Index transparency and the false promises of governance
EDHEC-Risk Institute's Frédéric Ducoulombier calls for full transparency of methodology and historical information for indices.
In the context of the ongoing regulatory debate on financial benchmarks and the recent consultations by the International Organisation of Securities Commissions (IOSCO) and the European Securities and Markets Authority (ESMA)/European Banking Authority (EBA), EDHEC-Risk Institute wishes to underline that transparency is both crucial to allowing users to assess the risks, relevance and suitability of indices and the most powerful tool to mitigate conflicts of interest existing across the indexing industry.
EDHEC-Risk Institute is concerned that discussions pertaining to define an 'adequate level of transparency' and balance the needs of index users with the purported necessities of confidentiality or intellectual property protection may result in a framework that falls short of providing users with the information they need to discharge their due diligence responsibilities (at a reasonable cost or at all).
Against this backdrop, we must warn regulators against the temptation to trade lower levels of transparency against stronger governance mechanisms or stricter codes and standards. Because the latter have too often proven ineffective in ensuring good behaviour or protecting the interests they are expected to defend, they can at best support transparency and at worst exacerbate moral hazard and adverse selection phenomena. We therefore wish to warn regulators against promoting a false sense of confidence by organising or condoning a framework that would give the illusion that conflicts of interest have been dealt with.
Within the European Union, these discussions may pave the way for a regression in terms of transparency relative to the high standards established by ESMA for harmonised retail funds, whereas the focus should be on generalising the investor protection and market competition advances introduced in the context of financial indices used by UCITS to the maximum extent possible.
In this regard, we disagree with the position of the ESMA Securities and Markets Stakeholder Group (SMSG) in its advice to ESMA dated 26 February, which not only makes the assumption that the governance approach and transparency approach are substitutable and that therefore a lack of transparency could be compensated by an improvement in the rules of governance, but also presents the governance approach as the high road and transparency as a fallback solution enabling external monitoring to be carried out in the absence of "sound governance mechanisms".
As an academic institution, EDHEC-Risk Institute wishes to recall that the position of the SMSG is in total contradiction with research results showing clearly that the efficiency and integrity of a market are directly related to the quantity and quality of the information available and not to the goodwill displayed by participants in the market. The position of the SMSG appears in this sense to contrast starkly with the commitment to transparency rightly demonstrated by ESMA in its recent Guidelines on ETFs and other UCITS issues.
We consider that the appropriate level of transparency is full transparency of both methodology and historical information provided on a fair, non-discriminatory basis and at reasonable cost – which is not currently the case. Historical information should include the values, constituents and weights of indices, as well as documentation describing the basis for and justification of each discretionary decision and change of methodology.
Such transparency not only allows index users to understand the benchmark and its construction principles but also enables them to independently replicate its track record, gauge the systematic character of its methodology and conduct performance and risk analyses so as to assess its relevance and suitability against their specific goals.
Frédéric Ducoulombier is director of EDHEC Risk Institute-Asia