Benchmark providers eye banks’ prop index disposals

The capture of “non-significant benchmarks” by incoming European regulation – such as the proprietary indexes banks offer via subscription to small groups of investors – is prompting some dealers to accelerate the sale of indexing businesses

Independent index providers are hoping to grab a lucrative slice of business from European investment banks, with several dealers understood to be accelerating planned disposals of their proprietary indexing units in response to the EU's forthcoming regulation on financial benchmarks.

A slew of new rules governing the administration, governance and use of indexes – chief among them the new EU framework due to enter force in 2017 – have left banks pondering whether to outsource index calculations or offload their in-house index businesses completely, in order to dodge potential future conflicts of interest and avoid the costs of implementing the new requirements.

The moves are likely to benefit independent index providers such as giants FTSE Russell, MSCI, Stoxx and S&P Dow Jones Indices (SPDJI), many of whom already provide calculation and administration services for some banks. Several firms confirm privately that they are in negotiations with banks over the sale or outsourcing of indexing operations.

"We have seen demand from some investment banks who would like us to administer their indexes. They understand that an organisation whose primary business function is the development and administration of benchmarks is well placed to run a proprietary index. The recent increased demand is in response to the burdens of the regulation," says Chris Woods, director of governance, risk and compliance at FTSE Russell in London.

One source at an index house said outsourcing or disposal transactions typically take place under non-disclosure agreements, so they couldn't speak about any deals they were currently negotiating. But they added that index tendering was "widespread".

If these two parts have to be separated a bank may think it better to abandon the business model
Alain Dubois, MSCI

Several banks were already understood to be weighing a sale of their indexing units before the final scope of the EU rules emerged, partly in response to heightened regulatory scrutiny and a number of high-profile enforcement actions. In December 2015, Barclays announced the sale of its Risk Analytics and Index Solutions business to Bloomberg for $790 million. The bank did not respond to a question on whether impending EU regulations were one reason behind the divestiture in time for publication.

SPDJI says it has also seen investment banks looking to sell their index businesses. A spokesperson for the company said in an emailed statement: "While we cannot comment on specific transactions, we can confirm that this is happening within the industry. It has always been our contention that banks will leave the indexing business due to tighter European regulations on benchmark administrators. The events surrounding Libor clearly drive home the point that providers of indexed-based investment products should not be administering the benchmarks that these products are based upon."

Proprietary indexes have been a lucrative business line for dealers in recent years. Societe Generale's Risk Premia Index, launched in September 2014, has seen inflows of more than €1 billion ($1.09 billion). BNP Paribas, meanwhile, has made waves with its Ethical Equity Index linked to World Bank-backed Green Growth Bonds, with over $500 million in sales since August 2014. And funds linked to BNP Paribas' Guru strategy, which uses a proprietary stock-selection process intended to deliver benchmark-beating returns, raised $1.6 billion in new cash in the first three quarters of 2015 alone.

The EU's looming benchmark regulation, which is expected to be finalised and passed by the European Parliament later this year, will capture proprietary indexes in its scope under the label "non-significant benchmarks." These are defined as benchmarks used as a reference for financial instruments or contracts, or for the determination of the performance of investment funds having a total average value of less than €50 billion.

Transparency demands

The transparency requirements of the benchmark regulation are a particular bugbear for dealers and are a further reason why they might be keen to sell up. Article 7b of the proposed regulation orders administrators of all types of benchmark to publish the key elements of the methodology for each index it produces. Dealers that issue highly engineered proprietary indexes may find themselves vulnerable to predatory activity by competitors when hedging investment products linked to such indexes.

"If an investment bank creates a proprietary index and they need to offset their risks through hedging, they do not want an index with a published methodology that highlights the potential trades they are going to have to do in advance. This would allow their competitors to front-run that hedge. If indexes are too transparent, particularly when trying to capture premia through small or illiquid stocks, investors are very susceptible to front-running," says FTSE Russell's Woods.

Under Article 5 of the proposed regulation, proprietary index administrators must implement "robust governance arrangements" and "take adequate steps to identify and to prevent or manage conflicts of interests", as well as ensure that "where any discretion or judgement in the benchmark process is required, it is independently and honestly exercised."

Hartmut Graf, Stoxx

These new burdens are encouraging banks to downsize or get out of the indexing business entirely, say index providers. "Banks started to think about outsourcing their activities quite early in the [EU benchmark regulatory development] process. Doing so would also end one of the potential conflicts of interest banks face as both product and index provider," says Hartmut Graf, chief executive at Stoxx in Frankfurt.

A carve-out in the EU rules exempts administrators of non-significant benchmarks from having their index units be operationally separate from any part of their business that may create a conflict of interest. Despite this, it appears some banks want to dispense with them regardless.

Alain Dubois, head of new product development at index provider and research firm MSCI in London, says: "A part of the benchmark regulation concerns input data. If you are a benchmark administrator you need to sign a code of conduct with data providers. How can you do that if, as a bank, you are the data provider and the administrator? Theoretically, if you put up Chinese walls internally there is nothing that prohibits this, but if these two parts have to be separated a bank may think it better to abandon the business model," he says.

Dubois adds that a sell-off of index units may also be driven by the EU's Market Abuse Regulation (MAR). The manipulation of benchmarks by individuals or groups is proscribed under the regulation, and issuers of financial products linked to them have their own disclosure requirements to adhere to. Dealers that create indexes and then sell exposure to them through fund or structured products wrappers would therefore be captured by both the benchmarks regulation and MAR.

Sensitivities around conflicts of interest in the provision of proprietary indexes ratcheted up in 2015 when UBS paid $19.5 million to the Securities and Exchange Commission (SEC) in the US to settle charges that it made false and misleading disclosures relating to the performance of one of its self-designed products.

Meanwhile, concerns over transparency were thrown into sharp relief when Barclays was hit with a $1 million fine in November 2015 by the US Financial Industry Regulatory Authority for publishing its Pan Euro ABS Floating Rate Index with inaccurate coupon-return information and failing to disclose the error to index subscribers.