The implications of European Benchmarks Regulation on index-based products

Dan Barnes Welcome to ETF TV, I’m Dan Barnes. Joining me today is Deborah Fuhr of ETFGI, and Rick Redding, CEO of the Index Industry Association. We’re going to be talking about the way that regulation is impacting indexing, self indexing, and other products based upon those benchmarks.

Deborah Fuhr Yeah, Rick, I’d be interested in your view, given you get the chance and often are asked to speak to regulators around the world, what are the key regulatory challenges and opportunities facing indices and especially looking at it through the lens of the ETF industry?

Rick Redding So post -IBOR crisis, a number of governments decided to regulate the index administrators, so fx countries like Japan or in Singapore, they decided to just do their IBOR equivalents. Only one, being the EU, has decided to regulate every index that an EU investor could use. And it has extraterritoriality features. And that’s what most people don’t understand is, any index provider basically anywhere in the world, if their indices are used in Europe, they now have to comply with the benchmark regulation.

Deborah Fuhr Do you find that most of the index providers are complying with or have gone forward and gotten regulated in the EU?

Rick Redding Most of them have become compliant with the IOSCO standards, the IOSCO principles, and most of the major ones are compliant with EU regulations. There are others that have decided not to make their indexes available in Europe and others are still trying to figure out what they need to do. Index administrators outside of the EU, there’s a phase-in period for them, so that hasn’t come into full force yet.

Deborah Fuhr And sitting here in London, when the UK exits the EU officially, what happens with the UK in the scheme of this regulation?

Rick Redding We don’t know. I think this is tied up in a bigger issue of Brexit and how that’s going to be treated. We do know that the UK, as part of the EU, has followed and has actually been a leader in establishing those procedures for regulation. So from an equivalent standpoint, they’re probably the best positioned of anyone in the world to get that. Now, most of the large indexes are going to be deemed third-country index providers, because many of the administrators are actually headquartered in the UK.

Deborah Fuhr And when you talk about all products offered in the EU, does that cover structured products and mutual funds and certificates, etc.?

Rick Redding It includes everything, I mean, there’s obvious places like the ETFs or exchange listed derivatives, but it goes to whether the benchmark is used at all. A lot of people aren’t thinking about it, so they think, ‘oh, well, we’ll just do some structured products through some banks, or we do some warrants through a bank.’ Those will now have to be authorized to be used within the EU.

Dan Barnes What are the potential impacts of that regulation then on investors, both in terms of people complying and the effect that has, but also potentially with noncompliance?

Rick Redding The issue of noncompliance becomes, EU investors just won’t be able to use the products. And that becomes a very difficult thing for European investors, because fx, if there’s a well known index that for whatever reason cannot get authorization, it’s not clear what’s going to happen to European investors. Do they have to trade out of the product? Can they just no longer get access to it? So it’s not clear how this all works through in the end. Compliance is where asset managers need to make sure that every index is authorized. It’s not, is my index administrator authorized? It’s, is this specific index we use for this fund authorized, and is the index we use for this fund authorized etc.? So we’ve been working with the regulators in Europe to see if there is a way to have it posted by families of funds or family of index funds to make that easier. It’s a little more complicated for the European regulators to do, but we think that’s ultimately an easier way for the asset management community to access this.

Deborah Fuhr And what about products that are domiciled in countries, because ETFs are listed on exchanges, right. So people in Europe can access products listed in Australia, China, the US, exchanges in 58 different countries. How do they get impacted by the set of regulations if they’re self index?

Rick Redding Technically, I mean, if you look at the letter of the law, they probably can’t access it. But there’s also a little bit of an enforcement issue there too, right? How would the regulator know that someone’s trading a product on the Australian exchange unless it comes to the brokerage account or somethin?. So if you don’t think about it from an individual standpoint, but from an institutional aspect, they have the ability to domicile a fund fx in another country. How does that work? So there’s a lot of issues around this and how it’s actually going to be implemented.

Deborah Fuhr Yeah, an interesting topic. And especially because many firms are writing research on products around the world. So I think many people don’t realize there are restrictions on what you can or can’t buy, and also the tax and regulatory implications of doing it.

Rick Redding That’s a great point, Debbie. What happens if you’re in a global index and some of the underlying indexes are authorized and some aren’t? Can a European investor not use the product? It becomes very complicated very quickly. And it took them a good six or seven years to get to this point because they tried to regulate everything. And it’s just very difficult once you start peeling back the onion. They’ve also looked at ESG indexes and there’s actually separate regulation on ESG indexes, and actual separate regulation on a couple of climate related indexes. So we just don’t know how the regulators are going to enforce it, because they just don’t have enough information.

Deborah Fuhr Yeah, and I think data sources is a big issue. Right. So is it self reported and where are you getting the data from? Is it consistent?

Rick Redding It’s not only the underlying data is difficult. It’s difficult to get people to coalesce around what is ESG? Even investors fx in Germany and France, don’t necessarily agree on if nuclear is green or not. You also get into issues that, if you follow the Paris accord; they follow carbon footprint, which is not a measure of output. So even within the EU, they don’t measure carbon output the same way. You know, if there’s 15 different factors in ESG and we all agree on 14 of them, but the one we disagree on is not the same. We now have to create three indexes to measure that. So it’s a very big issue, and obviously, this is a really important issue, because it’s just growing so quickly all over the world, not just in Europe. And this one, I think, is going to take a while to figure out.

Deborah Fuhr Yeah. And the other and biggest challenge is it’s a very personal thing. So you think about energy companies, if they’re trying to develop alternative sources, I may think it’s good to invest where you might think energy companies shouldn’t be invested in at all.

Rick Redding And it gets more complicated even at the next level down, so what if you provide valves to a utility company and you don’t have anything to do with the energy other than you make valves and, you know, the utilities happen to buy it. You have to know what your issues are and what you want your investments to impact. Because what good is it, if the company is actually a positive carbon producer and has the worst gender record of any company. I mean, you’ve solved one problem and created another. So we see more and more people thinking about scoring companies across all these different factors and coming up with kind of high scoring companies within ESG.

I think the other factor that, from a practical sense and from an investment standpoint, is if you make the indices too narrow, you have capacity issues. So it’s a great idea for the index, but can you actually invest in it in any real way? Think about a person putting their risk budget in different areas, saying, ‘well, I can’t have 80% of my portfolio in these 20 stocks that are carbon positive stocks.’ So you’re starting to see the indexes reflect the same underlying characteristics of the parent index, if I can call it that, with social screening underneath. So there’s a lot of great things going on here. I’m hopeful that we don’t stop the innovation in that part of the business, because I think there’s a lot more good stuff to do and, think about product development from the asset management and community standpoint as we start to incorporate big data a lot more, why can’t you do an ESG factor index? I mean, it opens up a whole lot of really interesting thing,. So I hope that we get this right for the investors’ sake.

Dan Barnes I’d like to thank Deborah Fuhr and Rick Redding for their insights and, of course you for watching. To catch up on our other shows, go to ETFTV.NET or TRADERTV.NET.

Published on May 13, 2020