are based on transparent methodologies or observable market information, where available. We understand that the line between indices that fall within and outside of this category may be difficult to draw. We would be pleased to further discuss this issue with the Task Force to determine an appropriate definition of benchmark that removes these types of indices from the scope of new regulatory coverage.
If the definition is not amended, we encourage IOSCO to develop a recommendation that applies appropriate levels of oversight and transparency to prices, rates, indices or other figures included as benchmarks with due regard to indices that do not pose appreciable risks of manipulation.
Chapter 2 – Discussion of Potential Issues
IIA agrees that a benchmark should reflect the key characteristics of the underlying interest it seeks to measure. IIA members follow this principle and generate indices based on observable market data. For certain asset classes where underlying data are not available, members calculate indices on the basis of rules-based models. Because of the competitiveness of the index provider industry and the substitutability of indices, IIA members are necessarily dedicated to providing users with indices that are reliable and easily understood.
Our reliance on retrieving market data, where available, substantially decreases the risk of data vulnerability or the need to independently verify the data underlying an index. For example, many of our members rely on data provided by exchanges, which are highly regulated entities subject to the rules of national securities regulators, their own rules, and the trust of the marketplace. While IIA members take steps to verify that reported trades or information are properly transmitted to index providers (as discussed below), the high level of scrutiny imposed on exchanges and other regulated entities minimizes the potential for inaccurate data to be included in index calculations.
Certain of our members’ indices are based on asset classes that are not exchange traded. Such indices are calculated and disseminated to meet client demand for access into new markets, and the decision not to require exchange trading is grounded in regulatory market structure. For such asset classes, our members employ transparent methodologies to educate institutional investors about the calculation and dissemination process underlying an index, giving them the necessary knowledge to appreciate and understand the integrity of the index calculation and dissemination process.
We note that the Consultation Report takes the position that the use of algorithms to compile stock or other indices or to rebalance the weighting or composition of index components is a potential data vulnerability. We respectfully disagree with this assessment. Indeed, rebalanced and reweighted market indices are necessary in order to provide an up-to-date reflection of a given market. For example, reweighting of an index might be needed because of a change in shares outstanding of an issuer due to corporate events such as share buybacks or issuances. Consequently, in order to provide their indices, IIA members continually update their indices to respond to corporate actions and market developments, including, but not limited to, company stock repurchases, private placements, tender offers, and corporate actions that make an issuer ineligible for membership in a given index.
We also note that mandating specific methodological requirements for index production may reduce competition among index providers and result in less choice for index users. In the marketplace of indices with transparent methodologies, index providers by necessity are highly competitive. In order to gain an advantage over a competitor, index providers must discover new methods of compiling and disseminating data through indices in a way that delivers value to their clients. Requiring certain new methodological requirements, such as only permitting indices to be composed of markets of a certain size, could reduce the push for innovation or even discourage index providers from providing existing indices. That would result in less investor choice and access to indices and limit opportunities for investors to explore new investment options.
Transparency is a fundamental element of IIA members’ business models. The use of market data, where appropriate and available, is a central part of our role as index providers. IIA members produce high quality, substitutable indices, which in most cases are calculated according to transparent index methodologies on publicly accessible websites. When available for a particular asset class, data are most often generated by retrieving inputs publicized by a regulated exchange or from actual traded prices, actual bids and offers or other observable market activities.
For indices where underlying market data is not exchange-traded, IIA members provide index users with transparent methodologies to educate them about the index calculation process. Such methodologies also mitigate the potential for conflicts of interest or the capability of an index to be manipulated.
We think it is essential for index providers to provide high-quality and transparent benchmarks. However, we stress that indices are inherently competitive and private goods. On one level, indices are private goods because index providers are contractually dependent on data providers that restrict the use of data in a given index. In turn, index providers also restrict the use of indices to comply with the terms of a contract with a data provider.
On a more fundamental level, however, indices are private and competitive goods because index providers continually invest in intellectual property underlying their indices to provide the best products possible to their clients. Those investments have allowed investors to benefit from access to an unprecedented number of new markets and opportunities. Index providers can continue to provide new and innovative indices so long as their investments and efforts are protected by strong intellectual property rights and not undermined by requirements to provide granular information that would be of no benefit to an index user, particularly if an index’s methodology is transparent and observable market data is used in the calculation of an index. Thus, any new financial benchmark regulatory framework should consider (1) the potential impact on investors resulting from disclosure of key intellectual property rights and (2) whether such disclosure would actually be useful to an investor.
Accordingly, when determining the appropriate level of transparency applicable to a methodology, the extent to which the underlying data and the investments in a methodology made by an index provider should be carefully considered. We believe that the best balance between these two goals is achieved when an index provider provides index users with a clear and thorough understanding of the methodology underlying an index. We also support the use of observable market data, to the extent that such information is available for an asset class.
We believe that this model is a reasonable approach for measuring the transparency of IIA member indices. Index users and regulators can rely on the transparent methodologies underlying an index to ensure that a provider is not subject to a conflict of interest; moreover, when public data is available, an index user may refer to that data in its evaluation of an index’s transparency. This approach thus balances the need to protect valuable intellectual property and research and development investments with the need to ensure that an index is timely and representative of the market which it represents. However, requiring additional granularity on the intellectual property underlying an index could potentially eliminate any market advantage held by an index provider and discourage index providers from developing new and more innovative indices to the detriment of investors and the capital markets.
Along these same lines, we support the Task Force’s comments that a change in an index be comprehensive, transparent, fair and timely. Index providers sometimes transition to new methodologies or make changes to existing indices to better reflect market conditions. These changes often require clear and wide-reaching public notice to prepare index users of upcoming changes.
Ultimately, however, an index provider remains responsible for adjustments to an index to the extent that such data should reflect fundamental changes in the market, such as index eligibility after a merger or dissolution, in order to maintain the integrity and quality of an index. Such revisions should be clearly communicated to market participants on a timely and fair basis.
The Consultation Report also asks how often an index provider should review the design and definition of a benchmark to ensure that it remains representative. While one across the board requirement would be inappropriate for all benchmarks, we note that IIA members periodically revise internal rules for selecting companies, treatment of dividends, share counts or other matters. Further, index methodology remains under review by advisory committees for best practices. Some index providers may also periodically coordinate with outside experts, such as exchanges, to obtain up-to-date information on fundamental corporate transactions that may affect an index. These procedures may also be generally appropriate for benchmarks.
IIA agrees with the Task Force that benchmarks must be credible and free from internal or external conflicts of interest. Effective governance is a vital element of a credible benchmark, especially when a benchmark is subject to the discretion and judgment of an information setter or administrator. Importantly, however, the Wheatley Review notes that the degree of, and balance between, governance and oversight and formal regulation will depend on the type of benchmark, how it is derived, and the risk of manipulation of a given benchmark.
These principles should guide the Task Force when it designs recommendations for the governance framework of financial benchmarks. By necessity, IIA members produce clear indices that reflect economic realities and are not subject to manipulation or potential conflicts of interest. Any possible manipulation or conflict of interest would be recognizable by market participants and would immediately discredit the integrity of an index provider. Given the highly competitive and substitutable nature of our indices, IIA members cannot afford to allow their indices to be subject to conflicts of interest or manipulation. This is in stark contrast to certain benchmarks, such as interest rate benchmarks that are opaque, based on surveys and estimates, and have few, if any, direct competitors.
Accordingly, some of the recommendations in the Task Force’s Consultation Report are not applicable to IIA member indices. For example, the relationship between exchanges and index providers significantly differs from certain benchmarks, particularly interest-rate benchmarks based on surveys and estimates (e.g., LIBOR, EURIBOR). The Consultation Paper suggests several possible reforms for data providers, or submitters, and index providers, or benchmark administrators, including verifying data received from submitters. The assumption underlying these recommendations is that the data submitter seeks to profit from the manipulation of the benchmark to which they submit data. However, data submitters for our indices report actual market information disclosed through observable market data, unless an asset class is not publicly traded. They do not benefit from changes in the values of IIA member indices. Thus, the pure data relationship between submitters and providers of such indices eliminates conflicts of interest that may exist at this level for other types of benchmarks.
It should be reemphasized that providers of indices based on transparent methodologies and publicly reported information are neutral with respect to a given index’s value and do not take a position in an index. As such, there is no commercial interest at the firm level in manipulating such indices. To the extent that conflicts of interest may arise at the employee level, IIA members maintain robust internal compliance policies and procedures to handle any potential conflicts of interest that may arise in the context of personal securities trading, attempted improper or attempted improper influence of a member’s employees. As a best practice, IIA members “firewall” index data information exchanges and employees involved in index development, calculation, and maintenance from commercial functions. Many of our members also maintain strict global codes of ethics designed to mitigate or eliminate these and other conflicts of interest. Thus, IIA members take the necessary steps to ensure that conflicts of interest do not influence the index calculation and dissemination process, to the extent that such conflicts arise.
IIA members also employ advisory committees to periodically review changes to index methodologies. Advisory committee members continually review corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies being considered as candidates for addition to any index, and any significant market events. IIA members also use specially trained analysts to monitor data quality and to notify managers of an index if a discrepancy emerges. We believe that this practice is necessary to ensure the objective nature of our indices.
In addition to internal controls, the Consultation Report also suggests that an oversight committee scrutinize the governance of data submissions, changes to methodology, and an index provider’s internal procedures may be appropriate. An oversight committee would include a range of stakeholders in a benchmark, including submitters, users, and other key stakeholders. While we appreciate the Task Force’s desire to ensure the integrity of the index calculation process, we believe that such oversight committees would not add benefits to the transparency and integrity of indices, and, in some cases, could potentially detract from it, and would also interfere with the editorial process that is used to develop and maintain an index.
Involving market participants in oversight committees that would examine and perhaps make investment decisions would create serious conflicts of interest. International regulators recognize that including market participants in the benchmark setting process may actually jeopardize the integrity of a benchmark. For example, Commodity Futures and Trading Commission Chairman Gary Gensler recently noted the importance of objective data by noting that in order:
“…for the public to have confidence in benchmark rates, which are at the foundation of our economy, they must reference observable transactions. It’s through real transactions between arm’s length buyers and sellers coming together in a marketplace that prices are discovered and set.”
Requiring data submitters and market participants to serve on an oversight committee would reduce the current arm’s length relationships between index providers, data submitters, and market participants and potentially introduce unseemly or inappropriate external influences to the index calculation and dissemination process. In particular, market participants purchasing licenses for indices would be heavily motivated to influence the composition of an index to their benefit in a manner similar to the recent interest-rate benchmark scandals.
In fact, having market participants or exchanges involved in oversight committees may introduce some of the same conflicts of interest currently being examined in the interest-rate benchmark scandals, as the requirement closely resembles bank panels reviewing and auditing quotes that will ultimately be incorporated into their own products. To avoid these conflicts of interest and inappropriate forms influence, the index calculation and dissemination process must be independent.
We therefore urge the Task Force to reconsider the appropriateness of oversight committees for indices that are based on transparent methodologies and not subject to conflict of interest risks. Maintaining the independence of index providers is a critical element of ensuring the integrity of an index.
Setting appropriate accountability standards for index providers is an important part of ensuring that indices are not susceptible to abuse or manipulation. However, we emphasize that the scope of accountability measures should be proportionate to the risk of manipulation for a given benchmark. Put another way, benchmarks that are not capable of being manipulated may not benefit from additional regulations to further ensure the accountability of a benchmark administrator or calculator.
In particular, the proposal for an external audit review of the operational processes of an index provider is inappropriate for IIA member indices. As discussed above, IIA members are neutral providers of indices and have no self-interest in manipulating an index. They also maintain robust internal compliance procedures to ensure that no conflicts of interest arise at the employee level. IIA members take the responsibility of producing high-quality and transparent indices seriously, because market participants would cease to use an index if it was not representative of its underlying market.
Given the strong motivation to maintain the integrity of indices, an external audit review requirement would not enhance the index calculation and publication process. It would, however, increase the costs of index research and development, ultimately increasing the cost of investment in index-based products for investors and consumers. We therefore strongly encourage the Task Force to weigh the costs and benefits of its accountability recommendations against the risks posed by a particular index or benchmark.
We would be pleased to discuss alternative methods of ensuring the accountability of our member indices with the Task Force. Given lack of conflicts of interest in the calculation process for IIA member indices, we would support alternatives that affirm compliance with high standards of integrity and governance without imposing substantial costs. These alternatives would also supplement existing IIA member policies addressing any potential conflicts of interest.
Role and responsibilities of Administrators
We agree that benchmark administrators should maintain adequate policies and procedures to verify submissions and benchmark compilation, which might include provisions on managing conflicts of interest, data integrity, and protocol for market stress events. The market demands that IIA members have robust policies and procedures that ensure the integrity of their indices.
Along these lines, the requirement that benchmark administrators maintain clear policies and procedures could be part of a best-practices code of conduct. The code of conduct would draw upon the extensive experience of index providers to guide the industry towards the consistent production of high-quality and reliable indices. We would be pleased to engage in further discussions with the Task Force about the complementary role that a best-practices code of conduct would play in its financial benchmarks regulatory framework.
Chapter 3 – Discussion of options for enhanced oversight of Benchmark activities
Approaches to Enhanced Oversight
The Consultation Report considers the costs and benefits of several approaches to financial benchmark regulation, including industry standards and voluntary codes of conduct, development of a self-regulatory organization, and direct regulation of the submission, calculation, and administration of benchmarks.
At the outset, we note that IIA members typically obtain data from non-interested regulated entities, such as exchanges or broker-dealers, and adding another regulatory layer to the index calculation and administration process may not result in an appreciable benefit to the quality or integrity of data received. As noted above, additional layers of direct regulation would ultimately increase costs for users of index-based products, reducing the attractiveness of this cost-effective investment strategy. Additional regulation may also create disincentives for data submitters to enter into agreements with index providers.
Instead, we urge the Task Force to recognize that IIA is currently developing a voluntary code of conduct for indices for its members’ indices. The Consultation Report highlights the major criticism of voluntary codes as (1) not being grounded in effective, enforceable and sanctionable legal rules; (2) lacking an independent enforcement mechanism; and (3) not taking adequate account of the wider economic and social interests affected by a benchmark. While it is true that voluntary codes of conduct are not legally enforceable, the risk of losing market share to a competitor compels IIA members to produce indices that are representative of a given market. Because only highly substitutable indices face this type of market pressure, voluntary codes of conduct would be an appropriate method of establishing best-practices standards that would be enforced by the market and closely followed by index providers agreeing to be subject to that code.
The Consultation Report also recommends that certain restrictions should be attached to the use of benchmarks, possibly including a determination of suitability by an index provider or index-based product provider. While this may be an issue for certain exotic financial benchmarks, we note that users of our indices already have all of the information necessary to understand the methodology underlying a given index. These users understand the components of an index and use them as tools to track the performance of a market in which they choose to invest.
Moreover, a wide variety of users depend on index-based products, including individual asset owners, active asset managers and passive fund managers, broker-dealers, banks, and exchanges. Given these varying uses, it is not advisable to restrict the use of indices. IIA’s members are committed to constructing analytically sound indices that reflect a given market segment. Certain investment product developers may then use our indices to develop products for use by other investors. Therefore, to the extent that the use of benchmarks should be restricted, regulators should focus on the suitability of an investment product linked to an index for a given investor, rather than the suitability of a given index for an investor. In short, suitability determinations are best left to regulated providers of investment services, which are already subject to a variety of regulatory regimes.
Drawing Regulatory Distinctions
In analyzing the issues surrounding financial market benchmarks, the Task Force has noted that “a one-size-fits-all approach may not be appropriate for the universe of Benchmarks considered by this consultation.” We agree that such an approach would be problematic and potentially ineffective because indices, rates, and other figures are diverse products that have varying degrees of transparency, accountability, and governance. Further, users of IIA member indices have access to the methodology underlying those indices, while this may not be the case for users of certain benchmarks and other figures. Accordingly, the Task Force should evaluate whether applying its methodology, transparency, governance, and other proposals to indices such as those produced by IIA members would provide a benefit to consumers and investors or only result in additional and unnecessary costs.
The Consultation Report requests comment on whether regulatory distinctions among indices should be made on (1) the basis of the economic impact of a benchmark, (2) the general failure of governance and controls in a benchmark, (3) whether a benchmark is referenced in exchange traded derivatives and securities, and (4) the regulatory status of submitters, administrators and/or the interest measured by a benchmark. While we generally agree that each factor plays a role in framing the appropriate regulatory response to the risk posed by a benchmark, certain factors, such as economic impact or incorporation in an exchange traded product, should not be dispositive in determining whether a benchmark should be directly regulated or subject to the rules of a self-regulatory organization or a voluntary code of conduct.
Instead, we encourage the Task Force to closely examine the nature of each type of benchmark when making distinctions in a potential financial benchmark regulatory framework. Accordingly, distinctions on the basis of the level of transparency and verifiability of a benchmark should be kept in mind. For example, IIA member indices rely on timely representations of the marketplace for our users, and thus should not be associated with the risks posed by indices based on subjective methodologies and the use of subjective estimates as inputs.
Another potential regulatory distinction could be made on the basis of whether an index was capable of being manipulated. For our indices that are based on asset classes that are not exchange traded, the high degree of transparency behind an index’s methodology mitigates the potential risk of manipulation and separates those indices from certain opaque interest-rate benchmarks.
As an organization devoted to promoting the highest levels of transparency and integrity, we recognize our members are responsible for maintaining the public’s trust in our indices. However, there is a distinct trade-off between attempting to improve indices with restrictions on use and the social harm with making them less accessible and restricting choice for the professional analyst and investor and retail market places.
Chapter 4 – Data Sufficiency
The sufficiency of data used to construct Benchmarks
IIA members have long recognized that the quality of their indices is inextricably linked to its representation of an underlying market. In certain cases, index users have the independent ability to track the inputs and composition of an index, and a significant discrepancy between a user’s calculation and the value of an index would discredit an index provider and considerably damage their business reputation.
We therefore agree with the Consultation Report’s observation that benchmarks should, to the extent possible, be based on observable market data, and anchored by observable transactions entered into at arm’s length between buyers and sellers to the extent possible, in order for them to function as credible indicators of prices, rates or index values. As the Consultation Report notes, basing benchmarks on observable market information provides “visible evidence of market metrics and commercial practices, which not only fosters confidence by Market Participants but also facilitates surveillance by relevant authorities.”
As a result, indices based on observable market data do not pose the same risks of manipulation or transparency concerns as benchmarks based on surveys, estimates, or individual judgments. As such, many of the concerns and recommendations concerning the compilation, distribution, and use of financial benchmarks in the Consultation Report do not apply to indices produced by IIA members or to any other benchmark based on transparent methodologies or observable market data.
For certain asset classes not based on exchange traded data, the sufficiency of data should be measured with respect to how much data is currently required to be made publicly available. Because our indices are client driven, we aim to provide index users with the most information possible with regard to the data underlying an index. Therefore, the sufficiency of data in an index should be measured with respect to the amount of data currently available in the marketplace as a result of these regulatory market structure decisions.
Market discipline essentially requires that IIA indices remain representative of an underlying market. Failing to meet these standards would incentivize index users to simply use a competitor’s investment product based on a similar, but more accurate, index. Where indices or benchmarks do not face this same type of market pressure, the Task Force’s recommendations on improving data quality should apply.
Recent investigations and lawsuits against interest-rate benchmark administrators and submitters have highlighted the degree to which investors and the broader public rely on certain key rates and figures. Indeed, IIA members recognize that many of their indices are referenced in thousands of investment products and are often used as macroeconomic indicators.
However, what separates these indices from other benchmarks, such as interest-rate benchmarks based on estimates or surveys, is their simple substitutability and transparency. IIA members produce millions of indices, providing investors with choice and access to different investment strategies. Moreover, index users understand the composition of our members’ indices and even have the ability to purchase the constituents of an index to replicate an index’s performance.
In some cases, a belief that an index is no longer credible and could not be revised to be credible would necessarily require a loss of faith in the underlying data itself. This would mean that the investors would need to believe that the producer of such data, such as an exchange, is no longer reporting accurate transactions. While these events have occurred in the past, market participants have been alerted almost instantaneously of these events and have adjusted their investment strategies accordingly.
Accordingly, any requirements for a transition plan or a “living will” should apply to data submitters and not index providers. We again note, however, that any onerous regulation placed on data submitters may discourage them from providing full access to underlying market data. This would cause indices to become less robust and subject to outliers and erroneous prices. Accordingly, we encourage the Task Force to consider the trade off between the costs of imposing new regulations on data submitters and the benefits from imposing new requirements on providers of transparent and observable market data.
IIA has been pleased to provide its response to the Task Force and IOSCO on its Consultation Report. The index industry is strongly committed to providing indices that provide reflections of the marketplace and that can ultimately be used by investors to diversify their risks and increase their investment returns. Our members are committed to providing transparent information to their index clients that can be used to pursue their unique investment needs.
The Task Force correctly notes that concern over the fragility of certain benchmarks has the potential to undermine market confidence. In our response to the Consultation Report, we have endeavored to identify why transparent indices based on observable market data do not pose the same risks as other financial benchmarks and why the same concerns about fragility, manipulation, and conflicts of interest would be misplaced. Proposals for the oversight of financial benchmarks should therefore concentrate on benchmarks that would benefit from increased transparency, governance, and accountability.
We appreciate the opportunity to provide our comments to the Consultation Report and look forward to collaborating with IOSCO on addressing regulatory concerns in the financial benchmarks industry.
/s/ Rick Redding
Executive Director, Index Industry Association