Nearly three million benchmarks and indices are in use globally. Some are highly recognisable and have been used for many years. They are so embedded and trusted to the point their failure could pose a systemic risk to certain markets. Other indices are niche and pose little to no material risk to the market. But this does not mean they do not pose a risk to consumers.
Trillions of dollars change hands based on indices. So their criteria, calculations and methodology for including assets are incredibly important, since they underpin pricing or valuing financial instruments, contracts, funds, pensions, mortgages and more. Consequently, if an index provider gets something wrong, millions of investors - both institutional and retail - could suffer.
Because of this, there is a trend of an increasing need for transparency and rigour in indexing. Regulators were first off the mark and set minimum quality requirements for index providers following the LIBOR rate-rigging scandal and, more than ten years later, they continue to evolve their thinking on, and approaches to, the sector.
But regulators are not the only group with skin in the game. Direct users of indices are demanding more information too. Their operational exposure is driving them to request more insight, data, dialogue and, ultimately, assurance over the administration of the indices they use.
Data provider or financial advisor - a regulatory stand-off?
Index providers are currently stuck between a rock and a hard place. Over the past decade, regulators’ approaches have been, at root, fairly uniform - governed by one fundamental truth: an index provider must be independent and free of conflicts of interest. This approach aims to ensure index methodologies are objective, fair, repeatable, and free of bias.
But regulators potentially appear to be diverging in their approaches to supervise the sector. Emerging opposing stances could result in different regulatory outcomes depending on jurisdiction which would prove very challenging to index providers operating in multiple jurisdictions.
EU regulators essentially believe index providers should operate as data providers - entirely objective, rules-based and non-judgemental, and free of conflicts of interest in how their indices are used in the market. These rules (the EU Benchmarks Regulation) have been mirrored in the UK and reproduced more loosely in other jurisdictions.
The US Securities and Exchange Commission (SEC) is exploring a different approach. It has asked whether index providers need to be regulated as investment advisers. The argument goes that index providers simply cannot be a pure and objective data provider because they are the ones creating index methodologies in the first place, they run and update the indices, and they react to changes in the market. By definition, the SEC argues, this is indicative of advising users on where funds should be allocated.
Both regulators are looking to tackle fairness, risk, and accuracy, but they seem to be doing so from opposite ends of the argument: objective (the EU), and subjective (the US). Tricky for both to be true at the same time.
Navigating the increasing demands of index users
We have talked about the policy pressures on index providers. But there are other pressures emerging too. Let’s look at two examples:
- Operational resilience: Asset managers and ETF issuers, who use index providers as a critical service, are under increasing pressure to safeguard and demonstrate their operational resilience. This means index providers are being put under new and heightened scrutiny as a service provider, rather than just a data provider. Their customers want more insight, transparency, and comfort about index providers’ operational processes. Consequently, they are asking index providers for information about areas of their operations not currently covered by regulation. Examples of this include how they create new indices; the rebalancing and reconstitution cycles, dealing with errors, and even to what extent controls over their systems and technology are effective.
- The growth in popularity of ESG investing: This pressure is more about consumer protection, including delivering on a desired outcome beyond investment income. Whilst there are some regulatory parameters for index providers producing ESG indices, rules in this area are still relatively underdeveloped.
The average investor interested in ESG issues does not look for individual stocks to pursue their goals of income and, say, carbon neutrality or even environmental benefit. That would be time-consuming and expensive. Instead, to pursue their desired financial and market outcomes, they typically buy products that link to an ESG index, in the hope such a product supports their aims.
The problem is twofold. First, there are no currently agreed, widespread, and standard criteria for labelling companies ESG-friendly (whatever that might mean). Second, ESG ratings agencies are not currently regulated (often they are part of the same corporate group as the index provider themselves, but not subject to the governance and control of the index provider). ESG index providers inherit both these problems and expose themselves to elevated demands for transparency into the ESG index methodologies they apply.
So does the customer really get an ESG-friendly investment product? Some say no, most say it's impossible to tell. Where this happens, it is quoted as a failure of consumer duty on the part of the index provider. Their use of data and methodologies have failed to describe an economic reality and therefore allowed for an undesirable outcome.
Delivering transparency for everyone is no small task
It is clear that index providers have to provide transparency and comfort to an increasing range of stakeholders, from regulators to asset managers and now even individual retail consumers too. Achieving this transparency mustn’t be too time-consuming or expensive, but it must be rigorous and independent. Taking bespoke and individual approaches to delivering on these aims for all groups of stakeholders is likely to be far too burdensome and expensive.
Independent audit has played a role in this market for some time, traditionally auditing one set of requirements against management’s subjective interpretation of the IOSCO Principles for Financial Benchmarks - a global set of best practice principles. This is not enough for all of today’s stakeholders.
Instead, audits of index providers need to evolve to efficiently and inexpensively provide assurance to multiple stakeholders for multiple purposes, ensuring appropriate transparency. It has to be versatile and innovative enough to ensure senior management and those charged with governance at the index provider, regulators, and customers can all draw confidence that the index provider is complying with regulation, their contractual obligations, following through on their methodologies and managing operational risk appropriately.
Auditors have a great deal of expertise in testing data and controls. And they are used to providing the kind of trusted information that helps companies answer questions from their board, and current and prospective customers. The enlightened index provider understands their auditor’s job should be to go beyond an audit ‘stamp’ and instead signal maturity and control to the market, identify weaknesses and flaws, and, ultimately, enable the business to grow and improve. Their work sends the message to all stakeholders that the index provider is continuing to strive for ever-greater quality and transparency.
It is important that any assurance provider understands the forces pulling on the indexing market and the challenges facing the broader group of stakeholders. They must be sympathetic to the goals and needs of the index providers themselves as well as those of their customers and their regulators. Those index providers seeking an independent audit should look to engage a trusted assurance provider whose product meets the emerging need for a higher level of trust.
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