Scandals over the rigging of interbank interest rates such as Libor and Euribor and the alleged fixing of gold and silver prices have highlighted the dangers of a lack of transparency in the calculation of indices and benchmarks.
So it may come as a surprise that European politicians are being accused of harming investors by backtracking on plans to force unprecedented transparency on index providers, investment banks and others responsible for the often lucrative array of benchmarks that underlie modern-day financial markets.
In an open letter to Roberto Gualtieri, chair of the European parliament’s economic and monetary affairs committee, Noël Amenc, professor of finance at France’s Edhec Business School, said: “We would have thought that, in a concern for better investor protection, your parliament would have strengthened transparency requirements rather than weakening them. If this provision is adopted it would constitute a step backwards.”
The row centres on how much information index providers should have to reveal about the past and current composition of their indices, and the methodology used to revise or rebalance each index.
In 2012, the European Securities and Markets Authority barred Ucits funds, primarily aimed at retail investors, from using indices that do not disclose both their “full calculation methodology” and the respective weightings of their components.
In the wake of the Libor scandal, the EU launched a fresh push to combat the potential manipulation of benchmarks that initially promised to widen this provision to cover all benchmarks that underlie financial instruments and contracts in the EU.
An early draft of the regulation said benchmark providers would have to publish the input data used to determine the benchmark immediately, although there was provision for this to be delayed if immediate publication adversely affected the “reliability or integrity” of the benchmark.
Number of pension funds and other institutions from 20 countries in Edhec survey
However this provision has now been struck from both the European Council and the parliament’s draft text, although it remains in the European Commission’s version.
Coen ter Wal, a spokesman for Cora van Nieuwenhuizen, the rapporteur who removed the provision from the parliament’s version, says there were issues around benchmark providers’ intellectual property rights as well as “issues of practicality, whether it would really work to have such a transparency regime in place”.
Respondents who believe Esma’s transparency rules should be extended to non- Ucits products
“Ultimately …it might jeopardise the production of benchmarks , so we came out on the side of removing it altogether. The benefits of having it there did not weigh up to some of the drawbacks,” says Mr ter Wal.
Given that several members of the Econ committee have submitted amendments on this issue, Mr ter Wal did not rule out the possibility of a compromise solution when MEPs vote on the regulation this week. However, with the European Council, which represents the EU’s 28-member governments, seemingly also opposed, any progress may ultimately be limited.
For his part, Prof Amenc dismisses the notion that transparency would undermine the ability of index providers’ to protect and enforce their intellectual property rights.
He argues that the existing legal and contractual tools, such as licences, at their disposal mean they can defend themselves against unauthorised use of their methodologies and data. Moreover, the danger of freeriding and front-running can be combated by releasing the data with a time lag.
Edhec’s concerns centre on so-called “strategy indices”, such as those classed in modern-day parlance as “smart beta”. Whereas many traditional market indices, such as the S&P 500 or FTSE 100, merely seek to represent an available opportunity set, these strategy indices typically seek to outperform the market, and only exist as commercial products as long as enough investors believe they are capable of outperforming.
Their creators, often investment banks, therefore have an incentive to ensure that any simulated historical track record or back-tested data they produce points to as strong a performance as is possible.
In the absence of transparency, Prof Amenc says there are risks that the index methodology may have been optimised with little or no regard for the stability of persistence of future performance, or that hindsight biases, such as choosing from survivors, using restated data, picking winners or shunning losers can enter a simulation, whether or not there is an intention to mislead.
“Opacity typically increases the scope for conflicts of interest to play out as abuse and intensifies the risk of adverse selection, whereby informational asymmetry between providers and users causes low-quality products to be incentivised and high-quality offerings discouraged.
“Without sufficient transparency, the riskiest and least robust indices will thrive as long as they promise the highest performance, the lowest costs or the easiest implementation,” says Prof Amenc, who is also director of the Edhec-Risk Institute.
Agathi Pafili, senior regulatory policy adviser at the European Fund and Asset Management Association, whose members are substantial users of benchmarks and indices, also warns that “opacity is one of the reasons for conflicts of interest, manipulation and abuse. There is a public interest reasoning for ensuring transparency of input data,” she says.
The European Council’s current text does contain a stripped down provision demanding transparency of methodology, but not input data.
However Ms Pafili regards this as inadequate, pointing out that the Libor scandals were able to occur even though everyone knew the methodology behind the benchmark, because it was the input data itself that was being rigged.
One argument advanced by the index industry is that, while users of Ucits funds are most in need of protection, large institutions investing outside this format should be big enough to look after themselves, and be willing to reject a benchmark if they are not happy with the level of transparency.
Ms Pafili rejects this argument, arguing that, because of reporting requirements, asset managers often do not have discretion around the benchmarks they use, while changing the measures that underlie long-term contracts may be difficult.
Prof Amenc says the legislation will also catch many retail investors who invest outside of Ucits funds, such as in structured products or notes.
But even among institutional investors there is concern. Prof Amenc cites a survey of 109 pension funds and other institutions from 20 countries conducted by Edhec, which found 71 per cent believed Esma’s transparency rules should be extended to non-Ucits products and mandates, with only 21 per cent against.
“The lack of transparency on index methodologies and compositions prevents the market from forming an opinion on the risks of these indices.
“With the increasing number of strategy index offerings that are more complex and often riskier than cap-weighted indices, we feel that the absence of transparency is harmful to both private and institutional investors,” he says.
Letter in response to this report:
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