Transitioning from carte blanche: India tightens its influence on powerful index providers with new regulations – Opinion News

Sandeep Parekh

In the coming months, Indian bonds will be included in JP Morgan's Government Bond Index – Emerging Markets, a move seen by many as a game-changer. This is expected to attract significant foreign investment to the country. The inclusion of Indian bonds in a globally recognized index, a milestone in its own right, also highlights the importance of indices in the broader context of the financial landscape.

The creation and management of an index is based on methods and criteria adopted by index providers, which operate with a high degree of autonomy, whereby the inclusion or exclusion of a security constituting an index results in observable signaling effects in financial markets. Because indices form the basis for creating passive products, decisions regarding the composition of an index can significantly impact the overall performance and direction of markets. The potential conflicts of interest this may create, coupled with the steady rise in passive investing, were the key drivers of the Sebi (Index Providers) Regulations, 2024, announced on March 8. The regulations follow the recommendations of a working group released for public comment in December 2022 to address the regulatory vacuum that index providers have previously operated, particularly given concerns that such providers have carte blanche despite their critical importance in the financial ecosystem.

The regulations are guided by the IOSCO Principles for Financial Benchmarks, a set of globally recognized standards adopted by index providers around the world. They broadly follow a principles-based approach and leave the intricacies of implementation to the index provider. The regulations target index providers that manage “significant indices” for use in the Indian securities market. Only paid or free indices consisting of securities listed on Indian stock exchanges and tracked by domestic mutual fund schemes whose cumulative assets exceed a specified threshold will be regulated.

Regulations focused on addressing concerns about the discretion exercised by index providers are focused on three overarching themes: conflicts of interest, integrity and accountability.

The possibility of a conflict of interest in the creation and rebalancing of the index is obvious. For example, in private arrangements whereby index providers design bespoke indices for funds, the risk that the index construction will be biased in favor of certain players is inherent and cannot be eliminated. In addition, individuals responsible for index creation may be incentivized to modify the indices in a manner consistent with the commercial interests of the index provider. Information about confidential decisions about index composition or the weighting of index constituents also runs the risk of being leaked to the benefit of front-runners.

To accommodate conflicting interests, the regulations require that index provider activities be conducted through a separate legal entity. In addition, appropriate governance arrangements must be put in place to protect the index determination process and those responsible for index governance must be separated from the commercial function of the index provider. Key provisions include the formation of an oversight committee, separate from the staff engaged in day-to-day indexing activities, to monitor the methodology used to develop indices, review the need for changes, and consider whether such methodology reflects the description of the Indexes. The regulations also place responsibility on the index provider for formulating policies and procedures to address conflicts of interest. These procedures must also effectively control the exchange of information between employees involved in activities with potential conflicts of interest and ensure the confidentiality of the information. In addition, the regulations require index providers to establish a control framework to facilitate early detection of potential misconduct and complaint management within the index provider.

In addition, the regulations also provide for maintaining the quality of the index, the methodology used for index calculation and protecting data integrity. To maintain the quality of the indices, the regulations require index providers to take into account factors that represent the underlying interest that the index seeks to measure, while eliminating any factors that could cause price, rate or value distortions. Index providers have also been given the opportunity to formulate a code of conduct for their data submitters, addressing quality, oversight, conflict of interest management, record keeping and whistleblowing, and to conduct due diligence on such entities. The regulations also seek full transparency in information dissemination to enhance investor confidence by requiring index providers to document and make publicly available information about the methodology used for index calculation and maintenance. This not only enables an understanding of how the index is derived, but also promotes a fair assessment of its representativeness, relevance and suitability as a reference for passive investments. In addition, the regulations require regulated markets and exchanges to ensure equal, unrestricted, transparent and fair access to data to all index providers that have entered into a data exchange agreement with them, in order to avoid inequalities in the timing, format and manner of data processing such information dissemination.

Another issue the regulations revolve around is accountability and disclosure. The regulations require index providers to establish an accountability mechanism by adopting a grievance redress policy to facilitate the filing of complaints about whether a particular index represents the underlying interest it seeks to measure. Index providers are also required to provide a dispute resolution mechanism to resolve all claims, differences and disputes between their subscribers and themselves arising out of their operations in the securities market. In addition to providing timely information to Sebi when requested to do so, index providers must also assess their compliance with the IOSCO Principles every two years by an independent third-party auditor to ensure fairness and full transparency in this assessment. Every assessment report from an independent external auditor must be published on the provider's website.

Given the explosive growth of passive investing in recent years, it is no surprise that the regulator is focusing on index providers that have significant influence in financial markets and are referred to as “power brokers” in Western markets. The principles-based nature of the regulations gives index providers sufficient scope and provides the necessary flexibility to support the dynamics of passive investing. It is important to note that index-based investing has been a driving force and provided benchmarks for providing low-cost and market-based returns to investors, escaping major scandal with one major exception (the LIBOR scandal). Given the track record, a soft approach would be useful in practice if the regulator is only used for relatively serious actions.

(The author is Managing Partner at Finsec Law Advisors. This article was co-authored with Rashmi Birmole and Navneeta Shankar, Associates, Finsec Law Advisors.)