Examining the Potential Regulatory Landscape for Index Providers
[Sakshi is a student at Maharashtra National Law University, Mumbai.]
An index is a standardized way to track the performance of a group of stocks, assets, etc., belonging to listed companies. To formulate an index a basket of securities are chosen, either from a specific sector or from the entire market, next a peculiar methodology is constructed and applied to track their performance in the market. The companies with appropriate infrastructure and human resources dedicated to design and calculate indexes are called 'index providers'.
The need for a regulatory grip on index providers appeared with the exponential growth of passive investment strategies since the year 2015, wherein a market index is tracked and replicated. Passive investing does not require the fund manager to actively select stocks for the purpose of investing, it comprises of a simple process in which investment is made in stocks similar to that of the index that is being tracked. This type of investing relies completely on an Index’s output. Additionally, the assets under management of passive investment schemes grew 34% in 2023, nearing a figure of INR 7 lakh crore. This situation raises serious concerns due to absolute reliability on an unregulated entity.
Further, there are other market entities/participants that are accessing and relying on the indices to make crucial financial and investment decisions, for instance to ascertain the performance of equity or other assets of any company belonging to any specific sector, investment in mutual funds or alternative investment funds, etc. Currently, there are two prominent indices in India NIFTY 50, a wholly-owned subsidiary of NSE Data and SENSEX, a joint venture of S&P Dow Jones Indices and BSE Limited. Accordingly, they are associated with and under the purview of the Exchanges registered with the Securities Exchange Board of India (SEBI). There are no private players on their own yet, but it cannot be presumed that there would not be any private parties operating independently of the exchanges in the future.
Considering the above, it seems essential to ensure that the indices are undertaking proper due diligence and deploying a fair and transparent mechanism to arrive at a benchmark.
In light of the above, on 28 December 2020, the SEBI released a consultation paper on composing a comprehensive framework for the regulation of the "index providers". Through this framework, SEBI seeks to instill transparency, openness and address conflicts of interest in the benchmark-setting process. It is based on the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks (IOSCO Principles), which is also the basis of regulation of index providers in many foreign jurisdictions.
The Proposed Regulation
The regulation would apply to domestic as well as foreign index providers, given that their users are based in India. Accordingly, the indices being tracked by Indian investors and having a minimum net worth of INR 25 crores would mandatorily have to get registered with SEBI to operate as an index provider. Moreover, an individual is not allowed to be an index provider, only a legal Company is. Further, the regulatory framework clearly defines the role and liabilities of the Administrators, it lays down a code of conduct for the Submitters and imposes a mandatory internal framework when certain services would be outsourced by the providers. Concerning the maintenance of transparency and addressing the client's interests, the framework mandates the formation of an oversight committee, which would review the indices design and various aspects pertaining to its methodology, and a grievance redressal mechanism for solving internal conflicts.
Another welcome feature of the new framework is the compulsory enactment of internal policies and procedures to manage conflicts of interest that might arise due to the element of discretion used in the management of indices, such as while rebalancing or reconstitution of the index. For instance, the index providers work very closely with the AMCs who track them for benchmarking or index funds, the employees of index providers could easily transfer information of the inclusion or exclusion of certain securities in the process of determining the benchmark, to the fund managers in exchange of personal benefits. Such situations could be curbed by having appropriate internal checks in place, like deploying a Chinese wall or restriction on circulation of information amongst the staff as suggested in the framework.
Recently, SEBI in its board meeting gave an in-principle approval to this framework. The proposed mechanism has a wide scope that addresses many issues concerning the governance of index providers in India. However, it fails to include certain guidelines essential for the operation of the indices in challenging situations. They have been briefly discussed below.
Policy on transition
The framework is duly based on the IOSCO Principles, but it has not included within its ambit appropriate guidelines for the 'transition' of a benchmark, which has been significantly delved into in the report provided by IOSCO. According to the IOSCO Principles, transition guidelines should be in place in case there is a need for possible cessation of a benchmark. The need for cessation could arise due to changes in market structure, product definition, or any other condition because of which the benchmark becomes no longer representative of its intended interest.
SEBI should consider making the incorporation of appropriate policy concerning the Transition of benchmark mandatory. As per the IOSCO guidelines, the policies should include provisions with the criteria for the selection of a credible alternative benchmark, the practicality of maintaining parallel benchmarks, procedures in case a suitable alternative could not be identified, the intended time period while the benchmark would be operating, and the procedure for engaging stakeholders, regulator and national authorities for noting their views/opinions. Further, the IOSCO Principles suggest that the policies and procedures should be proportionate to the estimated breadth and depth of contracts and financial instruments that reference a benchmark and the economic and financial stability impact that might result from the cessation of the benchmark. It also states that while formulating these policies views of the stakeholders, the relevant regulators, and national authorities should be duly considered.
There should be a mechanism in place for the clients of the index providers to fall back on, providing them with a timely solution or enabling them to claim help from the index providers to navigate through the situation.
Policy on contingency plans
Recently, IOSCO released a consultation paper looking to understand the dynamics of asset managers and index providers, to completely examine the potential conflicts of interest. As part of this consultation paper, IOSCO is seeks to understand what governance arrangements index providers have in place in case of “exceptional market events”. It has made a clear distinction between 'regular' and 'ad-hoc exceptional' circumstances, regular such as corporate actions and the latter being unforeseeable situations like COVID-19 or the Russian market collapse due to the Russia-Ukraine War.
The Russian invasion was so grave on the capital market forces that it compelled Weiner Boerse a global index provider to abruptly discontinue its benchmark for RDX and AMC along with 14 other indices. Further, index providers led by MSCI decided to remove Russian securities from their emerging market indices at a price that is effectively zero, AMCs like BlackRock and Invesco terminated their Russia and Eastern Europe ETFs as they had become untradeable. This caused a total market collapse affecting the operations of index providers and in some cases even forcing them to shut down.
Considering the impact of ad hoc exceptional circumstances, the IOSCO consultation paper expects indices to have a structured mechanism to operate during such situations. Further, it seeks to understand the nature of the mechanism to examine whether it is comprehensive enough. Efforts on a global level are being taken, and understanding its importance, SEBI should incorporate contingency provisions into the new framework to deal with unforeseeable and exceptional circumstances. The mechanism might be of a committee structure, including provisions to deal with different issues that might arise, for instance, liquidity issues impacting the sufficiency of the indices or having appropriate disclosures of actions to be taken to be made to the clients within a timely manner.
The possibility of index providers as investment advisors: Would it be viable in the Indian securities market?
The Securities Exchange Commission (SEC) of US has released a discussion paper with the objective to assess whether index providers should be reclassified as ‘Investment Advisors’ which would eventually impact their regulation by the SEC. This is because of the increasing influence of index providers in the US market, for instance, inclusion of a company’s stock for benchmarking creates a significant demand for that stock and exclusion from benchmark leads to decline of its demand and price. These instances give the apprehension of index providers providing investment advice.
If we consider reclassification of index providers as investment advisors in Indian securities market, this change comes with some serious regulatory challenges. The investment advisers by the virtue of SEBI (Investment Advisers) Regulations 2013 have the obligation of fiduciary duty towards their clients - on the other hand, whether index providers owe such fiduciary duty towards their clients is currently a moot point. Further, the functioning of both intermediaries diversely differ - index providers follow a methodology for index compilation, whereas investment advisers understand the financial condition of their clients and undertake research to analyze investments, strategies and market conditions based on which they provide the most appropriate investment option for their client. In comparison, the impact of the index provider’s benchmark on buying and selling of stocks could be construed as merely passive advising. It is to be noted that such passive advising is an inherent by-product of the provider’s main objective of benchmarking.
Accordingly, if India considers adopting such reclassification, it would alter the fundamentals of index providing and the way in which they currently operate. The regulatory oversight over them would tighten making it difficult to maintain their independence for achieving their main objective of benchmarking. However, considering the influence of such passive advising on market investments and the power the provider gains due to this, it should not go unchecked by the regulator.
If the new framework (including or excluding the provisions suggested herein above) is enforced, India would be the second jurisdiction in the world after the European Union to have a comprehensive framework for the regulation of index providers, leaving behind countries such as the US, Singapore and Australia in this aspect. SEBI seems to be widening its regulatory scope and trying to monitor the areas wherein issues have not yet began. It is indeed a welcome move which will strength SEBI’s grip on the market participants, prevent abuse of the information asymmetry and maintain investor’s trust in the market.