[Ritvij Ratn Tiwari is a 4th-year B.A., LL.B. (Hons.) student at the National Law School of India University, Bangalore]
The Securities and Exchange Board of India’s (“SEBI”) recent decision to withhold its proposal for regulating index providers has placed the spotlight on a significant juncture in the regulatory landscape surrounding the financial markets in India. In December last year, SEBI unveiled a Consultation Paper (“CP”) outlining a prospective framework to oversee index providers operating within India. The main trigger for this regulatory move was the massive growth of passive funds linked to market indices, with assets under management in such index-linked investments crossing Rs 6 lakh crore in 2022. Amidst this exponential surge, SEBI had growing worries about potential conflicts of interest, excessive discretion, and a lack of transparency in how index providers construct these underlying indices.
The core apprehension revolved around the prospect that index providers could wield discretionary power by manipulating methodologies, leading to the inclusion or exclusion of stocks or adjustments to constituent weights. Such alterations have the potential to reverberate across stock volumes, liquidity, pricing dynamics, and investor returns emanating from index-linked funds. Since there was a regulatory vacuum, SEBI proposed to regulate these providers by importing the standards prescribed by the International Organization of Securities Commissions (“IOSCO”) to the Indian landscape. This post aims to assess and critique SEBI’s regulatory proposal. It argues against the creation of a new regulation and instead advocates for integrating index providers into the existing framework of investment advisors, akin to the approach planned by the U.S. Securities and Exchange Commission (“SEC”).
The Backdrop of Passive Investment Funds
Traditionally, a securities index has been a concise snapshot capturing the market’s temperament at a particular instant. Its fundamental role has been informational – furnishing market players with crucial insights for their endeavours. Over the last couple of decades, an evolved role has emerged. Indices now underpin “passive” investing, epitomized by index funds. The defining feature of these funds is that their portfolios are designed to mimic the constituents of the relevant index. Since the index is constructed from a list of constituents and weights, the fund will simply form a portfolio that consists roughly of these same securities in proportions that are approximately the same as those weights.
While index providers disclose the methodology of index construction publicly, they still exercise discretion and administration through subjective interpretations of selection criteria, thereby rebalancing the rules and timing. Despite claims of rules-based functioning, index providers make discretionary decisions in applying those rules that sway returns of passive funds tracking them. Consequently, SEBI embarked on formulating a regulatory structure.
The Regulatory Proposal
The proposed regulation applies to index providers based on the usage of their indices in India – for benchmarking, passive products or derivatives trading. This extraterritorial application is rooted in SEBI’s investor protection principlethat regulations must cover products marketed to Indian investors regardless of the source. However, indices used only abroad escape this oversight based on the territoriality principle, limiting SEBI’s powers to India’s geographical jurisdiction.
The proposed regulatory framework aims to bring governance and transparency to index providers through adherence to IOSCO principles. Eligibility criteria such as minimum net worth requirement, restrictions to prevent conflicts of interest, mandates to ensure index quality, due diligence of data sources, public disclosures and periodic audits are part of the framework. It also posits uniformity in the calculation of an index by using standard factors such as availability and sufficiency.
Index Providers as Investment Advisors
The regulatory discourse, as also highlighted in the CP draws attention to the SEC’s recent inquiry in June 2022. The SEC sought public opinions on whether specific index providers should be considered ‘investment advisers’ in accordance with the U.S. Investment Advisers Act of 1940 (“US Act”). Interestingly, the CP omits any reference to the relevant Indian regulations – the SEBI (Investment Advisers) Regulations, 2013 (“SEBI Regulations”).
There are strong similarities between the definition of “investment adviser” under the US Act and the SEBI Regulations. The US Act defines an investment adviser as someone engaged for compensation in advising others on investing in securities or issuing reports or analysis on securities. Similarly, the SEBI Regulations define an investment adviser as someone engaged for consideration in providing investment advice on securities or investment products.
Both have three essential requirements – providing advice on securities, doing so as a business activity, and receiving compensation for it. The concept of “advising others” in the US Act matches with “providing investment advice” in the Indian regulations. Now, index providers fit squarely within this regulatory ambit based on their role in passive funds. They design market indices that passive mutual funds and exchange-traded funds track to deliver index-linked returns to investors. In doing so, index providers analyse the securities market and provide advice to passive funds on which securities to invest in and their allocation by way of the index composition and weightings. This constitutes securities investment advice. Passive funds invest solely based on the index to deliver indexed returns to investors. Hence, the index is the key advisory input that determines the funds’ investments and portfolios. Index providers also receive licensing fees from passive funds for the use of the indices, meeting the compensation criteria. Further, licensing indices is a regular business activity for index providers. They are engaged full-time in constructing indices specifically for use by passive funds.
Therefore, through their advisory role in enabling passive funds’ security selection and portfolio construction, index providers fulfill all regulatory criteria – securities investment advice, commercial service, and compensation. Therefore, it makes sense that if index providers, due to their involvement with passive funds, meet the criteria of an investment advisor, the appropriate regulation to be applied is the SEBI Regulations.
A Redundant Regulatory Framework
The SEBI Regulations already encapsulate entities that provide investment advice, research, and recommendations on financial products. Index providers supplying indices serving as benchmarks for financial products logically fall under the definition of investment advisers. By using the already existing standard, regulatory harmony would prevail, fostering consistency and coherence across the financial sector. The foundational principles of transparency, conflict of interest management, and client protection embedded within the investment advisor framework are inherently pertinent to the activities of index providers. This integration not only sidesteps redundancy but also streamlines regulatory efforts, optimizing resources for the robust execution of oversight.
The investor advisor regulations mandate registration, certification, disclosures, conduct norms, and record maintenance. These existing norms already address the market risks posed by index providers to a significant extent. Introducing another layer of regulation without evidence of gaps would increase compliance burdens without commensurate benefits.
Imposing a separate set of rules on index providers would lead to regulatory fragmentation by subjecting one part of the investment advisory industry to disparate norms. This goes against the principle of regulatory consistency. A knee-jerk reaction to devising sui generis regulation for index providers in India may further stifle financial innovation and growth in the indexing industry.
The exponential growth of passive funds linked to market indices, coupled with concerns about conflicts of interest and transparency, has triggered this regulatory move. However, the proposition of introducing a new regulatory framework raises questions about its necessity and effectiveness. By avoiding redundancy and adopting an integrated approach, regulatory consistency and coherence across the financial sector can be achieved. As international players like MSCI and FTSE might consider discontinuing their index services due to regulatory uncertainties, it becomes even more crucial for SEBI to adopt an approach that balances investor protection with the facilitation of a conducive environment for financial innovation.
Furthermore, we need to consider the unique complexities of creating indices. The decisions made by index providers can affect not only specific investments but also the entire market’s balance. To strengthen the SEBI Regulations, we could think about improving them based on the IOSCO Principles for Financial Benchmarks, especially focusing on the methodology of index construction and quality.
– Ritvij Ratn Tiwari