I have a piece in today's Financial Express with Rashmi Birmole and Navneeta Shankar on SEBI's new regulations on index creators (effective after 6 months). Good move, but a light touch regulation in practice would be recommended.
In the coming months, Indian bonds will feature in JP Morgan’s Government Bond Index – Emerging Markets, a move that is being heralded as a game-changer by many and that is expected to attract significant foreign investment into the country. The inclusion of Indian bonds on a globally recognized index, a milestone in its own right, also speaks to the significance of indices in the broader context of the financial landscape.
Simply stated, an ‘index’ is simply a collection of traded securities (known as constituents), which represents a segment of the financial markets. One of its myriad functions is to serve as a benchmark to measure the performance of an actively managed fund or the economy, as a whole. The function that holds greater relevance for investors is an index’s use in the creation of passive investment products, which are typically present in most investment portfolios. These products may range from index funds, which mimic the performance of broad-based market indices, to thematic or sector-based funds, which rely on customized or bespoke indices, available in the public domain or designed at the behest of fund managers.
The construction and management of an index is based on methods and criterion adopted by index providers, who operate with a high degree of autonomy, with the inclusion or exclusion of a constituent security resulting in observable signaling effects in the financial markets. It stands to reason that, given that indices are foundational for the creation of passive products, any decisions regarding the constitution of an index can substantially impact the overall performance and direction of the markets. The resultant conflicts of interest that may arise, coupled with the steady rise in passive investing, were the key drivers of the SEBI (Index Providers) Regulations, 2024, which were notified on March 8, 2024. The regulations emanate from the recommendations of a working group, which were released for public comments in December 2022, to address the regulatory vacuum that index providers have operated hitherto, specially given the apprehensions that such providers enjoy an element of carte blanche despite their critical importance within the financial ecosystem.
The regulations are modeled on the IOSCO Principles for Financial Benchmarks, a set of globally accepted standards adopted by index providers worldwide, and by and large, follow a principle-based approach and relegate the nitty gritties of implementation to the index provider. The regulations target index providers that administer ‘significant indices’ for use in the Indian securities market. This essentially means that only the indices, both paid or freely available, which consist of securities listed on Indian exchanges and which are tracked by domestic mutual fund schemes whose cumulative assets exceed a predetermined threshold shall be regulated. It follows that the framework will not apply to indices consisting of foreign securities or used exclusively in foreign jurisdictions.
The regulations, which are focused on addressing concerns around the discretion exercised by index providers, are framed on three overarching themes - conflict of interest, integrity and accountability.
The possibility of conflict of interest in index construction and rebalancing is apparent. For instance, in private arrangements where bespoke indices are designed by index providers for funds, the risk of the index construction being influenced to benefit certain players is inherent and cannot be ruled out. Moreover, individuals responsible for index construction may be incentivized to alter the indices in a manner that suits the commercial interests of the index provider. Information regarding confidential decisions on index composition, or weightage of constituents, also runs the risk of being leaked to the advantage of front runners.
To address conflicting interests, the regulations make it compulsory for index provider activities to be carried out through a separate legal entity. Appropriate governance arrangements will also need to be put in place to protect the index determination process and individuals responsible for index governance must be segregated from the commercial function of the index provider. Among the salient provisions include the constitution of an oversight committee, separate from personnel engaged in indexing activities on a day-to-day basis, to oversee the methodology employed to design indices, review the need for changes and examine whether such methodology reflects the description of the index. The regulations also place the onus of formulating policies and procedures to address conflict of interest on the index provider. These procedures must also effectively control exchange of information among personnel involved in activities involving potential conflicts of interest and ensure confidentiality of information. The regulations further require index providers to institute a control framework to facilitate early detection of potential misconduct and complaint management within the index provider.
Additionally, the regulations also provide for maintaining the quality of the index, the methodology used for index calculation and protecting the integrity of data. To maintain the quality of indices, the regulations mandate index providers to consider factors which represent the underlying interest that the index seeks to measure, while eliminating any factors that may result in distortion of price, rate or value. Index providers have also been given the leeway to formulate a code of conduct for their data submitters to address quality, oversight, conflict of interest management, record-keeping and whistleblowing and perform due diligence on such entities. The regulations also strive for complete transparency in dissemination of information so as to promote investor confidence by making it compulsory for index providers to document and make information relating to the methodology used for index calculation and maintenance publicly available. This will not only allow an understanding of the manner in which the index is derived but will also encourage a fair assessment of its representativeness, relevance and appropriateness as a reference for passive investments. Moreover, the regulations also place an obligation on regulated markets and stock exchanges to ensure equal, unrestricted, transparent and fair access of data to all index providers having a data sharing agreement with them so as to avoid any disparity in timing, format and manner of such information dissemination.
Another theme around which the regulations revolve is accountability and disclosure. The regulations mandate index providers to establish an accountability mechanism by putting in place a complaint redressal policy for facilitating submission of complaints pertaining to whether a specific index represents the underlying interest it seeks to measure and application of the methodology to a specific index calculation. Index providers are also required to provide for a dispute resolution mechanism for resolution of all claims, differences and disputes between their subscribers and them arising out of their business in the securities market. Apart from furnishing timely information to SEBI, when called upon to do so, index providers are also required to assess their adherence to the IOSCO Principles through an independent external auditor, on a biennial basis, to ensure fairness and complete transparency in such evaluation. Any evaluation report of an independent external auditor has to be compulsorily disclosed on the website of the provider.
Considering the explosive growth of passive investing in recent years, the regulator’s focus on index providers, which wield significant influence in the financial markets and are dubbed as ‘power brokers’ in the western markets, comes as no surprise. The principle-based nature of the regulations give index providers ample room to maneuver, providing necessary flexibility to support the passive investing momentum. It must be stated that index based investment has been a force for good, providing benchmarks for providing low cost and market based returns to investors, which have escaped major scandal with one big exception (the LIBOR scandal). Given the track record, a light touch approach in practice would be useful, where the regulator comes in only in relatively egregious actions.
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