Regulating index providers is the need of the hour

Bringing the index providers under the regulatory fold has been on the cards for sometime now.
Bringing the index providers under the regulatory fold has been on the cards for sometime now.

Summary

  • The regulations provide for mandatory adherence to IOSCO’s principles, constitution of oversight committee to review index design, and powers of Sebi to initiate special audit, among others.

Trying to “beat the market" is taking a backseat today as investors seem to find “replicating the market returns" easier and more intuitive. In his seminal paper on ‘efficient market hypothesis’, Nobel laureate Eugene Fama’s theorem posits that it is not possible to beat the market as all information is fully reflected in the stock prices, and neither technical analysis nor fundamental analysis can help one achieve more than market returns on a sustained basis. However, it is possible to achieve market returns by passive investing.

Passive investing involves mimicking the indices and replicating the index components in the investment portfolio. Globally, the assets under management (AUM) under passive funds is growing more rapidly than actively-managed funds and has surpassed the active AUM. In India, passive industry AUM is over 6 trillion as on 30 November 2022 and, though still less than active AUM, is fast growing. Besides passive funds, the world of investing has several index-linked products like ETFs (Exchange Traded Funds), and index-linked derivatives. Since, by definition, passive investing involves virtually delegating the job of picking stocks to index providers, they have become akin to fund managers. More than that, the very concept of ‘market returns’ is what the broad market index shows it is. Indices don’t just act as barometers of market performance and as guiding beacons for passive investing, they also serve as benchmarks to gauge the effectiveness of active investment strategies, answering the investors’ question, “Have they beat the market?"

With the growing importance of indices, several questions arise: how reliable are the indices as measures of market performance? Are they constructed without bias? Who constructs and administers them, and most importantly, are they regulated? Indices in India are designed and administered by index providers set up as subsidiaries of the stock exchanges, like NSE Indices Limited, which operates Nifty 50 among other indices, or as a joint venture between a stock exchange and index providers, like Asia Index Private Ltd, which administers Sensex among others. Besides the broad market indices, the index providers also provide other types of indices like thematic indices and sectoral indices, and provide bespoke indices too.

Bringing the index providers under the regulatory fold has been on the cards for sometime now. Questions on integrity of the benchmark administration process came to the fore during the LIBOR (London Inter-Bank Offered Rate) scandal in 2012, which prompted IOSCO (International Organisation of Securities Commissions) to publish a report in July 2013 proposing a framework of principles for financial benchmarks.

Based on IOSCO’s framework, Sebi issued a discussion paper in 2017 to introduce a code of conduct for index providers, and then another in 2020. Then in 2022, a working group presented its recommendations to the Secondary Market Advisory Committee. This resulted in a consultation paper for introducing a full-fledged regulatory framework, based on which Sebi notified on 8 March the regulations which will take effect in 180 days.

While the consultation paper proposed that Sebi registration must be taken by Indian and foreign index providers if the users of the indices are located in India, irrespective of dealing with Indian or global assets, the final regulations are made applicable only to Indian and foreign index providers administering ‘significant indices’ comprising of securities listed on Indian exchanges for Indian users. Registration shall be considered based on fulfilment of fit and proper criteria, minimum requirements for net worth, among other criteria. The 2022 paper, while duly acknowledging that there is transparency to the extent that the methodology and composition are disclosed in the providers’ websites, points out that there is room for discretion, which increases the susceptibility to governance challenges like conflicts of interest and manipulation. Further, news of inclusion or exclusion of stocks in the indices is price-sensitive and, if not properly handled, could lead to insider trading. The regulations provide for mandatory adherence to IOSCO’s principles, constitution of oversight committee to review index design, and powers of Sebi to initiate special audit, among others. Bringing index providers under the regulatory ambit is timely and crucial, even as passive investing is becoming actively preferred.

Usha Ganapathy Subramanian is a practising company secretary in Chennai.

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