|Shifting Gears On Strategy Indices|
|10 February, 2012|
Page 2 of 2
The most controversial of ESMA’s recommendations concerns the transparency of financial indices. Currently, in order to be eligible to underlie a UCITS, a financial index must be published in an appropriate manner, using sound procedures to source market data and to calculate and publish index levels. Information on an index’s calculation and rebalancing methodology, any changes to the index rules and any operational difficulties must be made public in a timely manner.
Standard industry practice for benchmark indices based on securities (whether debt or equity) is to put the detailed index methodology, as well as daily index levels, into the public domain. The index provider’s intellectual property is protected by trademark and by the assertion of copyright. However, while patents are commonly granted to index developers in the US, they are much more difficult to obtain in Europe. Access to information on an index’s underlying constituents is typically provided on a contractual basis, accompanied by a fee. Such fees, together with revenue from the licensing of indices for financial products, constitute the normal business model for benchmark index providers.
ESMA’s proposed guidelines aim to bring strategy indices into line with traditional benchmark indices. To be eligible for use by a UCITS, says ESMA, strategy indices cannot remain opaque. Those indices based on proprietary information, which the index provider is unwilling to disclose (or, in the case of a third-party strategy, unable to disclose) will no longer be eligible. Under the draft guidelines the index provider must disclose the full calculation methodology, allowing investors to replicate the index. This means the disclosure of index constituents, of the calculation and rebalancing methodology, and of changes to the index methodology. Index providers will also need to publish index allocations (although this may be done retrospectively) and must put index levels into the public domain.
Historically, strategy index methodologies were closely guarded secrets; the index's developers were keen to protect their intellectual property, as well as to prevent traders from arbitraging or “front-running” the index allocations. The typical business model for an investment bank operating strategy indices is, to use industry jargon, “vertically integrated”.
Under such a model, the bank develops quantitative (i.e., rules-based and non-discretionary) strategies in an index format, while the day-to-day running of the index is either performed in-house or subcontracted to an independent service provider. Access to the index’s performance is then offered to institutional clients through over-the-counter derivatives (swaps or notes), while retail investors can buy structured products, exchange-traded notes, and sometimes funds from an affiliated ETF provider.
Under a “horizontal” model, strategy indices may be licensed for use by ETFs issued by third parties. In this case the index providers will need to move, at least partially, to a fee-based revenue model.
As ESMA’s draft guidelines cover only the use of strategy indices by ETFs and other UCITS, some scope for regulatory arbitrage remains, however. The same index exposure may be offered via a non-UCITS structured product, thus falling outside the scope of the proposed rules. ESMA says it hasn’t forgotten the need for a cross-sectoral initiative, covering non-fund investments such as notes and certificates, as well as UCITS.
A related question is also on the regulators’ radar, one concerning “self-dealing” or conflicts of interest. In the US, for example, special permission is needed for an ETF to be based on an index run by an affiliated company. In its consultation paper, ESMA poses the question of whether such potential conflicts of interest in the European funds business need to be addressed more formally.
Meanwhile, in the absence of a big regulatory stick, one key question is whether the prospective licensing revenue is attractive enough for the strategy index providers to make the shift from the current proprietary model. One suspects that, if the banks don’t do this, then independent index providers will quickly move to fill the gap.