Index Industry Association
1270 Avenue of the Americas
New York, NY 10020
Interest Representative Register ID Number: 884587210198-78
November 29, 2012
Directorate General Internal Market and Services
Financial Markets — Securities Markets
Rue de spa 2
1000 Bruxelles, Belgium
Re: Response to Consultation Document — Regulation of Indices: A Possible
On behalf of the Index Industry Association (“IIA”), we are pleased to respond to the European Commission’s (the “Commission”) Consultation Document on the Regulation of Indices. Founded in 2012, the IIA was created to represent the global index industry and the needs of investors by developing and promoting practices that strengthen markets by advocating the highest level of ethics and integrity. Several of the leading index providers in the world are members of the IIA, including Barclay’s, FTSE Group, Markit, MSCI Inc.,
NASDAQ OMX, S&P Dow Jones Indices, LLC, and Russell Investments. In the aggregate, the members of the IIA calculate over one million indices for their clients, covering a number of different asset classes, including equities, fixed income, and commodities.
Indices are fundamental to maintaining and growing a vibrant and robust marketplace and have become a major part of several types of investment products. Investors use indices as an information resource for obtaining reliable and clear updates on market developments and investment performance. Index-based products provide investors with new sources of diversification and access to asset classes normally unavailable to them. Moreover, markets benefit from the increased liquidity and investment that result from index-based products. Given these various uses, index providers calculate and provide a diverse range of indices that differ in scope, methodology, and use.
Part of the IIA’s mission is to consider ways to promote best practices for index providers, which makes it a natural supporter of appropriate and proportionate industry standards. There are, however, many types of indices that capture and provide information for a number of different uses from various sources of information. Moreover, some indices 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 market segment. Some indices rely entirely on estimates or surveys, while others are tied to public market data or observable transactions.
Given these substantial differences, a one size fits all approach may not be appropriate in governing the use of indices as benchmarks in financial and other contracts. Instead, a framework for the regulation of indices would benefit from distinguishing between indices that are transparent and independently verifiable and those that are not and, consequently, subject to abuse. This distinction would avoid unnecessarily increasing the cost of using indices, which would ultimately be borne by investors, that do not pose manipulation or conflicts of interest concerns.
Therefore, we encourage the Commission to conduct a thorough review of the characteristics of the different types of indices that are in circulation, their methodologies, uses and user bases, existing governance and transparency policies, and the costs of creating additional layers of oversight before determining what issues may have relevance for particular market measurements and whether a regulatory response is advisable with respect to a particular type of index.
In the spirit of collaboration, the IIA would be pleased to meet with the Commission to further discuss the points raised in this letter. Our members are dedicated to promoting transparency, sound operational practices, intellectual property rights, education, and effective index management practices. Because of our unique membership, the IAA collectively has unrivaled expertise and knowledge of the index industry.
We provide our response below with brief introductory remarks, followed by responses to the chapters of the Consultation Document on the Regulation of Indices.
As modem investing and portfolio management theories have evolved, it is important to note that investing on the basis of indices has become increasingly popular. This is because of the overall perception of poor performance of managed funds, and because of the growing awareness of academic work such as the efficient market hypothesis, the random walk theory and other quantitative insights.1 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 2011.2
An index fund investment product in whatever form (e.g., mutual funds, exchange traded funds, UCITS funds, etc.) generally 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 the like that are considerably lower than for actively managed funds. Indeed, the growing popularity of index funds has played a role in the overall decline in fund expense ratios paid by investors. 3
In short, index funds permit individual investors to pursue diversification and asset allocation strategies on a cost effective basis. Such products have become so popular among investors and investment advisors that they now form the “core” of many investor portfolios and they have thereby contributed greatly to the capital formation process, retirement security and many other worthwhile public policy objectives. Certainly a number of policy considerations are raised by the growth in index investing. However, it is important to emphasize that such issues 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 Document.
The alleged manipulation of several interest-rate benchmarks has correctly encouraged several regulators throughout the world to investigate the transparency and accountability of the index industry. As part of this effort, the Commission issued its Consultation Document on the Regulation of Indices to obtain information on the index industry, determine if regulation of the industry is necessary, and define the objectives and scope of any such regulation. The Commission’s overarching goal is to ensure that the index industry provides clear indices that accurately reflect economic realities and are not subject to manipulation or potential conflicts of interest.
We strongly support the Commission’s commitment to transparent and high-quality indices. However, in developing a framework to govern the index industry, we believe that the Commission should consider the inherent differences between indices that use actual transaction data or data based on observable market transactions versus indices that rely on surveys, estimates, or other subjective methodologies.
Moreover, the importance of indices to investors and the markets should be carefully considered when developing an index regulatory framework. It is a well-established principle that investment diversification leads to reduced risk and increased return. Index based products play a fundamental role in investment diversification by providing the necessary means for individual investors, asset managers, banks, hedge funds and pension funds to diversify their holdings in a simple and cost-effective manner. Therefore, market participants benefit from transparent, straightforward, and reliable indices to serve their investment needs.
Consequently, any regulatory framework developed to govern the production and use of indices should seek to address only those aspects of the index industry that may benefit from new regulation. Accordingly, our response to the Consultation Document is meant to provide the Commission with a thorough background on the construction of indices by index providers and the commitment of IIA members to providing reliable and transparent indices to index users.
Chapter 1—Indices and Benchmarks: What are they, who produces them and for which purposes
At the outset, we note that IIA members primarily provide indices that are easily distinguishable from other products, such as the interbank interest rates set by LIBOR and EURIBOR. IIA members generate indices on the basis of transparent, open, and verifiable data, most often on the basis of information publicly reported to the market. For certain asset classes where underlying or observable market data is not available, members calculate indices on the basis of rules-based models. Because of the competitive index provider market and the substitutability of indices, IIA members are necessarily dedicated to providing users with indices that are transparent, reliable, and easily understood.
With regard to the size of the index industry, IIA members calculate over one million indices, with the oldest dating back to 1894. IIA member indices provide users with a method of measuring changes in a portfolio of securities, commodities, or other financial instruments. In many cases, indices are generated by retrieving inputs publicized by a regulated exchange, such as actual traded prices, or other observable market activities.
IIA members invest heavily in continuous index research and innovation to provide the best products possible to our clients. And, in many cases, HA members consult with the broader investment community to discuss and improve upon the methodologies used to generate an index. In our experience, we have found that generating accurate and timely indices is of paramount importance to index users.
With this background in mind, we believe there may be some confusion regarding the draft definition of the term “benchmark,” which will be used in the Market Abuse Directive and Market Abuse Regulation to prohibit the manipulation of indices. The Commission’s definition considers any commercial index that uses a formula to determine the amount payable under a contract to be a benchmark. This definition is too broad and risks imposing substantial costs on index providers, and ultimately investors, that generate indices based on underlying or observable market data that cannot be manipulated.
Clarifying the term “benchmark” is important because the current definition risks imposing the same types of transparency and governance reforms on index providers that use estimates, surveys, and other subjective methodologies on index providers that calculate indices that provide an objective reflection of underlying or observable market data. In the interest of informing the discussion, we suggest that a starting point for a new benchmark definition could be “something that serves as a standard by which others may be measured or judged.” Since many indices simply reflect a market segment and do not serve as a measuring standard, many indices are not benchmarks and should not be regulated as such.
The IIA would be pleased to continue this discussion and meet with the Commission to discuss the definitions used in a framework governing the creation and use of indices, including the definitions of index and benchmark. We believe that such collaboration would lead to a regulatory framework that addresses those aspects of the index industry that would benefit from increased regulation of manipulative practices.
Chapter 2— Calculation and Benchmarks: Governance and Transparency
As noted above, transparency and governance are the foundation of IIA members’ business models. The use of transaction 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. Data is 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.
Indeed, the quality of IIA member indices overwhelmingly depends on accurate, fair, and timely index generation. IIA member indices are meant to provide a comprehensive representation of an investable segment of the market. Consequently, IIA members continually update their published 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.
IIA members’ rules-based approach is also essential to constructing unbiased and informative indices for market consumption. We promote transparent and rules-based approaches for the construction and maintenance of our indices, which are published online and publicly available. Our rules promote trust among retail investors and investment managers, as they are able to track, verify, and replicate our indices in many cases using accessible and publicly available information.
Moreover, many IIA members employ independent governance committees to periodically review the performance of an index. Governance 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.
IIA members also periodically revise internal rules for selecting companies, treatment of dividends, share counts or other matters. Further, index methodology is constantly under review by internal audit departments for best practices and changes are announced ahead of time through notice to the public and clients. Index providers also periodically coordinate with outside experts, such as exchanges, to obtain up-to-date information on fundamental corporate transactions that may affect an index.
In this context, several of the features proposed by the Commission for a framework governing the regulation of indices are already in place at IIA member institutions. For example, IIA members’ strong commitment to governance and transparency is consistent with the Consultation Document’s recommendation that index providers have adequate management systems and effective controls to ensure the integrity and reliability of our indices. Although we do not oppose incentives to provide accurate or sincere estimates, it is already in our members’ self-interest to provide the most reliable and accurate indices possible in order to retain a competitive advantage in the marketplace. Thus, the Commission’s development of governance and transparency standards for the index industry should recognize that many index providers already have internal index quality standards that are overwhelmingly dependent on the production of accurate and reliable data.
IIA member index quality standards should especially be considered in the context of any proposals to regulate index calculations. IIA members strive to provide users with clear and transparent explanations of the methodology underlying the calculation of an index.
Moreover, since our indices use publicly available information where available, IIA member indices are a reflection of the data provided to the entire market. Any errors in such data would be the result of the data source and not of the index calculation methodology. 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.
Chapter 3— The Purpose and Use of Benchmarks
In developing a framework to govern the use of indices, we emphasize that the Commission should differentiate between the regulation of index providers and investment product providers who incorporate indices into their offerings. The majority of our indices are based on underlying or observable market data, which cannot be manipulated by an index provider by its very nature. Moreover, our emphasis on maintaining the integrity of a benchmark that accurately reflects a market segment provides little incentive for manipulation of an index. An index that erroneously reflects a market segment would be easily identified by its users and would damage the reputation and ultimately the business of its index provider.
Transparent and high quality indices provide users with the information necessary to determine if a product is suitable for their investment needs. 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. These users may also use indices to track the performance of a market, price financial instruments, and conduct comparisons on investment performance.
Given these varying uses, it is not advisable to restrict the use of benchmarks on an industry-wide basis. Our commitment to transparent index production provides the basis for constructing analytically sound indices that accurately 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.
Chapter 4— Provision of Benchmarks by Private or Public Bodies
The Commission requests comment on whether indices are public goods, whether public institutions should play a role in governance of benchmarks, and the benefits and costs of the provision of indices by public bodies. We understand the Commission’s goal of regulating the potential manipulation or conflicts of interest surrounding indices that are widely used in the marketplace. However, we stress that indices are inherently private goods. Index providers invest heavily in indices, license them to their clients, and continually refine and improve indices. Indices should not be owned or produced by public bodies simply because they are extensively used.
A public good is typically understood as being non-excludable and non-rivalrous, meaning that using a public good does not exclude others from using it or reduce its availability. In contrast, indices are in fact competitive private goods that are licensed for specific uses. IIA members 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. Moreover, indices are inherently competitive goods because of the substantial research and development investments made by index providers to better serve their clients’ needs.
We also caution against a regulatory approach that assumes that all indices can be exploited for the benefit of an index provider and to the detriment of the public. Our members have developed indices that rely on accurate and timely representations of the marketplace for our users, and thus should not be associated with the risks posed by indices based on subjective methodologies.
We understand that the Commission may decide to regulate the index industry or establish baseline standards for the creation of indices. If so, the IIA would welcome the opportunity to provide additional background information to the Commission on the index industry in order to assist the Commission in determining what portions of the index industry would benefit from additional oversight. If the Commission decided to exercise oversight over the provision of market-based indices, we believe the best approach would be to employ a series of best-practices standards. Best-practice standards would draw on the extensive experience of index industry providers to guide the industry towards the production of high-quality and reliable indices.
We also understand that a limit on available government resources means that the Commission must prioritize how and to what extent index industry oversight should be addressed. Given these limits, we believe the best use of public resources would be to focus on the regulation and production of the data underlying a given index. All market participants benefit from government enforcement against inaccurate or deceptive reporting of market data, and indices would reflect improvements in such reporting.
Chapter 5—Impact of Potential Regulation: Transition, Continuity and International Issues
The transition from current benchmarks to new benchmarks that are subject to new regulatory standards, government oversight, or promulgation by public bodies would pose challenges. Currently, 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. However, a required transition to indices or benchmarks that were subject to entirely new standards or provided by new entities would require considerable investment, a well-thought out and sufficiently lengthy transition period, and significant disclosure explaining what changes had been made to an index and how that may affect a given investment. Certain investment products may also need to be re-registered with securities regulators and exchanges, thus increasing the cost of investment for investors and consumers.
Further, the implementation of a regulatory framework by the Commission may lead to inconsistencies in the regulation of the index industry on an international basis. As noted in the Consultation Document, the United Kingdom Financial Services Authority is conducting its Wheatley Review of LIBOR and the International Organization of Securities Commissioners is reviewing the need for oil price reporting agency oversight. We encourage the Commission to develop a regulatory framework, if required, that would be consistent with the ongoing initiatives of these regulators.
The Commission also correctly notes that, because of the substitutability of indices, index users may decide to simply use indices in less regulated markets. To avoid this possibility, one solution which might have benefits for all and which IIA would be willing to help to develop in collaboration with the Commission would be the development of best practices standards that could harmonize the criteria for the construction and dissemination of indices. That model would recognize the existing self-interest of index providers to provide transparent, reliable, and accurate indices and provide a forum for engaging in a dialogue with public bodies to address where the index industry would benefit from additional oversight.
The IIA has been pleased to provide its response to the Commission on its Consultation Document for the regulation and production and use of indices serving as benchmarks in financial and other contracts. The index industry is strongly committed to providing indices that provide accurate reflections of the marketplace 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 Commission correctly recognizes that index-based products are critical investment tools that are essential elements of many investor portfolios. Additional government oversight of these investment tools should therefore concentrate on the parts of the index industry that would benefit from increased transparency, governance, and accountability.
We appreciate the opportunity to provide our comments to the Consultation Document and look forward to collaborating with the Commission on addressing regulatory concerns in the index industry.
/s/ Rick Redding
Executive Director, Index Industry Association
Prentice-Hall, Inc., 1983 (1975)
2. 2012 Investment Company Fact Book, Investment Company Institute, Washington, DC
3. 1d. at 73.