|How Index Sponsors Get Paid|
|April 23, 2012-|
Index-based investing has seen a phenomenal rise in popularity over the last 20 years. However, one of the side-effects of the indexing boom has been confusion over who owns the intellectual property (IP) embedded in an index and how those owners get paid.
Index sponsors earn revenues through their commercial policy, which tends to include two elements: a licensing agreement for the issuance of financial products based on an index, and a data usage licensing agreement, covering the provision of information on the index’s underlying data, like constituents, rebalancing dates, and so on. In recent years index sponsors’ price policies have become increasingly opaque under the pretext of customer confidentiality. One index provider is famous for stating during a US market data industry meeting in 2010 that its price list was official—but would be discussed on a one-to-one basis only.
Licensing agreements are typically used in funds and structured products that either track indices or use them as performance benchmarks. Where funds are concerned, the prices paid by different firms for the same index licence can vary widely. Most index sponsors will not charge heavily for the use of their indices in active funds, preferring to charge larger fees for their IP rights in the passive funds market. In the last decade, index sponsors have gained significantly from the emergence of index-linked exchange-traded funds (ETFs).
In the passive funds market, index sponsors typically charge for the use of their indices as a basis point share per year of the total assets under management, thereby gaining from any increase in fund size and generating a recurring revenue stream.
There are further opportunities for index sponsors to charge for their IP in both active and passive funds if their constituent and weightings data are to be used by fund sponsors in performance reports, related marketing materials, institutional reporting or even in regulatory reporting.
In the structured products market there’s typically a tighter range of index licence fees. Until a few years ago, index licences were almost always negotiated by the front-office desk managing the structured product issuance. Such “single-trade” licences were also typically charged in terms of basis points of the notional issuance amount, either on a one-time or recurring annual basis.
As structured product issuers’ legal and market data sourcing and procurement departments have become more involved in the licensing process, blanket or annual flat-fee index licences have become more prevalent. Offering unlimited issuance linked to a particular index or family of indices for a period of one or more years, these annual agreements are often cost-effective for the issuer. However, for many of the more popular indices, sponsors have decided not to make blanket licences available, and charge per-trade licensing fees.
Index Data Policies
As mentioned above, the second income stream for index sponsors comes from the licensing of index-related data. A single index sponsor may request up to 11 different data licences for the same index information (for example, real-time, delayed, historical, constituents, per location, web display, manipulation licence, and so on).
European securities exchanges have been under heavy commercial pressure since the 2007 Markets in Financial Instruments Directive (MiFID) enforced greater competition between trading venues. An apparent side-effect of the squeeze on trading-related fees is that exchanges are relying increasingly on their index data licensing arms to generate incremental revenues. As evidence for this supposition, many exchanges’ data charges are now rising by double digit percentages each year.
In recent years index sponsors have also targeted fund administration and securities services firms, treating those involved in these activities as “data redistributors” and putting pressure on them to sign chargeable third party agreement or customer service agreement licences.
Impact of Changes in Market Structure
Recent and upcoming changes in market structure, such as MiFID II and the European Market Infrastructure Regulation (EMIR), as well as the multiplication of distribution channels, are making index providers’ data and price policies even less transparent. To boot, market data distributors like Thomson Reuters or Bloomberg may add a layer of chargeable usage rights to those of index sponsors, resulting in a higher price for the end-client.
Even data collected via free quotes from dealers and distributed by inter-dealer brokers (IDBs), commonly used in the creation of custom indices, has become a chargeable item under the derived data part of market data distributors’ policies. A number of IDBs with dominant positions in the over-the-counter (OTC) and commodities markets report having been “encouraged” by some market data distributors to make their data chargeable and to introduce data usage policies as an opportune way to compensate for the revenue volatility they face on transactions after the recent credit crunch.
However, market data distributors also profit from this new policy of data licensing by charging related administrative fees. Since 2005, some of them have expanded the notion of “business activity” or data historisation rights to allow licensing of this type. In theory, it could be argued that market data distributors are not adding value but merely taking advantage of a legacy duopolistic situation to deprive index sponsors of revenue that they are theoretically owed.
In response, some index sponsors are looking to charge directly for market data distribution. However, such attempts to bill end-clients directly have brought new administrative challenges for index users.
In the course of their efforts to confirm that they are being paid for the use of their indices and the related IP, index sponsors are making increasingly frequent use of audit and compliance reviews. Typically, when market data distributors stand between them and the ultimate index user, sponsors fear their IP rights are not fully protected, and that unlicensed deals or renegade usage may take place. In such cases, audits may allow them to claw back revenue.
However, auditing practices and the associated licensing rules, often allowing just 30 days for compliance, are creating extra demands. Auditors working on behalf of the index sponsors have broadened their investigations as unclear data policies allow for a wide interpretation of “non-compliance”. Some index sponsors now even use third-party auditing firms to track web-based index usage or identify new usage trends that might not be covered by existing licences.
Resolving challenges and improving communication
There are now as many as 70-80 mainstream index sponsors. End-users have had to learn quickly how to manage contracts with those sponsors and with the market data distributors that often stand between them. Unfortunately, index sponsors do not “speak” the end-user’s language in terms of product and service inventory. Typically, indices used to underlie funds and structured products are neither billed consistently across vendors, nor named in line with prevailing market standards.
Meanwhile, the bundling of services is also a potential source of confusion. Bundling leads to market data administration and finance teams having to set up and maintain a mapping table for each index sponsor to make sure the invoices received really match services delivered. It is an exercise which is further complicated when the billing is performed by a market data distributor using a third, proprietary naming convention.
For these reasons, creating a Unique Product Identifier (UPI) for indices is a topic that’s been widely discussed by market data associations in Europe for over three years. However, very few index sponsors have so far engaged with their end-clients to implement a set of UPIs for the whole index product set. It appears that few index providers currently feel a real incentive to introduce UPIs.
The increased use of offshoring and outsourcing practices by index licensees argues for more standardisation, however, as the best-structured vendors will be the quickest to receive payments. When moving to lower-cost locations, some fund and product issuers have been unable to retain the experienced but “expensive” resources needed to perform the administrative tasks necessary for the index sponsors. Consequently, it takes longer for index vendors to get paid.
Some so-called “market data management” (MDM) service providers have the ability to manage index costs accurately, but others do not even report fees. Typically if an index structuring fee has been levied on an annual basis then structuring and data licensing fees may end up being overpaid if a note or certificate expires or is called early by the issuer. Usually, there is no possibility under most index sponsors’ contracts to receive credits for the unused time period.
To overcome problems in mapping index usage to the services provided, Cossiom, a market data user group, is developing a “Niagara Index Matrix” (NIM). Niagara offers a precise description of index services and policies and, once fully mapped to different MDMs’ services, should help address any firm’s management reporting need, from issuance to data usage.
Index sponsors also increasingly require their clients’ assets under management (AUM) to be reported quarterly or even monthly, forcing an increase in the administrative workload for clients to avoid incurring non-trivial penalty fees. Using automated tools that interface with internal corporate systems, such as the workflow engine (RPM) from MDSL (Market Data Services Ltd), the regular communication of AUM, numbers/locations of user accounts and the number of funds is now possible in a time and cost-optimised way.
Developments on the indexing front resemble those at exchanges a few years ago, where MDM and consulting firms worked to design reporting tools highlighting clients’ access to and usage of real-time data from over two hundred trading venues like exchanges, multilateral trading facilities (MTFs), automated trading systems (ATS) and dark pools.
As a result, there is no valid reason why the clients of index sponsors should not be able to take advantage of equivalent reporting tools. Such “inventories” of index information are now capable of displaying accurate and consistent usage information in different formats, allowing the integration of data for informed decisions by the management of client firms. Those business managers then have the ability to assess the full and direct financial impact of a proposed new index-based product as well as being able to benchmark it by cost, asset class, and coverage. The ability to link the issuance costs of index-related investment products to licensing charges will benefit both the buy-side and sell-side clients of index firms.
When index sponsors and market data distributors decide to invest in MDMs similar to those used by their clients, and agree to use a UPI to standardise communication streams, a very significant number of issues will disappear—starting with payment delays.
This article has been co-authored by Graham Downie, regional co-chair of the Information Providers’ User Group (IPUG), André Kelekis, head of global market data strategy at BNP Paribas, Jean-Pierre Gottdiener, CEO of Lucidine Conseil, and Steve Ellenberg, senior consultant at Market Data Services Ltd.