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Throughout much of their existence, index providers have operated without direct regulatory oversight.
The regulatory philosophy in the U.S., relying on the Publishers Exemption to the Investment Advisor’s Act, is to regulate the index product but not the provider. The courts felt comfortable that index providers were not giving investment advice when they created indices, as the index merely reflected the market, was not a recommendation of securities and was offered to a broad audience, rather than an investor where there was a direct relationship. This approach has worked well for many years but is this the case anymore?
While index providers expanded their business into the sale of data and analytics systems, for the most part, they stopped short of offering investment products. For years, the concept of index customization was a function of piecing out an existing broad-based index. When the LIBOR scandal came to light in 2012, it upset this status quo.
LIBOR changed the index landscape in some very important ways. First, it opened the eyes of regulators to the potential conflict of interest that can exist if the index provider is also setting input prices for the index and issuing or trading products on that index. Regulators discovered that the ability to influence the level of an index can have a financial impact and, absent appropriate protections, incentivize manipulating the index. Second, and perhaps most importantly, regulators became aware of the size and breadth of the index provider industry for the first time.
One of the major challenges facing index providers going forward will be the continued increase in regulatory oversight. It is just a matter of time before index providers are directly regulated in the US. The SEC is already been looking at this issue. Regulation is inevitable in the US and is being driven by forces outside the control of index providers.
One factor driving the further regulation of index providers is the continued shift of active assets to passive products. While investors and index-focused investment managers, such as BlackRock, Vanguard and State Street have benefited from this trend, active managers and stock picking financial advisors also have seen an outflow of assets and reduced fees. Active managers responded to this trend by consolidating to reduce costs and, more recently, converting their traditional funds into ETFs. These measures don’t solve the core problem: Studies have shown that active managers have a hard time consistently beating an appropriate benchmark. In addition, as indexed assets have grown the question of the aggregate impact of index products on the market is being discussed more frequently.
Another factor accelerating the path to increased regulation is the growth of new custom, thematic, strategy and ESG indices. These indices involve more design discretion, and rather than just measuring a segment of the market based on constituent capitalization, they are being developed to achieve a desired investment outcome. This focus raises the question of whether index providers are providing some form of investment advice and no longer operating under the Publisher Exemption, which has been used to shield them from direct regulatory oversight.
Finally, with the growth of index-based assets, many are arguing that index managers, the sponsor of index funds and ETFs, have ceded control over governance issues to index providers. This argument arises as index managers claim that they just “follow the index” with respect to security selection. The issue has been magnified with the growth of ESG indices and investment products.
With the continued focus on index providers and growth of index-based investment products, increased regulation is inevitable.
One of the issues the SEC is believed to be looking at is where to draw the line. Should regulation cover all indices, including broad-based indices, or just narrow based indices built for one customer. In some respects, the European approach is easier to deal with as all index providers are treated the same while in the US, we could end up with a regulatory scheme where some indices are regulated and some are not depending on how they are used. This would mean some index providers are regulated while other are not resulting in an uneven playing field. Regardless of the regulatory approach, there will be some interesting outcomes.
First, the big index providers will have an easier time adapting their business. They can afford the cost of being regulated. They have already established the compliance and governance structure that will be required. For a small provider, regulation will increase costs and could become a barrier to entry. For a more complete discussion of the advantages big name providers enjoy, and what that may mean going forward, check out part 1 of this series.
Another interesting issue that will arise is liability. Traditionally, index providers avoid liability through disclaimers in their license agreements. In a more regulated environment, one can expect that an index methodology will start looking like a prospectus with every risk being disclosed. Changes to index methodology will require additional public disclosure much like modifications to a prospectus. These demands will add cost and complexity. Under a regulatory scheme, the specter of increase liability in the forms of fines, sanctions and civil law suits increases dramatically. The current economics don’t provide for this shift in legal risk and the likelihood of raising index fees to cover potential liability is a non-starter.
With the memory of the LIBOR scandal still fresh, regulators across the world are looking to prevent future problems. In Europe, the BMR already sets out the path and is well under way. Other countries, including the US will inevitably follow.
Alex Matturri is the retired CEO of S&P Dow Jones Indices and currently an advisor to The Index Standard and a member of the Board of Directors of CBOE Global Markets.
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