March 11, 2013 - In the context of the ongoing regulatory debate on financial benchmarks and the recent consultations by the International Organisation of Securities Commissions (IOSCO) and the European Securities and Markets Authority (ESMA)/European Banking Authority (EBA), EDHEC-Risk Institute wishes to underline that transparency is both crucial to allowing users to assess the risks, relevance and suitability of indices and the most powerful tool to mitigate conflicts of interests existing across the indexing industry.
EDHEC-Risk Institute is concerned that discussions pertaining to define an "adequate level of transparency" and balance the needs of index users with the purported necessities of confidentiality or intellectual property protection may result in a framework that falls short of providing users with the information they need to discharge their due diligence responsibilities (at a reasonable cost or at all).
Against this backdrop, EDHEC-Risk Institute cautions regulators against the temptation to trade lower levels of transparency against stronger governance mechanisms or stricter codes and standards. Because the latter have too often proven ineffective at ensuring good behaviour or protecting the interests they are expected to defend, they can at best support transparency and at worst exacerbate moral hazard and adverse selection phenomena. [1] EDHEC-Risk Institute thus also wishes to warn regulators against promoting a false sense of confidence by organising or condoning a framework that would give the illusion that conflicts of interest have been dealt with.
Within the European Union, these discussions may pave the way for a regression in terms of transparency relative to the high standards established by ESMA for harmonised retail funds, whereas the focus should be on generalising the investor protection and market competition advances introduced in the context of financial indices used by UCITS to the maximum extent possible.
In this regard, EDHEC-Risk Institute disagrees with the position of the ESMA Securities and Markets Stakeholder Group (SMSG) in its advice to ESMA dated 26 February 2013 [2], which not only makes the assumption that the governance approach and transparency approach are substitutable and that therefore a lack of transparency could be compensated by an improvement in the rules of governance, but also presents the governance approach as the high road and transparency as a fallback solution enabling external monitoring to be carried out in the absence of "sound governance mechanisms." As an academic institution, EDHEC-Risk Institute wishes to recall that the position of the SMSG is in total contradiction with research results which show clearly that the efficiency and integrity of a market are directly related to the quantity and quality of the information available and not to the goodwill displayed by participants in the market.
The position of the SMSG appears in this sense to contrast starkly with the commitment to transparency rightly demonstrated by ESMA in its recent Guidelines on ETFs and other UCITS issues. [3]
EDHEC-Risk Institute considers that the appropriate level of transparency is full transparency of both methodology and historical information provided on a fair, non-discriminatory basis and at reasonable cost (which is not currently the case). Historical information should include the values, constituents, and weights of indices as well as documentation describing the basis for and justification of each discretionary decision and change of methodology.
Such transparency not only allows index users to understand the benchmark and its construction principles but also enables them to independently replicate its track record, gauge the systematic character of its methodology and conduct performance and risk analyses so as to assess its relevance and suitability against their specific goals. The latter assessment is particularly important for new forms of indices that do not aim to be representative of a market or market segment, but instead attempt to achieve a given risk/return objective. While these "strategy indices" can provide investors with improved risk to reward profiles and other benefits, they also bring distinct risks of their own; unfortunately, their high level of opacity on detailed methodology that is routinely justified by the use of proprietary models makes the evaluation of risks difficult.
EDHEC-Risk Institute is very supportive of financial innovation, particularly in the area of benchmarks, where it considers that the new forms of indices can bring real benefits to investors. However, these smart beta indices contain exposures to different risk factors than cap-weighted indices and rely on methodologies that obviously present model and parameter estimation risks. It is therefore essential for investors to be able to carry out risk analysis easily and to avail of non-biased information on the quality of track records and the robustness of the performance displayed by index providers, and all the more so in that index providers logically use simulated track records for the most part to promote the performance of indices.
Providing the public with the information required to independently replicate an index for evaluation or research purposes should not be misrepresented as denying index providers the right to protect and enforce their intellectual property rights. There are legal as well as contractual tools (e.g. licenses) to defend index providers against unauthorised uses of their methodologies and data (not to mention the "natural" protections afforded by the added value (e.g. brand or services) that index providers provide to the lawful users of their products.) We also note that the transparency required for the said purposes can accommodate important time lags in the release of the underlying data, thus greatly reducing opportunities for free-riding and front-running, which third parties could engage in at the expense of index users. Opacity (typically) increases the scope for conflicts of interest to play out as abuse and, worse, practically denies the public the ability to assess the relevance and suitability of indices; it should not be tolerated as blanket protection against intellectual property infringements or, in the context of indexing, presented as a way to protect the interests of investors.
A detailed presentation of EDHEC-Risk Institute's recommendations on financial benchmarks can be found in its response to the recent ESMA/EBA Consultation Paper on Principles for Benchmarks-Setting Processes in the EU.
[1] As Macey remarks in Corporate Governance: Promises Kept, Promises Broken (Princeton University Press, 2010): "Indeed, one of the great ironies of the myriad new corporate governance rules passed by courts, legislatures, administrative agencies, and stock exchanges in response to the collapse of Enron is that Enron itself met or exceeded the higher standards ostensibly promulgated to prevent future "Enrons." Oddly, if Enron survived to this day, it would not have to change its corporate governance structure at all at to conform to the requirements of the Sarbanes-Oxley Act."
[2] ESMA Securities Markets Stakeholders Group, Advice to ESMA – Benchmarks/Indices, ESMA/2013/SMSG/03, 26 February 2013.
[3] ESMA, Guidelines on ETFs and other UCITS issues – Consultation on recallability of repo and reverse repo arrangements. Report and Consultation paper, ESMA/2012/474, 25 July 2012.
