Iosco offers general and specific principles to deal with equity and benchmark indexes

Equity indexes may be different from market benchmark indexes, such as Libor, but they are just as easily open to manipulation. But just how similar these indexes are is one of the dominant features of the International Organization of Securities Commissions' (Iosco) draft Principles for Financial Benchmarks. The deadline for replies to the regulator group's investigation falls today (May 16).

Regulators might also need to step in where conflicts of interest arise from index providers involved in the commercialisation of products, says Rosa Abrantes-Metz, associate professor at the Stern School of Business, New York University, and a member of the panel that prepared the draft document.

"Given the motive, ability and opportunity, the likelihood that indexes will be cheated on is significantly increased when potential conflicts of interest arise," says Abrantes-Metz. "The challenge is to find a way of creating the right incentives for cheating to be minimised, and an important component is the independent audits to be performed on the benchmarks."

Thomas Wulf, secretary general of the European Structured Investment Products Association (Eusipa), suggests some indexes do not need any regulation. For example, he says strategy indexes, which work like algorithms, rather than depicting the price evolution of an asset, hardly run the danger of being manipulated. Besides, Wulf points out that national civil law protects investors from being cheated on, as they enforce that strategy indexes are followed as defined in the prospectus.

A source close to Iosco's panel says the need to push for regulation of equity indexes comes from the idea that virtually all benchmarks involve some degree of judgment in design or calculation. Therefore, it would be impossible to guarantee they are immune to manipulation, he says. "It is wrongly perceived by the public that indexes are immune to manipulation," he says. "Virtually all benchmarks involve some degree of judgment in design or calculation. I am saying this because many used this as an argument for equity indexes to be excluded from the scope of the regulatory framework."

Index provider MSCI stated in its submission to the consultation that more regulation on indexes could well lead to increased costs, potentially damaging the industry. "The consideration of costs and unintended consequences is why we do not think regulation at this point is necessary or useful for the equity index business, and may in fact lead to a lessening in competition, innovation and services, particularly to the extent that regulation would lessen index owners," it states.

Iosco's draft principles, which were produced on April 16, reveal how hard it is to distinguish between different types of benchmarks and consequently the way they could be regulated – or whether regulation should apply at all.

Unlike a release from the European Securities and Markets Authority (Esma) in January, Iosco has attempted to differentiate between a benchmark, such as Libor, and an equity index, after taking great pains to avoid placing a ‘one-size-fits-all' approach at the core of its discussions.

"Clearly, a one-size-fits-all approach is not going to work in relation to benchmarks," says a source close to the panel. "The important question here is 'How to address this problem?' Or better yet 'Can we address this problem?' In response, Iosco has decided to design level 1 high-level principles at the top, which will cover and apply to all types of benchmarks, and level 2 principles, where the degree of prescriptiveness will be adjusted depending on the type of benchmark. Level 2 responds to the issues around indexes, and tries to solve the one-size-fits-all problem that arises, because indexes have characteristics that require differential treatment.

"Is this the perfect solution? It is important to realise that there is no 'best' single set of principles and no single solution that will work across all benchmarks/markets and completely address the 'one size fits all problem'," he says

Third-party index creators accept there could be dysfunctions in certain indexes, like those where the product issuer is the index provider, says Alex Matturri, chief executive of S&P Dow Jones Indices in New York. "Good practice on this would mean separating the commercial and editorial functions, so the commercial side of an index has no impact in the stock selection or in the methodology," says Matturri.

Barclays, in its comment submitted to Iosco, says regulation on equity indexes should be avoided, but it recognised certain areas can be improved. "Some kind of standardisation of index governance requirements could be a good idea, but any initiation of regulation or codes of conduct for these types of indexes should be carefully considered in light of the clear differentiation between independently owned benchmarks and benchmark rates." The bank also notes that the practice of implementing a consultative process of some form that involves index users should be widely adopted for any indexes, and appropriately documented.

While the Iosco guidelines do not have the power of law, Abrantes-Metz is confident that at least in the US and the UK, the investigation will be followed by large-scale change. "Most of the largest benchmarks are based in those two countries, which have been directly leading these efforts," says Abrantes-Metz. "The Commodity Futures Trading Commission chairman Gary Gensler is very committed to making significant changes in the US. Elsewhere, I think regulators will be encouraged to make changes, but it's left to each jurisdiction: they will take from the principles whatever they want."

Therefore, national regulators will have the last word. Iosco represents a large proportion of them, which collectively oversee 95% of the world's markets.