A task force of the International Organization of Securities Commissions (“IOSCO”) has announced a consultation on financial benchmarks. The consultation demonstrates the heightened regulatory interest in the uses and reliability of market measures. In addition, the consultation and its results will also likely be considered by many market participants in connection with the construction of a variety of both proprietary and non-proprietary indices. IOSCO’s materials relating to the consultation may be found at the following link: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD399.pdf.
To some extent, the consultation focuses on interest rates and exchange-traded products as examples of benchmarks that are subject to its review. However, the scope of the review extends to indices and other common market measures.
In the consultation, IOSCO requested responses to concerns regarding the potential inaccuracy and manipulation of different investment benchmarks. The consultation identifies a broad range of questions and policy issues.1
Among the issues addressed by the consultation are:
- the methodology of benchmarks, and whether they are appropriate as to the asset or assets that they are measuring;
- the transparency of benchmarks;
- the potential for manipulation of benchmarks, or errors in their calculation;
- the extent of a sponsor’s discretion in calculating the benchmark, or making adjustments based on unforeseen circumstances;
- the process by which benchmark changes are made and publicized;
- oversight of a benchmark, and whether an independent third party is used to address questions and conflicts; and
- the degree of regulatory oversight (including possible self-regulation) that may be appropriate for different benchmarks.
According to the consultation, IOSCO’s task force considers benchmarks as needing to have the following characteristics in order to be credible:
- Representative: a Benchmark should clearly convey the economic realities of the underlying interest it seeks to measure to its users;
- Reliable: the data relied upon to construct the Benchmark should be sufficient to represent that interest and the data should be bona fide;
- Transparent: there should be sufficient transparency over the Methodology, calculation and inputs to allow users to understand how the Benchmark is derived and its potential limitations; and
- Subject to clear governance and accountability mechanisms.
Most market participants would probably generally agree as to the validity of these criteria. However, in light of the wide variety of investment benchmarks and their various assets and markets that they measure, a one-size fits all approach would probably not be workable.
The consultation raises the topic of “independent review” of a financial benchmark. This topic is often controversial in the context of proprietary and bespoke indices. For some index manufacturers, the index may have a new and untested market, or may be directed at a relatively limited number of investors. Under these circumstances, the benchmark's developer may be reluctant to invest in the effort to educate a third party reviewer as to the rules and nature of the index, or to commit to the ongoing expense of retaining these types of services. Accordingly, for many types of proprietary indices, the absence of independent review may remain an ongoing obstacle to conforming to any review practice that emerges among some types of indices. Instead of independent review, sponsors of these indices are likely to seek to adopt alternative systems of controls to ensure integrity, and to avoid the misuse of discretion.
The consultation also does not appear to differentiate between benchmarks that are designed to serve as a measurement of a market sector, such as the S&P 500 Index or a typical commodity index, on the one hand, as opposed to proprietary indices that follow a particular investment strategy that is designed to outperform the market, or to avoid correlation with other assets. These latter types of market-measures are often likely to involve different planning considerations than the former. In fact, because proprietary indices are not typically thought of as “benchmark indices” that are put to broad use, they may not be the principal focus of IOSCO’s inquiry.
The task force indicated that it expects to issue final principles to reflect the findings of its review. However, it will not (emphasis in original) make recommendations relating to any particular benchmark.
IOSCO has requested responses to the consultation on or prior to February 11, 2013.